China’s deleveraging drive squeezes developers

The Chinese property development industry is feeling the effects of the government’s ongoing push to reduce corporate sector debt levels. The deleveraging drive is making it harder for developers to raise funds; smaller property companies in particular are facing liquidity challenges, which may ultimately result in more and more distressed situations. Valuations of debt issued by Chinese property companies have become quite attractive, but this is largely a reflection of the weak technical environment. For corporate bond investors interested in the sector, we recommend sticking to debt issued by the large developers with strong liquidity profiles.

Deleveraging drive spares no one, but the impact varies
For a number of years, the Chinese authorities have been carrying out an ambitious plan to control the pace of growth in system-wide leverage. June data pointed to a slowdown in overall credit growth in China, but shadow financing actually shrunk. Controlling credit growth is positive for the long-term sustainability of the economy; at the same time, it has a clear impact on the corporate sector. The impact is especially profound for small companies with more constrained funding situations, while the larger corporates and state-owned enterprises (SOEs) are feeling less of a pinch. In an environment of tight funding conditions, lenders would most naturally prefer larger, investment-grade issuers or SOEs with government backing. Smaller or weaker companies, often high-yield, may become part of the collateral damage.

Impact more pronounced on high-yield corporates
For investment-grade non-SOE corporates, access to funding is still reasonable, albeit at higher cost. High-yield issuers, on the other hand, are experiencing limited funding options and much higher funding costs. Privately owned corporates or those operating in over-capacity sectors face more challenges in managing their liquidity positions. Recent bouts of onshore defaults highlight the current delicate funding conditions.

The property industry is policy-driven and is therefore subject to government cooling measures aimed at curbing unsustainable growth in transaction levels and selling prices. In larger cities, such measures typically include sales permit restrictions, price caps or other monetary restrictions imposed on buyers. When sales are transacted, mortgage disbursements (cash payments to developers) are slower than before.

At the same time, developers are still active in land acquisitions and are ramping up construction in order to increase scale. The resulting negative operating cash flows prompt more funding needs. In an environment where funding options are limited, developers have no choice but to pay more for funding. Bank loans are harder to get, except for the larger developers or developers that have SOE backgrounds. Trust financing is not readily available. Even if it were, the cost would be much higher than before, rising from 7%-9% to double digits.

Onshore corporate bonds, a market that developers utilized extensively in 2015 and 2016, remains largely shut for property developers. This leaves the offshore USD market as one of very few funding avenues for most developers. To make matter worse, many onshore corporate bonds issued in 2015/2016 will be puttable in the next 12 months. This further incentivizes developers to tap the USD bond market for refinancing purposes.

Current bond valuations reflect poor technical outlook

Since the start of 2018, the J.P. Morgan Asia Credit Index high yield spread-to-worst has widened by about 150bps, reflecting very poor bond technical for bonds, which in turn reflect low demand for USD bonds against an outlook of robust new supply pipeline. Recent new issues have been priced with hefty concessions, leading to weaker prices in the secondary complexes. Right now, weak demand makes it difficult to print large deal sizes, and investors are more selective about credit quality.

Given current valuations and lukewarm demand for new issues, it does not make economic sense for many corporates to call back their bonds at the next call date. Some developers have indicated they will not call their high-coupon bonds until funding conditions improve.

According to some reports, China’s National Development and Reform Commission (NDRC), the regulatory body that approves offshore corporate debt sales, may cut its offshore bond quota approvals in 2H2018. This follows market feedback that the commission had been overly generous with quota approvals in 1H2018. Should this be true, it could alleviate concerns about bond supply risk but there are still a lot of unused quotas out there that are likely to keep supply pipeline active in the near term.

Remain cautious on property credits
Valuation levels have become more attractive but given the poor technical picture, we prefer larger developers with strong liquidity profiles and no near-term refinancing risk.

We expect weaker developers to encounter distressed situations given refinancing needs. That said, we do not expect this to become a systemic issue for the broader market because developers should be able to sell some of their land to raise funds, if necessary. Deterioration in the sector may also prompt the government to loosen cooling measures given its importance to the economy, aiding in the recovery of the sector

Clement Chong, senior credit analyst at NN Investment Partners

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