Evergrande and China’s property sector: an EMD manager view
Following the news about Evergrande* this week has been a rollercoaster experience: on Monday, a looming deadline for an interest payment on its debt led to a global market selloff amid fears about contagion; on Tuesday, there were reports that the property developer had missed some payments due to banks; and on Wednesday, the company had apparently negotiated a deal on paying some bond coupons, which supported a recovery in risk assets.
What should we make of all this? As someone who has invested in Evergrande bonds, I wanted to share my perspective. At this point, though, I should emphasise that I am a bond manager – not an equity investor. I look at fixed-income securities’ risk/reward profile over their tenor, focusing on the issuer’s fundamentals and market technicals; I’m not looking to be a shareholder in perpetuity.
So, with that said, what made me conclude that certain Evergrande bonds could offer a worthwhile potential return as a small part of a diversified portfolio?
I believed that Evergrande could continue to aim to meet “the three red lines” set for it (such as reducing various leverage ratios) during the course of this year and next year. Progress was being made, and furthermore the group faced no imminent funding needs in the international (offshore) markets for the second half of this year. Management was instead looking to raise cash via selling or reducing its exposure to non-core assets. Finally, the valuations looked attractive, even allowing for Evergrande being seen as one of the more speculative credits in China’s high-yield property landscape (despite also being the largest real-estate corporation in China and one of the largest in the world).
We constantly monitor these risk/reward dynamics, however, and acted when the outlook changed. We started reducing our already-small Evergrande exposure in July of this year as rumours emerged that it had not been meeting their account payables in a timely manner, and that the Chinese government was telling Evergrande to get its house in order. Importantly, the price action of the bonds was also poor, so we exercised a stop loss to protect our clients’ capital and ultimately incurred no meaningful impact.
In terms of determining the outcome at Evergrande, the question remains whether the government can “ring fence” this credit effectively. Our base case remains that China will orchestrate an orderly restructuring rather than a messy liquidation. Clearly, China’s government imposed the three red lines in order to reduce leverage in the property sector and reduce systemic risk to the economy. It is uncertain what additional measures China will take to keep the “Common Prosperity” goals intact with respect to the housing sector, without allowing Evergrande risk to spill over into the country’s real-estate sector (which represents circa 25% of GDP).
While the expectation is that the Chinese authorities will not let the whole sector collapse and will eventually step in, there is no timeline regarding the scale and timing of such an intervention. That increases worries around contagion and weaker Chinese growth, which adds to existing concerns around growth having peaked, inflation stickiness, tapering, and how COVID-19 evolves as we head closer to winter.
These issues notwithstanding, we remain confident in the broader opportunity set in emerging-market bonds. Emerging markets continue to show higher economic growth, smaller deficits, and lower debt levels compared with developed markets. At the same time, we see supportive technicals for emerging-market debt (including healthy cash balances, cashflows and valuations) and strong multilateral support for emerging markets, plus the ongoing appeal of the asset class while so much of the developed world’s bonds trade on negative yields.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.