Outlook 2022: Asian Credit - China Property rebound? Who will survive and can the damage stay contained?

Key points

• China developers struggle in the shadow of Evergrande’s meltdown.
• There have been some encouraging signs, but risks abound. 
• Participation in China property’s recovery takes a diversified strategy to be positioned in good quality developers that could rebound with more policy fine-tuning.
• It’s important to not miss out on opportunities out of China.

How this sell-off differ from historical sell-offs

Asia credit has been dominated by the struggles of China property developers in the second half of 2021. With bonds repriced significantly after Evergrande’s liquidity strain, China property has single-handedly driven Asian High Yield (HY) spreads wider.

Looking at historical selloffs, both JP Morgan Asia Credit Index (JACI) BB and JACI B spreads had widened significantly during the financial crisis in 2008, EU debt crisis in 2011, China Credit Crunch (coupled with China/US Trade War) in 2018 as well as the COVID-19 sell-off in March 2020 (Exhibit 1). This most recentsell-off 3rd largest sell-off since 2007 in Asian credit market – is different from previous cycles as it originated from the China high yield property space due to policy tightening targeted at China real estate.

Exhibit 1

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Source: AXA IM, Bloomberg, as of Nov 17, 2021.

Combining upstream and downstream, real estate related industries contribute to about 25% of China’s GDP¹ . Also, around 70% of Chinese urban household wealth is tied to property, compared to around 30% in the U.S² . The strategic importance of the property sector in China could be a double-edged sword. While property sector has been a key contributor  to GDP growth, the high property price (especially in tier-1 and tier-2 cities) has worsened wealth inequality, taken up substantial financial resources and also is considered as one of the reasons for low birth rate. According to Nomura, 54% of bank loans went to the property sector at the peak in the 2016 easing cycle (Exhibit 2). To tackle these issues, China is trying to reduce its reliance on property sector and re-allocate financial resources to other sectors, especially the high-tech manufacturing.

Exhibit 2:

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Source: AXA IM, Nomura, Wind, as of August 24, 2021.

This is why we are seeing the unprecedented determination to tame the property sector this time. On top of the policies previously rolled out, such as the “Three Red Lines” to restrict developer leverage and “Two Red Lines” to restrict bank lending to property sector, the tightening in 2021 after the Evergrande event is more about stricter regulation on developers’ project company bank escrow account in local banks, which has triggered liquidity crunch as the flexibility of using pre-sales funding is compromised. While we do not expect the property curbs to be tighter for the next 12 months, a large-scale, broad-based policy loosening is also unlikely.

Timing matters, but quality matters even more

The funding channels for Chinese developers in both offshore and onshore bond markets are still mostly shut. In our view, the only way to turnaround the situation is a clear policy response from the government. This requires 1) further loosening on mortgage and construction loans; 2) some policy fine-tuning in the release of cash in banks’ escrow account; 3) relatively soft property tax policies.

We saw some rebound in the market in November 2021, especially for the higher quality names, following headlines indicating policy easings. For instance, it was reported that banks have been asked to ease curbs on development loans. According to the China Banking and Insurance Regulatory Commission (CBIRC), the country’s banking regulator, the Year-on-Year growth of outstanding bank loans of the property sector reached 8.2% in October (vs 7.6% in September). However, as we understood from several developers, the easings remain quite selective and only those higher quality private-owned enterprises may benefit from it. 

In the meantime, investors started to notice that the newsflows on ‘potential’ policy loosening can be mixed, and oftentimes caused market volatility. This is mostly due to the fact that many easings are from different regulators to address different issues based on their priority KPIs. While these signals may lift sentiment in the short-term, we recognize that developers still have heavy refinancing needs over the next few years.

As such, we remain cautious in terms of  “bottom fishing” for now as we think the market might remain volatile until we see more clarity.

That being said, we believe we are close to the bottom. What could be more critical than timing, is the quality of the “shopping cart”, as we expect the strong players are most likely to benefit from this consolidation process, whereas the weaker names might not be able to survive. To actively respond to the latest market dynamics, we have adopted an extra step in our decision-making by classifying China property names into different buckets based on their credit fundamentals, funding channels access, etc. The idea is to allocate some exposures to the right bucket in a potential recovery scenario. In the end, people tend to forget the binary game for bonds – what does not default will come back to par.

