Chinese high yield: buying deep value is always scary

We think this is a significant opportunity for investors to pick up an uncorrelated distressed asset. Though we have to admit it always feels scary to buy deep value, we think high-yield Chinese property bonds could be the top asset pick for 2022.

Throughout the rout in China’s property sector, our emerging-market economists have maintained a very consistent line of argument: the consensus is underestimating the likely hit to growth associated with this squeeze on developers, and the government’s threshold for intervention is further away than the market thinks.

We believe this changed last week. The consensus seems to have finally capitulated, with a number of high-profile downgrades to growth outlooks towards our number of around 4%. We see this as a potential line in the sand for the government. We agree that the aim to reduce the reliance on real estate as a key growth driver is set to continue, but growth below 4% puts long-term prosperity goals at risk and is not consistent with the need to maintain a robust jobs market.

But GDP growth isn’t the only thing that matters here. The property sector is undergoing a sizeable credit crunch, several developers have missed coupon payments, and home sales are down 38% year-on-year. Like in every credit crisis, increased nervousness among investors and rising risk premia make liquidity evaporate like dew in the desert. Liquidity problems can become systematic solvency problems when access to refinancing dries up for long enough, hence the collapse in asset prices and investor confidence.

Bad versus incorrect

However, we are a firm believer in the idea that there are no such things as bad assets, just incorrectly priced assets. We therefore started working with our emerging-market economists and the China credit specialists from LGIM’s high-yield team to determine whether the collapse in Chinese property bonds has gone too far.

As Erik blogged before, we do not find strong evidence of a property bubble in China. Moreover, the negative performance in China’s high-yield corporates is in excess of recent periods of significant stress and comparable to the selloff during the financial crisis. These periods of intense stress are generally followed significant rebounds. We believe the downside on the bonds to be reasonably limited at current prices, on conservative assumptions of recovery rates.

With the market having adjusted significantly, we are also seeing the first signs of a policy response, with relaxed restrictions for homebuyers’ access to mortgage finance and a dilution of the “three red lines” policy that has hampered liquidity for highly leveraged developers. It has been reported that high-quality developers will be able to place bonds directly with domestic institutional investors, including banks.

Recently, the People’s Bank of China took the unusual step of publishing monthly mortgage lending data for the first time, seemingly to highlight the nascent recovery at the start of the fourth quarter. The state-owned Securities Times opined that “for real-estate developers, the feeling of the recovery of the financing environment will become more and more obvious” going forwards. We also see signs that enough of the bad news is priced in from days of people forced-selling entire portfolios of bonds and markets rallying on no firm news.

Finally, we believe the government aims to rein in, not kill, the market. We don’t think it’s sensible to doubt the authorities’ ability to underwrite the near-term growth outlook when they see fit. For us, this all adds up to a signal that we are hitting a policy inflection point. Although buying deep value is always scary, we have decided to increase our exposure to the Chinese high-yield bond market.