ADVISORY
Evergrande and Asian Alternative Credit
Asia-Pacific Private Credit Newsletter
September 2021
The story so far…
China Evergrande Group is one of the country's largest property developers, founded in Guangzhou in 1996. According to its corporate website, Evergrande Real Estate owns more than 1,300 projects in more than 280 cities but the enterprise has expanded extensively beyond its core competence of homebuilding, into a myriad of businesses including mineral water, electric vehicles and football club ownership. This expansion has been financed primarily through debt and the group is understood to carry around US$300 billion in liabilities.
Evergrande has sought to reduce its debt load over the past 12 months but will still need to make US$669 million in coupon payments through the end of 2021, with US$615 million of that amount connected to its dollar bonds, according to Bloomberg. While the group has repaid all its public bonds this year, its options to accessing fresh capital are becoming limited and at the time of writing its dollar bonds are now trading around mid to low 20 cents in the dollar depending on which bond and tenor. This implies a distressed situation and likelihood of a restructuring at the very least.
Record level spreads
There are very few precedents for this kind of situation in China and it has impacted the price action of associated assets. Confining our focus to the dollar bond market, Evergrande has ca. $20bn of bonds outstanding and is the largest high yield dollar bond issuer in Asia. Its dollar bonds account for 16% of China’s dollar high yield bond market, 11% of Asia dollar high bonds and 3% of China’s total dollar bonds. According to a report from Bank of America Securities, “[if] Evergrande were to default, we calculate that the default rate for China HY dollar bond would increase from 4% currently to 20%, and the default rate for Asia HY dollar bond would increase from 3% to 14%.”
Chinese high yield bonds are now trading at yields north of 12%, while the OAS over Treasury for the broad Asian high yield index versus its US counterpart is at the widest level we have ever seen:
Is there risk of broader contagion?
The high yield market is often identified as the liquid, "public market equivalent" (PME) for the alternative credit market. Does this imply a broader contagion in the price of credit risk across the APAC region?
We do not think so, as we do not believe the market is yet sufficiently representative of broader credit risk in the APAC region.
Firstly, it is immature, and it will take time to broaden out and diversify across countries and sectors. In Europe and the US, the influence of private-equity sponsors engaged in leveraged buyouts (LBOs) and continued loose monetary policy have created abundant liquidity and a much more diversified industry structure. By comparison, while growing remarkably over the last decade, the Asian high yield market is dominated by the issuance of 10 large Chinese property developers, including China Evergrande.
According to Moody’s, cumulative issuance from 756 deals totalled nearly $260bn, which spurred a fivefold increase in rated debt to $135 bn at the end of June 2021 from $30 bn at year-end 2010. China property has accounted for 67% ($172 bn) of cumulative issuance from rated Asian high-yield companies over this period. This sector has around $50 billion in US dollar bonds maturing through 2022.
Using the Bloomberg Asia USD High Yield Diversified Credit Index, we can see that the asset class is far from diverse. Geographically, the PRC and its two SARs, Hong Kong and Macau, account for just over 60% of index holdings in the Asia index as of 13 September 2021. On a sectoral basis, property-related issues account for a substantial amount of the Financial Other sector which accounts for 29% of holdings, with an additional 5.9% in pure-play Home Construction issues.
DO EVERGRANDE'S TROUBLES IMPACT ASIAN ALTERNATIVE CREDIT MORE BROADLY?
In this Newsletter we focus on:
1. Thematic focus - What impact might Evergrande's troubles have on Asian alternative credit
2. News centre - Links to several articles and white papers we found interesting
Graph title
Asia High Yield to US High Yield: OAS to Treasury
Source: Bloomberg as at 15 September 2021
These data emphasise that Asian high yield debt is quite a concentrated play even when delivered in its broadest index form.
Second, this concentration skews the assessment of credit risk for high yield borrowers in the region. The same Moody’s report highlights that the dominance of Chinese developers has impacted covenant quality (CQ) scores for Asian high yield bonds in aggregate. CQ scores have weakened since 2011, with only 11% of bonds in the strong and good levels in the first half of 2021 compared with 82% of bonds in 2011, while 63% of bonds are in the weak and weakest levels compared with only 9% in 2011.
But this trend is not reflected in other parts of the market. ASEAN bonds typically offer stronger covenant protection for investors across all major risk areas compared with Chinese property bonds with yearly average CQ scores falling in the good and moderate levels in the past decade.
Finally, as we said back in April, there is a good argument for holding Asian credit risk in a diversified portfolio, given the compelling risk and reward dynamics of the region. There are higher returns available and, despite the declining trend within the market, bond covenants for aggregate Asian high yield bonds are comparatively stronger than counterparts in EMEA and North America.
The challenge for most investors is accessing this credit risk in a way that circumnavigates Chinese property developers and the Evergrande problem. The largest Asian high yield vehicles are ETFs and active strategies benchmarked against indices designed to capture the broad market with all its challenges. The alternative - building a customised Asian high yield bond portfolio - is beyond the resources and skill sets of most institutions.
Private credit as an alternative source of APAC yield?
This is one reason why we view the private credit opportunity set as a preferable access point for Asian alternative credit risk.
