China opportunity

WEBINAR: China real estate update

Adrian Petreanu, Portfolio Manager for Emerging Markets Corporate Debt, and Gustavo Medeiros, Ashmore’s Global Head of Research discuss recent developments in the China Real Estate market and the opportunities they believe we will see in the Asian High Yield bond market for this year.

The discussion covers topics such as:

  • The origin of the China Real Estate bond market crash
  • How big was the impact
  • Why the market started to recover in late 2022
  • Our outlook for 2023 and longer

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Transcript is available below.


Stewart McAndie: Good afternoon, everyone. I'm Stewart McAndie and welcome to the Ashmore China Real Estate Webinar. Following a big move in the Asia high yield sector, we're joined by Gustavo Medeiros, Head of Research at Ashmore, and Adrian Petreanu, Corporate Portfolio Manager in the Corporate Debt team, to discuss recent opportunities in the China real estate market, and opportunities for further recovery through 2023 and beyond.

The discussion should take around 15 to 20 minutes, and if you have any additional questions on top of the ones Gustavo will be putting to Adrian, I'll ask them at the end. So, with that, I'll hand over to Gustavo. Thank you, Gustavo.

Gustavo Medeiros: Of course. Thanks, Stewart, for the kind introduction. This is Adrian's show, but I'm just going to give a very brief background to the discussion. The normalisation of the Chinese real estate market should be talked about within a broader context. Chinese assets, particularly equities, underperformed significantly in 2022 for three broad reasons. First, due to the very challenging relationship between the government and tech companies (which started in October 2021, when the IPO of Ant Group was cancelled), second, the tightening of liquidity conditions in the real estate market caused by the ‘three red lines’ policy, and third, the zero COVID-19 strategy that impaired consumer mobility. These were all part of the overall negative macro environment for China last year.

Now, the change of the composition of the Politbureau following the reappointment of Xi Jinping for another term, allowed for an improvement in the relationship between the central government and technology companies. That happened just before a U-turn on zero COVID-19 policies, leading to greater mobility, as well as a much better environment for the real estate sector. Therefore, for 2023, our global macro view was that authorities would keep a pro-growth regulatory and a macro-prudential stance, after years of tightening. So, with that backdrop in mind, I'm going to ask a few questions to Adrian, specifically on the real estate market, which is a key component of Chinese GDP growth and the Chinese fixed income market. Adrian, can you kindly give us some broader context on the real estate credit crisis in 2022?

Adrian Petreanu: Hello, Gustavo, and thank you very much for your questions. And hello, everyone, and thank you for participating on this webinar.

Indeed, we are now more than two years into this property crisis in China. Going back to how things started, after the start of the COVID, and with China putting a lot of liquidity into the system to support the economy, towards the beginning of the second half of 2020, Chinese policymakers came up with a set of policies representing regulatory and financial tightening of the liquidity environment for the property sector. The most infamous of these rules were the three red lines, which, initially, were seen in the market, including ourselves, as a good way of fixing the high leverage problem faced by many real estate companies. These companies were likely to increase that leverage even farther, given all of the liquidity that was coming into the system.

Initially, our read was that the policy was quite logical and that, over the course of the next two to three years, would reduce leverage in the system. Evidence in the first half of 2021 suggested property sales were accelerating, and at the same time, real estate companies were saying they were meeting their deleveraging goals. Some companies even announced compliance the three red lines.

But we moved to a second stage of this crisis after the release of financial reports in August 2021, when it became apparent that while these companies were able to retire bond debt, at the same time they were accumulating heavy balance sheet obligations, especially in the form of trade payables and payables to their subcontractors.

Towards the end of 2021, that led to a crisis in some of these more highly leveraged companies. Evergrande was the clearest example, but also later in the year we had Kaisa and Fantasia, which had all gone into default. Nevertheless, all the way to the end of 2021, it felt that this was a problem for the highly leveraged companies in the system, and that it wasn't a systemic problem.

We started 2022 with expectations for a turnaround for the sector and for liquidity to improve. Nevertheless, 2022 proved a very big disappointment. We started with more expansion of the COVID crisis in China, with lockdowns enacted across several big cities. In essence, when the rest of the world was moving away from pandemic, China – which up to that point was a poster child in terms of dealing with infections and cases – had started to move backwards. That hurt confidence and led to a further decline in property sales.

The liquidity crunch expanded to pretty much the entire sector, getting to a level where 60% to 70% of private developers in the high yield part of the market went into default.

