Yes. In recent weeks, several Chinese property developers have defaulted, and spreads on Chinese high-yield bonds have widened roughly 600 basis points (bps), taking their year-to-date loss to 18%. While default rates are likely to rise further from here and recoveries will be low for some bondholders, we believe this distress has created opportunities for credit funds with the right skillsets.
Debt repayment difficulties for some developers should not come as a surprise. For some time, the government has been concerned about the problems of excess property investment and diminished housing affordability, especially in urban areas. Last August, the government rolled out new regulations intended to reduce debt levels and reliance on short-term borrowing by developers. Given that more than 90% of developers failed at least one of the “three red lines” 1 when they were implemented, a certain extent of deleveraging and difficulty accessing funding sources was always to be expected. The crackdown was also intended to help curb the shadow lending industry, which the government views as potentially threatening to financial stability.
Earlier in 2021 a handful of smaller defaults by other Chinese property developers went mostly unnoticed; however, last month’s failure of heavily indebted Evergrande to make a payment on some of its $20 billion in offshore bonds sparked concerns over a potential debt crisis given the company’s $300 billion in liabilities and publicly listed developers’ overall $2.5 trillion. Fears were compounded in early October as other small developers defaulted, with some analysts suggesting the default rate for the sector could top 20% by year end. The wreckage across the $270 billion Chinese offshore high-yield market (of which roughly half was issued by property developers) has been significant, with spreads peaking at 1,700 bps before calming in recent days.
The broad-based nature of the sell-off (which includes onshore debt) has created attractive opportunities. One immediate opportunity created by funds scrambling to raise liquidity (or forced to sell downgraded bonds) is potentially short lived. Another long-term opportunity involves rescue finance and distressed strategies aiming to capitalize on developers that will need to tweak capital structures. Property developer deleveraging may be a multi-year story, but intermittent government intervention (e.g., the recent loosening of mortgage credit) may mean the opportunity set ebbs and flows.
Investors tempted to bargain hunt should recognize that for both structural and political reasons, offshore creditors are likely to be treated less favorably than onshore, and recoveries may be limited in some cases. Using Evergrande as an example, offshore claims are subordinate to claims from onshore creditors, such as pre-paid buyers of apartments, contractors, and local banks (especially given government equity stakes in the latter). Thus, despite significant levels of assets, recoveries for offshore creditors may be minimal. Along these lines, we’d note that this week Evergrande made a scheduled interest payment to onshore bondholders.
Current bond prices may also reflect a discount for opaque balance sheets and complex corporate structures. Financial struggles of some developers have surprised investors as reported financials suggested operations were profitable. One explanation for some recent defaults may be that local government authorities have barred some developers from moving funds from local special purpose vehicles (SPVs) back to the parent company. This has impeded debt servicing but is not a sign of operational distress. Still, another may be that other developers have hidden liabilities in the form of private placements or investments in joint ventures.
Given these dynamics, investors should try to access the market through skilled private credit specialists that can analyze the claims of onshore and offshore liabilities, as well as negotiate their interests through potential restructurings. The most successful approach may be a multi-faceted one: credit opportunities funds can pick through the wreckage of publicly traded bonds and loans selling at steep discounts, as well as offer rescue finance to otherwise healthy businesses that have seen their access curtailed to public markets. Having the right local relationships might prove key, as the ongoing deleveraging of this sector (and related topics such as whether large employers are even allowed to default) will entail navigating numerous competing interests.