Hunting alpha in China's real estate bond jungle

China’s real estate sector is a large and diversified universe that’s seen historic downturns, the collapse of developers, and government intervention in recent years. Amid such conditions, investors hunting for opportunities have had to navigate a varied and changeable terrain. Yet, jungle metaphors aside, it seems that reopening its economy at the end of 2022 planted seeds of recovery in China’s post-Covid property market. Is the sector gradually coming out of the woods? And how can investors looking to generate alpha spot opportunities amid current market conditions?

The property sector’s protracted slump is easing

China’s property market began breathing sighs of relief when the government ended its stringent tightening policies on the sector in November 2022, closing the door on a rigorous two-year deleveraging phase. Full reopening of the country’s economy in December has further supported this recovery, with the Chinese government reiterating the sector’s strategic importance in recent months.

This has translated into the cancellation of most restrictive policies for new home purchases, the relaxation of requirements for mortgage applications, and the lowering of mortgage rates. Rates in 83 out of China’s 96 major cities have been dropped to their lowest levels since 2017, with first-time home buyers particularly favored, and this could materially improve housing affordability as well as real demand. Access to onshore funding for developers has also been drastically improved in recent months.

Signs of recovery are beginning to show up in the data. According to real estate consultancy China Real Estate Information Corporation (CRIC), total attributable contracted sales of the top 100 developers for the first four months of 2023 rose 10.5 percent year on year to RMB 1.634 trillion. The month of April saw a 32.3 percent year-on-year increase.

Material improvements have also been seen in both sales manager forecasts and recent buyer sentiment, pointing to a more sustainable and healthy housing market. Property sales prices started to recover in the first quarter of 2023: Intelligence firm China Reality Research (CRR) reports a 0.13 percent month-on-month increase in the April average selling price of projects. And, in contrast with the 12 months prior to April, developers are no longer offering the same level of promotional discounts. Surveys for potential home buyers also show gradually recovering consumer confidence.

A gradual recovery amid bond volatility

Although we do not foresee either a “V” shape rebound nor a quick “U” shape recovery for the sector, we expect a promising and gradual recovery in the second half of 2023 and beyond, even if the path to recovery may be bumpy. We expect a year-on-year drop in nation-wide contract sales in 2023 of around five percent, but believe this will rise to an increase of around 10 percent year on year thereafter.

Given the diversity of the Chinese property market, the rate and path of recovery will not be uniform across the country. So far this year, average selling prices in higher-tier cities (tier one and two) rose faster than in lower-tier cities, indicating a faster 2023 recovery in stronger regional markets. This is going to benefit developers with a higher-quality land bank and a stronger sales pipeline in tier-one and tier-two cities.

As mentioned above, the period of downturn in China’s real estate market saw default among property developers. In May, Chinese builder KWG Group Holdings Ltd. defaulted on debt payments, exacerbating the recent round of consolidation and selloff that has occurred since February, mostly from a few distressed names.

We believe the latest selloff does not reflect the top-down trend of sector fundamentals. It is mainly driven by panic sales after several idiosyncratic credit events, fund outflows, and the profit-taking that occurred after the last strong rally between November 2022 and February (the Iboxx China high-yield real-estate index was up 162 percent). These volatile bond-price moves were also prompted by herd mentality and the broad global market risk-off sentiment seen recently.

Prompted by the sector’s improving prospects, companies that have defaulted appear to be moving swiftly to conclude their debt-restructuring and return to normal as early as possible. Evergrande Group and Sunac are among the defaulted developers that we note have already released holistic restructuring plans, and we expect to see more restructuring deals finalized this year.

We believe that, over the next 12 months, special situations could provide plenty of opportunities for investors in the Chinese property sector. After the indiscriminate selloff, we see the potential for great opportunities from oversold Chinese property US dollar bonds, after careful credit selection.

Credit selection is key in a sector with stark divergences

In China’s large and diverse property market, there are 187 listed property companies. Of these 187 companies, 54 of which are listed offshore, 96 have issued offshore bonds in past years and carry credit ratings between BBB+ and CCC or below. They have vastly different degrees of exposure to regions in China, regions between which an economy gap as wide as that between developed and emerging markets may exist.

Although most of China’s property companies operate in at least two regional markets, others such as Central China Real Estate Limited (CCRE) are active in just one province, which can have both negative and positive consequences. While some developers focus on tier-one and tier-two cities, some opt to operate in low-tier cities.

The fact that Chinese property companies have different business models, strategies, and balance sheets means they have varied credit profiles and post sector-recovery prospects. Even though all are exposed to China’s macroeconomic backdrop and policies, what really matters is the bottom-up, company-specific analysis, which could help investors find alpha within such a deep and broad sector.

Among those 96 companies, 16 are state-owned enterprises, while the others are privately owned. We noticed state-owned developers posted a 52 percent growth in their year-to-date sales, while private companies saw a 25 percent decline on an aggregate level. That said, the price levels for private-enterprise bonds have factored in more than enough of their weaker fundamentals.

Even for defaulted names, many bonds are trading at a level way below their post-restructuring recovery rate. For investors with deep knowledge and on-the-ground insights, the current situation provides a fertile field for generating alpha after careful credit selection and portfolio construction.

Key takeaways

While a bounce back in contract sales since early 2023 speaks to recovery, it is likely to be many more months before the rebound of property sales returns to healthy levels. Similarly, it is expected that privately owned and stressed property companies – especially defaulted developers – may face a bumpy journey before they can turn the corner, though this is already priced into market expectations.

Despite the positive signs, we expect volatility to remain in credits this year but estimate a much bigger upside potential for high-yield property bonds, especially from selected names. With the default of KWG in May, a panic-driven selloff has pushed some company names back down to the low levels seen last November, a time when the Chinese government had not yet reversed its policies, and sector fundamentals were desperately weak.

What could this mean for investors? The current exaggerated market sentiment is reminiscent of last year's third quarter, right before the Chinese property sector started to rally in November. These conditions could provide opportunities for contrarian investors who may have missed the strong rebound last December. Although nobody can predict the market’s peak and troughs, when bond prices drop way below their intrinsic value, we see the potential for alpha.