Everything culminated with the big disappointment (from the market’s perspective) of the Communist Party Congress. With hindsight, arguably markets went into this event with too-high expectations for new policy announcements. But the congress has never really been the forum for the Chinese government to introduce new initiatives or make big announcements. Instead, it is about looking back on the achievements of the five-year plan.

Nevertheless, post-Congress was the moment of capitulation, where we saw new lows for the real estate sector. And to everyone's surprise, immediately after the Communist Party Congress, there was a strong push for reopening the economy and also a set of rules that led to an improvement in the liquidity conditions for the sector. These are really the four key stages of this crisis that has really lasted more than two years now.

Gustavo Medeiros: Okay. So, in recent months, we've seen a much better price performance, or at least a rebound from very low levels of valuations. What was the key factor that has led to this growing value so far?

Adrian Petreanu: You're perfectly right, Gustavo. The last few months have seen a very significant improvement in market sentiment and in valuations. Looking back, I would say there were really two factors which led to the significant rebound in the market.

One was to do with that capitulation I mentioned last October. Following the market disappointment with the Communist Party Congress, valuations reached lows I personally had never seen in over 20 years of investing in corporate bonds.

We had many bonds trading in single digits, way below what normal ‘recovery’ value. We also saw a lot of liquidations of funds. We reached a point in early November where 80% of the bonds in the high yield real estate part of the market were trading below 20 cents to the dollar. So, on one hand you had this complete undershoot of valuations, while on the other hand, you had this big announcement of China reopening, after an extremely disappointing year, which lifted equity market sentiment.

And at the same time, there was a big announcement of a 16-point directive from the People’s Bank of China (PBoC) and the regulatory body for the real estate market, which came up with very strong encouragement for banks to roll over loans which were coming to the market over the next six months for one year, and was also telling the banks that they would not have to reclassify those loans. While technically these were non-performing loans, the regulator was not planning to increase the capital requirements for these loans. So, these were very supportive statements from the regulator.

There was also the strengthening of the previous three arrows policy which had ensured companies were going to get access to raise capital in the renminbi market. Of these arrows, the first is the ability to issue bonds in renminbi, even to the extent that the government is going to provide government guarantees, ensuring that companies in the real estate sector can borrow at levels below 5%, and ultimately opening up the route for raising equity capital for these companies, both by issuing shares, but also by allowing state-owned companies (SOEs), to buy stakes in these private companies. So, these elements all contributed to this significant improvement in sentiment.

Gustavo Medeiros: Understood, that's clear. Thank you. You mentioned that about two-thirds of Euro bond issuers had defaulted. Are there any cases where the issue is close to that restructuring announcement or agreement?

Adrian Petreanu: Indeed, we had two very bad years in terms of default. We had 12 issuers defaulting in 2021, with about $43 billion of bonds – a significant amount – in default. Obviously, Evergrande was a very high issuer of bonds, but in 2022, there were 56 issuers defaulting among the biggest being Sunac and Shimao. But all the way up to the Communist Party Congress, there was frankly very little and very slow progress in terms of negotiating with the companies and moving towards a debt restructuring.

A lot of the time, the management of the companies were citing the lack of liquidity and the lack of visibility on the other side. At least while companies are in default, they don't have to service the debt. Once you come out of the default, you want to have a plan and you want to have access to liquidity and visibility over self.

Now, with the new set of policies announced after the Communist Party Congress, that set up incentives for the owners and the management of the company, really a 180-degree turnaround!

We have seen a lot of these companies now accelerating the process and wanting to move as quickly as possible out of the restructuring, because one thing that the Communist Party Congress said is that they will be helping those companies that help themselves. So, if you are in default, if you're not able to negotiate a solution to the creditor, it's going to be difficult to access these financing solutions that the government have put in place.

The restructuring process has definitely accelerated now. We managed to get agreement with companies on two of those restructurings. We believe that hopefully by the end of the first half of 2023 we might have four or even five restructurings, at least agreed, if not completed. It takes about two to three months to complete the restructuring once agreed, because it has to go through a voting system, and then has to be implemented through the courts. But in the last month, we've seen more progress than in the whole of the last year, in terms of moving towards restructuring.

And in situations where restructuring is announced (in Fantasia’s case, in January), just because terms are agreed and before restructuring is even completed, we've seen the bonds jump 50% in valuation terms, albeit from very, very low levels. You can clearly see the impact that these restructurings can have on the valuations of the bonds.

Gustavo Medeiros: Very good. So, the beginning of the restructuring process is already leading to a rebound. How do bond prices look today, and how does it compare with our own expected recovery value?

