Outlook for China’s Property Sector

The article below is from our BRIEFINGS newsletter of 03 March 2022

Are there signs of healing in China’s property sector? When the indebted property giant China Evergrande Group started defaulting on its payments last fall, fear spread that a potential bankruptcy would trigger a broader crisis in China’s debt markets — and global markets more broadly. Several months later, defaults on Chinese property bonds continue to remain elevated.  We spoke with Kenneth Ho from Goldman Sachs Research and Salman Niaz of Goldman Sachs Asset Management for their views on Chinese property credit and the Asia high-yield sector more broadly to understand what has changed.

Property developers’ debt-repayment problems have been among the biggest issues roiling Asia’s credit markets over the past year. Kenneth, as Goldman Sachs Research’s Asia credit strategist, how are you thinking about the China property high-yield market today?

Kenneth Ho: Credit conditions remain very tight. It feels that the market is still under a lot of stress, as a lot of easing measures from China policymakers have been piecemeal and haven’t led to a big impact on the physical market, and companies are still having trouble making payments. Our expectation going forward is that you would get more easing but at the same time you get more defaults. In 2022, we have a base-case estimate for a China property high-yield default rate of 19%. Last year was over 28%, so it’s still at very elevated levels of defaults. Saying that, we do expect the stronger companies to survive and these bigger, stronger companies are ultimately going to be the main beneficiaries of policy easing as lenders feel more comfortable extending credit to stronger companies. This will create winners and losers.

It’s hard to speak in terms of opportunities — it continues to be a difficult environment. We do think you can generate decent returns from China property high-yield but the risk around that is very high. Our view is to stay at the very high end and be diversified and wait for news to come before making a more definitive directional stance. You don’t want to be overly concentrated on specific issuers as idiosyncratic risks remain high. So it’s a neutral view; stay up in quality and be diversified.

2022 hasn’t got off to an encouraging start. How much more pain could China’s property market see — and could we turn a corner?

Kenneth Ho: You have to ask, what’s the ultimate aim here? It’s a medium-term deleveraging of the property sector. This is after a massive credit boom in China, post the global financial crisis. It’s trying to deleverage the property sector without causing a systemic crisis. Policymakers are being very pragmatic as we move along, introducing policy easing to cushion the downside effects without deviating from their medium-term goal.

It’s likely going to be volatile in the coming months. The physical market likely won’t stabilize until the later part of this year, which means there will be an extended period of volatility. We think the key here is on policy. Our 19% estimate for a China property high-yield default rate this year is based on more piecemeal easing which will eventually stabilize the sector, but it is a long grind. More defaults will come. And if easing comes at a slower pace, more companies will default and it will be closer to our downside case of 31.6% for default estimation. It all really hinges on policy outlook. It’s been difficult — the way policy has shifted in the last year has been a surprise to many market participants.

Salman, let’s get your thoughts on the investment opportunities given your role as head of Asia Credit for Goldman Sachs Asset Management’s Emerging Market team. How are you approaching investment opportunities in Asia’s high-yield sector more broadly?

Salman Niaz: We approach the asset class recognizing structural value and attractive total return potential, but with heightened uncertainty in the near-term, emanating from the Chinese high-yield property sector which continues to remain under significant pressure.

Utilizing our preferred benchmark as a starting point, which benefits from a relatively high degree of regional diversification and based on a range of potential default rate and recovery scenarios, we calculate potential cumulative return expectations over two years of between -2% and 24% (as of January 31st).

To get -2% you have to believe that almost two-thirds of Chinese property high-yield will default during 2022 from here, and expect a 10 cent recovery for every dollar invested. To get to a 24% return expectation, you have to believe that a quarter of Chinese property high-yield bonds default this year.

This leaves us with two important conclusions for investors. Number one: diversification is critical to help mitigate downside scenarios. And number two: If you are well diversified, the asymmetry of returns is heavily skewed to a positive return scenario (the downside is minimal even in a disaster scenario). But with the elevated default risks in the sector as Ken just explained, diversification is the way to invest.

We evaluate the return expectations we have for the market over a two-year cycle rather than one, as the visibility on restructurings and recovery is likely to be much higher in 24 months than in 12. While it may be early to get too excited about the investment opportunity in China property high-yield bonds, a recent restructuring proposal made by a Chinese property high-yield company highlights the potential for high recoveries. A mid-sized developer that defaulted in Q4 2021, has offered a par-for-par amend and extend proposal for offshore bond holders offering a package that could be worth 65-75 cents of present value assuming high discount rates. If other China property companies follow suit — and the sector stabilizes — the total returns could well be towards the high end of the range mentioned above.

How are you positioned within your portfolios? And what are the risks to be aware of? 

Salman Niaz: Putting the global macro risks aside, the most elevated risk elements in expected returns from Asia high-yield include: a lack of precedent in terms of restructuring and recovery of this scale. In Asia — especially in China property — this is an unprecedented situation, so we cannot overly rely on historical experiences. The other risk is that this market requires government policy support, and for investors it’s hard to predict the timing or nature of potential policy announcements.

We find tremendous opportunities in Asia beyond China, particularly in India, Indonesia, the Philippines and Vietnam. We’re particularly focused on attractively valued non-cyclical businesses across the renewable utilities and TMT sectors that we believe are undervalued given their resilience. We are cautiously optimistic on return outcomes in China property, however the risk environment does not lend itself to taking high concentration risk in any individual situation, and we believe a patient and selective approach is warranted. That said, very high yield levels justify being invested. 

Finally, what are some of the issues that you’ll be watching that could impact your investments in the sector? 

Salman Niaz: In China, we are closely monitoring policy announcements but, crucially, the real-world impact of these policies. There are three things we are watching: signs of stabilization in the physical market; an indication liquidity conditions are improving for developers; and company access to funding markets and for signs of onshore and offshore bond markets opening. Despite being announced in December, it is worth highlighting that Chinese policy maker support for the sector is now starting to show signs of implementation across cities; we are seeing reduced home purchase restriction, lower down-payments and encouragement of banks to lend to the sector.

Finally, for global investors, where policy uncertainty is often highlighted as a key challenge, we would note that policy risk exists across the investment landscape. After all, it’s very difficult to anticipate the Fed, or how political cycles in Brazil or Argentina, or constitutional reform in Chile, may unfold.

In an environment dominated by a focus on the Fed, commodities, and European geopolitical risk, Asia high-yield and China property risk can contribute to diversification at a portfolio level given its unique and idiosyncratic risk factors.