Senior Fixed Income Strategist
Summary: With Beijing reluctant to intervene with a bailout, the best-case scenario for Evergrande's bond investors is a restructuring of its debt. A liquidation could also be an option, but it would be a much longer process. A default of Evergrande poses a severe threat to the Chinese real estate market and smaller banks. However, we expect it to be limited to the Chinese market.
What is Evergrande, and why is it important?
Evergrande is China's second-largest property developer, which quickly turned from “the world’s most valuable real estate company” in 2018 to the “world’s most indebted company” recently.
To fuel growth amid the Chinese real estate rally, the company leveraged hefty amounts of credit. Little it knew it would have faced the Covid-19 pandemic and a long-term slowdown in the Chinese property market, provoking a fast deterioration of the company's fundamentals. This year, a debt squeeze led to suppliers' payment delinquencies, putting the company at risk of default.
The Chinese market faces the problem that Evergrande is a bellwether for the real estate sector with over a thousand projects across the country and total liabilities of over $300 billion. A default poses funding problems to Chinese real estate corporates and the Chinese banking sector, which inevitably increased exposure to the real estate giant during the past decade.
As Citigroup indicated, Chinese developers will have problems refinancing debt in the onshore market because of low demand. Refinancing in the offshore market would also be unviable due to the recent spike of funding costs for Chinese high yield corporates in USD. According to Bloomberg Barclays Indexes, yields rose from roughly 8% in May to 13.70%, the highest since March 2020 as the Covid-19 pandemic was hitting the market.
The property market will undoubtedly go through a period of adjustments as the collapse of Evergrande could suppress property values. Yet, we do not expect the government to tolerate a full-blown out collapse as more than three-quarters of household wealth in China is tight up in the property market.
Banks are also vulnerable amid an Evergrande's default. They would see their balance sheets deteriorate amid an increase in non-performing loans.
What should I know above Evergrande bonds?
Evergrande onshore bonds' trading has been suspended for a day, promising that it will resume tomorrow. The press release explained that the trading suspension serves to inform all investors about the company downgrade to A from AA, which for China Chengxin International is the lowest investment-grade rating. When a company is rated below AA, bonds must be traded via bid-ask and block platform rather than auction. It’s a move that prevents small investors from making speculative investments. Some expect the bonds not to resume trading at all and to be equitized. That explained the 8% plunge in the stocks, taking the securities to a fast track to 0.
Things are different for offshore bonds in the US dollar, which trade around thirty cents on the dollar. The first bond to mature is the Evergrande 8.25% March 2022 (XS1580431143). Although the company doesn’t have bonds maturing this year, the company was scheduled to make interest payments next week of $83.5 million for a dollar note and $36 million for a local note. Hopes for payment have now faded as Chinese authorities have told lenders not to expect interest payments next week.
At this point, there are two scenarios for bond investors:
What can we expect from Chinese authorities?
What we do not have to expect is for the Chinese government to bailout the company. During the past year, Beijing allowed several state-owned enterprises to default, showing a change of mentality about defaults. In the past, it was assumed that the government would step with a bailout if a state-owned enterprise defaulted. This year the government showed that it steps in only if contagion risk is identified, such as the one we have witnessed to this year with Huarong Asset Management. Huarong's default had the potential to shake up all the economy; that's why an agreement was arranged with Critic Group and other state-owned investors to inject $7.7 billion into the company.
In the case of Evergrande, it doesn't look like the government is willing to intervene. Firstly, Beijing wants to ensure sustainable growth within the real estate industry, eliminating overleveraged companies. Secondly, a bailout for $300bn would only transfer the debt from Evergrande to the government, producing volatility in the Chinese government bond market. The government can try to make the default as painless as it can by encouraging debt extensions and pushing credit committees, but a bailout doesn't look likely. A new fragmented world order can render some of today's infrastructure obselete, but it also calls for massive new investments across the globe, which requires a new set of strategic and tactical investment strategies.
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