Adrian Petreanu: That's a very good point. It's something I get asked quite often because everybody knows we had a significant rally in the market. Where are we now? We are definitely off the lows, but still about 80% of the bonds by market cap in the China real estate high yield part of the market are priced below 40 cents. At the worst point, we had 80% priced below 20 cents. Half of these 80% of the bonds priced below 40 cents are still priced below 20 cents. So, we have had a significant recovery, but from extremely distressed prices. In November we bought bonds at the beginning of the month at below two cents to the dollar.

Now, going to your second part of your question about the recovery value, we believe that we can achieve recovery values of around 40 to 50 cents to the dollar. Where we are we are involved in these restructurings we are trying to get the companies out of default and into a position to benefit from the expected improvement in sentiment, and pick up themselves.

We want to give these companies two years of runway of minimum requirements in terms of liquidity for them to support their debt. So, we are pushing maturities five, seven years out into the future. We are cutting coupons, and in some situations, we are talking about offering the company the ability to pick their coupons in the first one to two years.

We want these companies to use whatever cash they can generate to pay down debt, to buy back their bonds in the market because they are really trading at very, very depressed level. Ultimately, we want to be aligned with what the government wants to see, which is for construction to resume and for those units to be delivered in time.

But I want to stress that our intention is not to exit those bonds at 50 cents or 40 cents immediately after the restructuring. Our intention is to leave these companies on a better financial footing, with the ability to support their debt structure for the next two to three years, and to benefit from what we expect is going to be several years of recovery.

As we've done in the past when we restructure bonds, we think that if we do our job right with the restructuring, there is also significant future upside, post the immediate recovery. Now, of course, this is a very wide universe of issuers. We'll be trading out of some of the positions and buying back into others, but we want to keep these exposures for what we believe is a two- to three-year period of significant recovery in this space.

Gustavo Medeiros: Very good. Okay. So, broad context here. Obviously, while China was in lockdown, property sales declined significantly, but saving rates also increased, right? We  had some numbers from the National Bureau of Statistics and from the PBoC, which tend to churn out a fantastic dataset compared to what we get in other countries. But the broad impression is that saving rates have increased from around 30% in 2019 to around 33% over the last three years. So, that means that accumulative 6 trillion renminbi might have been accumulated in savings within the last three years, primarily from the urban population, whereas, saving rates for the rural part of the population remains relatively subdued. Against that backdrop, what is the outlook for property sales and have the numbers already started to recover?

 Adrian Petreanu: You're perfectly right, Gustavo. There is money in the system. There has been a huge accumulation of savings during the pandemic period. What, unfortunately, is lacking in the system is confidence. Property sales are really the key to this puzzle. I mean, we can do all we can in terms of buying time for these companies, and we can help them with their debt restructure, but we need to see confidence coming back into the system.

It's been a very difficult two-year period. People are very disappointed by the policy of the Chinese government, and many have lost confidence in their government. Even President Xi in a recent article said that the economy is suffering from a weak demand side, especially in the property sector. Also, it's very difficult to say whether we have started to see a turnaround in property sales, as last year we had a Chinese New Year in February, whereas this year the Chinese New Year was in January. It’s therefore difficult to compare January numbers this year with January numbers of last year. For a good comparison, we need to have the cumulative January and February numbers.

I believe that by the point we're going to get January and February numbers, we are going to see at least an improvement in the Tier 1 cities. Tier 1 cities are those cities where you generally have a wealthier population, and where you have more confidence. Also, in terms of recent trends we have seen some stabilisation in the prices in the Tier 1 cities which signals that demand there is picking up quicker. And in terms of the mobility data that we are seeing, we have seen populations slightly declining in the Tier 3 cities, and population increasing in the Tier 1 cities. Many people have lost their jobs during the pandemic, so it's normal for people to migrate towards the bigger cities with the bigger economy.

So, I think the first green shoots of recovery in property sales are going to be seen in the secondary properties and in the Tier 1 cities. But we are going to see also more government support, especially from the regional governments, in these areas with Tier 2 and Tier 3 cities. Because ultimately from the government point of view, they want two things. They don’t want people unhappy with not getting delivery of their apartments in time, and they also want to see a resumption of land sales. Selling land is really the main source of funding for these local governments. The SOEs have stepped in and bought some land from local governments, but the private sector has really been shying away from buying land. You need an increase in land sales to come back, and for the money to start flowing back to the local government. It is really in the interest of the government to support this process.

