China’s debt levels have surged since the global financial crisis and now sit at over 300% of gross domestic product (GDP), as of December 2020. The majority of that new debt has come from households and non-financial companies, which is why the Chinese government has made deleveraging a priority. Moreover, to help rein in the very high debt levels in the US$60 trillion China real estate market—which is likely the largest asset class in the world—more than 400 new regulations have been announced this year. As such, these regulations have caused Chinese junk-rated property developer bonds to underperform this year—and in the case of Evergrande, stoke concerns about broader economic spillovers.
“Default risk has clearly risen within the Chinese real estate market,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “However, we still think policy makers in China will prevent broader systemic risks to spread due to the deleveraging efforts currently taking place.”
As seen in the LPL Research Chart of the Day, yields on Chinese junk-rated bonds nearly touched 25% before falling recently. So far, this month has been one of the worst months in decades for the Chinese high yield market as the selloff in the property developer markets continued—the real estate sector makes up 66% of the high yield index. Additionally, of the $142 billion of U.S. dollar-denominated bonds trading at distressed prices (generally defined as debt with yields over 10%), 48% were issued by Chinese real estate companies, according to data compiled by Bloomberg. However, that the China investment-grade corporate index hasn’t responded in-kind provides us comfort that the spillover effects are, at this time, limited to the junk-rated property developer issuers. Property developers make up over 11% of the investment-grade index and while these companies have seen their yields increase, they haven’t increased nearly has much as their junk-rated counterparts. In aggregate, yields on the investment-grade property developers are still less than 5%.
Interestingly, the most recent move higher in junk-rated yields wasn’t related to Evergrande, which has likely already been priced into markets. Rather, a much smaller property developer, Fantasia, told investors that it wasn’t going to make a bond payment when it was due despite having the necessary cash on hand to make the payment. Bond investors are generally concerned about an entity’s ability to pay its debts but also its willingness to pay its debt. That Fantasia decided not to pay its obligations caused investors to question the commitment of the property developer market broadly in servicing its financial obligations. That breach of financial responsibility caused the People’s Bank of China (PBOC) to finally break its silence on the ongoing selloff in the property developer market by urging real estate developers to pay its bills on time.
Additionally, the PBOC finally commented specifically on the potential spillover crisis at Evergrande and said the risk was “controllable”, which likely means there won’t be a bailout per se but we do expect the PBOC to ring-fence the risks and prevent them from spilling over into the broader financial system and the economy. Time is running out on Evergrande, though, as the company could officially be in default on October 23 after the payment grace period runs out.
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