The current volatility in public credit markets should create additional opportunities across APAC for private credit. This is for several reasons that we have discussed in earlier newsletters. The current circumstances only serve to underline these points further:
1. We expect the situation in public credit markets will increase caution in regional bank lending, leading to further dislocations in the supply/demand dynamic for SME lending. The region already offers little in the way of cash flow-based credit lending and we expect banks to retrench further into their comfort zones of relationship and asset-based finance – leaving plenty of opportunities for private credit managers to generate mid-teens returns on productive senior secured loans.
2. The APAC private credit opportunity set is much broader than the Asian high yield PME would imply. Managers with a pan-regional mandate can access opportunities from a wide range of countries and industries. For instance, our strategy only focuses on China opportunities where we can take offshore security and it's a small part of our overall opportunity set. By way of example, the table below shows our current window on the market – it is highly diverse and very different in composition to the Asian high yield market.
3. Compared to the high yield market, these opportunities are predominately first lien, senior secured deals. What is more, as we discussed in April, compared to the larger private credit markets of North America and Europe, APAC structures and covenants are much more conservative and yet offer higher IRRs.
Investors are now forced to take real risk to make real returns on credit assets. As low rates continue to wreak havoc on pension obligations, solvency ratios and spending policies globally, investors will continue to seek new sources of yield and absolute return to plug the financial gaps.
This multi-year trend was covered in our February newsletter which discussed the increased usage of "growth-oriented fixed income" (GOFI) allocations in institutional portfolios – in effect a broad bucket that can include investments in EMD, high yield, convertibles, senior loans, and absolute return/multi-asset credit strategies.
While it is likely that US inflation will recede from current levels, it could well remain relatively elevated for some time yet. This has implications for the future mix of investors' GOFI buckets as investors continue to seek higher yields in more exotic assets. It is highly likely that this now seemingly perennial "search for yield" will have driven flows from US high yield to its Asian equivalents. Before the current spike, in the last 12 months, Asian high yield OAS over Treasuries still averaged around 3% higher than US counterparts.
Conclusion: The risks of "column A" investing in the current environment
In this regime, it is tempting for the allocator in a hurry to follow what a friend of ours called the "column A" investment strategy (put all your potential assets in a spreadsheet and sort from highest to lowest on yield). Coupled with the perceived almost instantaneous liquidity of ETFs, one can have a GOFI portfolio up and running in minutes…
But the current volatility in the Asia high yield market should show that this is not the way to go about it. Buying the index has rarely been a successful long term credit investment strategy, despite the lower management fees. More than their counterparts in other asset categories, credit portfolio managers get paid to avoid the blow-ups. Credit is an asset class with a negatively skewed risk profile. The keys to success in this environment will be to maintain a disciplined credit underwriting focus to assess risk, aligned with careful structuring and strong covenants. APAC private credit holds up well under this philosophy.
85% of the US HY market currently yields below US CPI
Source: Deutsche Bank Research as at 7 September 2021
Bloomberg Asia USD HY Diversified Credit Index exposures
(by domicile and sector)
Global context: Financial repression is forcing Investors to take real risk to make real returns
As highlighted by Jim Reid and the team at Deutsche Bank, financial repression has moved a long way out the credit spectrum. According to their calculation, 85% of the US high yield market currently yields below US CPI:
ZEROBRIDGE PARTNERS
Zerobridge Partners Asset Management Limited is focused on giving institutional & high net worth investors globally access to APAC alternative credit opportunities. The strategy seeks to take advantage of the less developed banking and capital markets in the APAC region and capitalize on our strong proprietary deal flow.
Zerobridge Partners Advisory Limited is a debt advisory firm focusing on raising new capital, creditor negotiations and debt restructuring for companies in Asia-Pacific. We come with deep investment banking experience and a strong track record across multiple credit cycles in Asia.
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Source: Bloomberg, Blackrock iShares as at 13 September 2021
NEWS CENTRE
Evergrande news
Introduction to Evergrande | Bloomberg
Timeline of the crisis | Bloomberg
Evergrande won't pay interests | Bloomberg
China considering nightmare scenarios for Evergrande| Bloomberg
China Evergrande Group: Three potential scenarios - Sirius Chan, Joyce Liang, Sharon Chang, CFA | BofAS GEMS Corporate Credit Research (contact your BofAS representative)
Other news
Funding gap persists in APAC | Asian Investor
DB CoTD: Should we rename High Yield? – Jim Reid and Raj Bhattacharaya | Deutsche Bank Research, 7 September 2021 (Please contact your DB representative)
Global Leveraged Finance Weekly Wrap – Craig Nichol | Deutsche Bank Research, 10 September 2021 (Please contact your DB representative)
Long-Term Asset Return Study: Fiat, fifty and frail – Jim Reid, Henry Allen, Luke Templeman, CPA|Deutsche Bank Research, 13 September 2021 (Please contact your DB representative)
If you have an article on Private Credit that you think is interesting, please send it to us at enquiries@zerobridge.com
Source: Zerobridge Partners as at 15 September 2021. The overall pipeline is composed by 90% of Senior Secured deals and 10% Senior Secured + Warrants. The IRR range is 14%-25%.
ZPAD Pipeline
