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Lex Midweek Letter: swollen China junk yields point to deepening panic

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Dear readers,

Sometimes a single number says more than a thousand words. Chinese junk bonds now yield a hair-raising 24 per cent on average. They have led Asian high-yield bond prices sharply lower in recent weeks, amid escalating credit worries.

The sell-off is spreading to China’s investment-grade bonds. Bonds issued by China Vanke, the largest listed local residential developer, and its Hong Kong entity have taken a notable hit.

Investors freaked out by apparent defaults by highly leveraged property group Evergrande have begun dumping debt from other sectors too. The yields of big, typically solid companies such as Alibaba, Kweichow Moutai, ICBC and Tencent have also risen.

Worries about contagion from real estate and associated sectors are understandable. They make up a large a portion of China’s economy, almost 30 per cent.

Beijing is stepping up pressure on developers. Those in Beijing and other big cities face tough new restrictions over how they can use their funds. An unusual feature of the local market is that they are permitted to finance new buildings and projects with proceeds from pre-sold properties.

It is their main source of funding other than bank loans. They may now have to finish buildings under construction before raising cash through presales.

The authorities have good intentions. They want to reduce the implicit leverage of developers that have been raising cash from unfinished properties.

Yet the timing is bad, restricting working capital when it is most needed. Projects under construction now have a higher chance of being completed. But buyers that have paid for the homes that are not yet under construction risk losing out in a developer cash crunch. That would further weaken sentiment and property prices.

Other sources of cash, both for construction and for repayment of debt, are running out. Dollar debt sales by local developers are down more than a third this year, reflecting diminishing investor appetite. Selling property is proving more difficult than expected. Evergrande, for example, has been able to sell assets that are unrelated to its core business, such as its two private jets. But potential buyers have spurned the bulk of its assets, which are in property.

That has been a common theme among worried developers. Modern Land China and Oceanwide Holdings are struggling to sell prime assets in Hong Kong and Beijing.

Many buyers do not have sufficient liquidity to buy large ticket items. Those that do are braving a deteriorating outlook and weaker confidence. They have an incentive to hold out for lower prices as sellers become increasingly desperate.

But when it comes to investment-grade bonds in sectors outside real estate, the picture is much brighter. China posted a record monthly trade surplus in October because of surging exports. Global supply chain disruptions have not had a significant impact on local companies. Exports rose 27 per cent last month compared with a year earlier to $300bn, according to customs data, marking the 13th straight month of double-digit growth.

Electronics and other machines accounted for almost 60 per cent of total exports by Chinese companies by value this year. That demonstrates the resilience of manufacturing earnings. Concern that the slowdown in the Chinese economy justifies a sell-off in local equities and bonds is overdone.

Wednesday is a big day for Chinese bondholders. The 30-day grace periods on three $148m Evergrande coupon payments expire. On the same day, China opens books to sell €4bn of new government bonds.

Evergrande bondholders are weary. Despite Evergrande pulling through with the payments in the last hours of its previous 30-day grace period, the steep haircut the bonds trade at has not narrowed.

Government bonds are a different kettle of fish. China’s trade surplus should widen further as demand for construction-related goods slows. Imports of commodities such as iron ore are directly correlated to the health of the weakening local property market.

China’s foreign reserves reached $3.2tn at the end of October, which was above expectations. These figures give Beijing the leeway to proceed with its crackdowns on the property sector. That cushion should also prevent contagion to global markets.

Returns from developed markets have begun to look exhausted. That means there will be bargains for fixed-income investors among China’s investment-grade corporate bonds and even its well-bid sovereign debt.

Enjoy the rest of your week,

June Yoon
Lex writer

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