Any spillover outside China property

Spillover effect outside of China property has so far been relatively contained. While China Real Estate HY is down more than 30% year to date³ ,  the broader Asia bond universe has a total return of -2.4%, with Investment Grade (IG) segment mostly flat. Also, while the market took a hit in September and October, it appears to be stabalized in November (Exhibit 3).

Exhibit 3

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Source: AXA IM, Bloomberg, as of Nov 18, 2021.

While the downward pressure on property may heavily weigh on the economic growth, the direct impact on Asia credit, more specifically, on our portfolios, is relatively limited.

China Banks: We think the risk of a systemic banking system stress is extremely low. Instead of regional banks, our exposures are mainly to major state-owned Chinese banks, which are strategically important to ensure financial stability, a key priority in China. The major banks in China have displayed sufficient capital buffers to weather the stress from a China property slowdown. In addition, to limit the property-related risk in the banking system, the regulator imposed “Two Red Lines”  at the end of 2020, which set caps on outstanding property loans to total RMB loans at five bank tiers.   

Property’s upstream sectors: On the real economy front, potential negative impact is conceivable on the property’s upstream sectors, such as construction companies, steel, cement, furniture, etc. About 35% of cement and 25% of steel demand come from the property sector in China⁴ . We expect the negative impact on these sectors to emerge in the second quarter of 2022, due to the lagging effect. Having said that, the property’s upstream sectors only account for a small fraction in Asia credit universe, with roughly 12 issuers (vs 636 issuers in JACI as of Nov 19, 2021) and the majority of them are SOEs, to which we have minimal exposures.

Momentum continues for those well-behaved

While all eyes are on China HY property, it is important to note that the sector currently only accounts for less than 5% (vs about 8% before the sell-off at the end of 2020) of JACI and around 24% of JACI Non-Investment Grade (Exhibit 4).

Exhibit 4

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Source: AXA IM, JPM

Outside China, Asian credit still offers good diversification. We continue to favor the Indian renewable energy names as their cashflow generation is underpinned by long-term take or paid contracts. In addition, this sector benefits from continuous global inflows given the increasing ESG focus of global funds.

We also see some upside in the Indonesia property space,  particularly in the mass market segment. We believe the property upcycle will continue on the back of record low mortgage rates and extended government stimulus to December 2022. We think the momentum may remain strong in 2022 but selectivity is key.

We also favor the Asian banks, which continue to display solid fundamentals in terms of capital and liquidity positions, while profitability may improve in a rising rate environment.

Global investors undeterred

Despite the significant sell-off in the China property space, Asia hard currency bonds still attracted large inflows. Over 66 weeks, Emerging Markets Asia ex Japan hard currency funds only recorded four weekly outflows⁵ . We expect the trend to continue in 2022, with the demand coming from global investors chasing for yield.

In addition, with U.S interest rates biased towards the upside, Asian credit – with its higher spread buffer and shorter duration –  could potentially help minimize negative capital return from further rate hikes .

On the IG front, JACI Corp IG is yielding at 3%, similar to US IG (JULI exfin), however, the duration is only 5.8 years compared to 9.7 years in the U.S. On the HY front, JACI Corp BB is yielding at 8.3% with a duration of only 2.7 years, vs US HY BB’s yield-to-worst of 3.6% and duration of 4.3 years⁶ .

Forward looking: positioning for 2022

On the IG front, With a focus on stable returns, we will emphasize carry, diversification and low volatility while maintaining an average Investment Grade rating profile. We will also position in favour of issuers with strong ESG features, an area we expect to grow strongly in 2022. Looking forward, the highest quality property developer credits would also provide some total return opportunities and decent carry for the strategy. With the monetary tightening cycle in sight, we think some prudency is necessary by staying short in duration.

With the HY end, we will focus on spread compression opportunities to enhance total returns. Following the recent sell-off, we think default risk may be overstated in some issuers’ credit spreads. 

Note: All stock/company examples are for explanatory/illustrative purposes only. They should not be viewed as investment advice or a recommendation from AXA IM.