Risks in China’s bond and credit markets
The default wave is extending into 2019, with two big issuers failing to meet their obligations this month. Given the reduced risk appetite and huge maturing volume, the outlook is poor, with RMB3.5tn in corporate bonds due in the next twelve months. Availability of credit for refinancing remains tight despite repeated monetary easing by PBOC. The yield spread between AA- and AAA on five-year notes stood at 306bps on 15 February, more than twice the level a year ago.
Commercial banks have remained cautious in lending to private companies and financially wobbly state-owned enterprises. The resulting deterioration of corporate cash flow was evident by collapsing M1 growth.
Aggravating the liquidity strain, real interest rates (benchmark lending rate minus PPI) have shot up to 4.3% in Jan 2019 from as low as -3.1% in Q1 2017. The consequential tighter monetary conditions would add to the financial stress on Chinese firms with high leverage and maturity mismatches. That doesn’t bode well for their debt repayment ability.
The real estate sector is a case in point. A worryingly large share of recent borrowing has come in the form of short-term bonds. Funding pressure facing property developers have been exacerbated by the housing slowdown. Home sales by floor area rose by a mere 2.2%
YoY in 2018, down from 5.3% and 22.4% in 2017 and 2016 respectively. Government ‘s crackdown on shadow lending also heightened builders’ refinancing difficulties.
That explains why investors are growing jittery about the property sector. Evergrande, the country’s second-largest developer by sales, sold USD1.025bn in bonds last month maturing in 2022 at a yield of 10.5%. That came after Shenzhen-based builder Fantasia Holding Group Co. sold 2021 bonds at 15% in December. Ominously, the high-yielding real estate bonds usually associate with higher default risk, according to Bloomberg default risk calculator.
Indeed, major barometers including quick ratio and debt/EBITDA point to the sector’s poor financial health:
• Quick ratio: On average, property firms’ liquid assets only able to cover 58% of their liabilities, the lowest among all industries.
• Debt/EBITDA: Builders’ total debt is about 7.3x their earnings before interest, taxes, depreciation and amortization, far higher than the average of 4.7x.
Small steps have been taken at the local level to encourage home buying since December such as lifting price caps and removing re-sale restrictions. In our view regulators could turn to all-round loosening in Q3 to soften the blow from a burgeoning trade war on an already faltering economy. Until then, expect more missed bond payments by Chinese builders.
Rates: Policy support vs improving sentiment
Support from the authorities on the monetary policy front is unlikely to abate just yet. Multiple policies have been announced by the PBoC over the past several quarters as China’s economic slowdown starts to bite. We argue that these measures have arrested the worst of financial market strains. Notably, interest rates across all tenors (7D repo to the 10Y govvie yield) are hugging close to their respective six-month lows. While further corporate defaults appear inevitable, credit spreads have stabilised, and the stock market has staged a nascent rebound (the CSI 300 is up by 13% ytd).
The govvie rally has been considerable as the curve bull steepened since early 2018. In fact, the 3Y/10Y segment of the curve looks steep by recent standards and probably accounts for why the curve has been level-shifting lower in more recent months. We think that the bulk of the duration gains may be behind us. As 10Y yields approach 3%, we would turn increasingly cautious. Along the curve, we think the duration pickup is attractive out to the 7Y tenor as bets on further monetary easing anchors frontend rates.
Going long China govvies is looking like a crowded trade. The reasons have already been well-flagged (economic slowdown, trade war, policy support, credit stress, index inclusion) over the past year. Unless economic conditions deteriorate further, the stock market may offer better risk-reward. We are not convinced that the current positive correlation between bond and stock prices is durable. If sentiment stabilises, the traditional relationship (negative correlation) should re-assert.
To read the full report, click here to Download the PDF.
The information herein is published by DBS Bank Ltd and PT Bank DBS Indonesia (collectively, the “DBS Group”). It is based on information obtained from sources believed to be reliable, but the Group does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation & the particular needs of any specific addressee. The information herein is published for the information of addressees only & is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Group, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Group or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Group & its associates, their directors, officers and/or employees may have positions or other interests in, & may effect transactions in securities mentioned herein & may also perform or seek to perform broking, investment banking & other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts & tables are CEIC & Bloomberg unless otherwise specified.
DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E.
PT Bank DBS Indonesia, DBS Bank Tower, 33rd floor, Ciputra World 1, Jalan Prof. Dr. Satrio Kav 3-5, Jakarta, 12940, Indonesia. Tel: 62-21-2988-4000. Company Registration No. 09.03.1.64.96422.