Gustavo Medeiros: Understood. Yes, indeed some high-level presale numbers are already suggesting some recovery volume in Tier 1 cities. I’ll now open up the floor to questions. Stewart, are there any questions from the audience?

Stewart McAndie: Yes, there are, specifically to the restructuring point. Adrian, you said we've already had a couple of restructurings and there will be a few more, because we're on the steering groups of these. But specifically, what do these restructurings look like? What is the incentive for companies to complete a restructuring? We saw Evergrande, obviously, postponing things last year and then cancelling. Can you just summarise what we think a good restructuring would look like, and what is the incentive?

Adrian Petreanu: Sure. What we are trying to achieve with restructuring is to give companies two to three years of runway, with limited requirements of cash flow needed from them to support the debt. Restructuring as we see it involves a limited amount of equitisation. Obviously, where some of these companies had too much debt, we will have to equitise some of that debt, but we try to keep that low to a 20-30% maximum.

It's good to take some equity in these companies because in some situations, the bond holders will end up owning more than 50% of the company, meaning the companies will be controlled by the bond holders. We will be in a position to put in board representatives, which will increase the transparency and availability of information for us as bond holders.

Also, it's most likely that there will be several bonds coming out of the restructuring. We don't want to create only one big bond. It's going to be a series of bonds, probably with maturities five to 10 years into the future. It's likely that coupons are going to be half of what we've seen before. Coupons used to be around 10-12%, so probably these will be reduced to 5-6%, with the ability in some cases for the companies to pick these coupons for the first one year or two years.

Also, one thing we really pushing in all of these discussions is for some fresh capital to come from shareholders. That capital can then be used to pay down debt, or be used to buy back bonds. There is a fantastic opportunity for companies right now to use any cash they have to buy back bonds. When their bonds are trading at 18-20 cents to the dollar, every dollar used to buy back debt, gives them five times leverage. Rather than waiting until maturity and paying $1 of debt with $1, you buy the debt back now and you can retire $5. So, it is very advantageous for them to use cash and where there is that possibility where the owners can bring cash. Alternatively, having a partner from an SOE or from local government that will bring some cash will also be very helpful in terms of accessing liquidity from banks.

That's the blueprint we are working to, in terms of agreeing on debt restructuring. Obviously, every situation is slightly different, but we are now very actively involved in six of these situations and that number is probably going to increase. As I said, everybody now wants to accelerate the process.

Stewart McAndie: Thank you very much, Adrian. Another question is talking more to the valuation opportunity, because we've seen Ashmore’s Asia High Yield Corporate Debt Fund NAV move up by over 100% since the beginning of November. In terms of the average prices of bonds now, can you put into context in terms where the prices are sitting now, specifically within China real estate?

Adrian Petreanu: Sure, so specific to our Asia high yield fund, we are focusing on three categories of bonds. In essence, you have the defaulted bonds, those under restructuring, which are trading in the teens and in the low 20s. Then you have the companies that have been stressed and in a difficult position, but managed to avoid defaulting. These bonds are trading between 40 to 60 cents to the dollar. Then there is the super strong credit. These are not defaulting, but they are trading now at 80 to 100 cents to the dollar.

We don't think there's any point buying bonds at 80 to 100, even if they are super high quality. Instead, we are focusing on the opportunity in the stressed and the distressed part of the market. At the moment we have about 70% of the fund in China real estate bonds, 30% is in distressed bonds that have avoided default, and are still paying coupons and ‘on the run’. The average prices in this part of the portfolio is 55 cents to the dollar.

We also have 40% in bonds which are distressed, which are likely to go through a restructuring, but the average prices here are around 18 cents to the dollar. Now, obviously, where you have the distressed names, we are a lot more diversified in the number of names. So, we have nine companies still paying coupons and have survived without having to default, and we have 15 which are in default. In total, we have 24 issuers in the China real estate part of the portfolio, which comes to pretty much 70% of the exposure in the fund. The fund remains very much focused on this opportunity. This is really the biggest value destruction and rebuild of credit event we've seen in the past 20 years, especially for Asia. This surpasses what we've seen during the financial crisis, as we've never seen a crisis involving so many issuers, so much market cap, and with so many bonds going in default.

Stewart McAndie: Thank you very much, Adrian, and thank you Gustavo as well. That was all we wanted to cover today. Please reach out to your Ashmore representative if you want to discuss this in any more detail. Thank you very much for the questions that came in whilst we were talking. We hope you have a lovely evening and we look forward to speaking to you again soon. Thank you.

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