China’s corporate default risk is not deterring foreign investors, many of whom are keen to gain exposure to debt assets such as a growing pool of non-performing loans (NPLs) and offshore high-yield corporate bonds.
The Covid-19 pandemic has caused a great deal of financial duress, not least among property companies. And Beijing’s crackdown on shadow banking and stricter classification rules for defaulting bank loans mean that China’s NPLs will undoubtedly grow.
China’s commercial banks had an outstanding NPL balance of Rmb2.83 trillion ($440 billion) as of the third quarter of 2020, according to data from the China Banking and Insurance Regulatory Commission (CBIRC). The NPL to total outstanding loan ratio grew from 1.8% in the first quarter of 2019 to 1.96% in the third quarter of 2020.
Meanwhile, bond-research firm CreditSights notes that Chinese property companies alone need to repay up to $53.5 billion of offshore debt this year, more than double the $25.4 billion that came due in 2020.
While China’s NPLs and the number of special situations opportunities have been growing, regulators have been working to clean up the country’s banking and legal system, creating a viable distressed debt market.
Market participants told AsianInvestor that the operating environment now has clearer rules, and with the worst of the pandemic behind it, some investors are targeting 13% to 15% annualised returns for such investments.
"We've seen growing interest in NPL assets since 2015" and demand has gathered pace in recent years, said Chen Lau, a partner with the restructuring and insolvency unit at PwC China.
Still, experts warned that aspiring investors need to be selective when choosing underlying assets, given the likelihood of further increases in default rates and credit downgrades.
NPL INVESTING CHALLENGES
According to a PwC report published in February 2020, international investors deployed around $3.6 billion in capital into Chinese private credit or special situation opportunities in 2019, in addition to the $1.1 billion invested into NPLs. This is a drop in the ocean compared with China’s NPL volume.
One of the reasons for this limited participation is that overseas investors cannot directly buy NPL assets from Chinese banks. Under the China-US Phase One trade deal, which the two countries signed in January 2020, Beijing agreed to allow US financial services firms to apply for provincial, and eventually, state-wide asset management company (AMC) licenses, which focus on distressed debt. So far it has yet to issue any such licences.
Instead, foreign investors have been accessing China’s distressed markets through joint ventures or via local or overseas funds, tapping local experts and teams to do some of the pre-buying work, according to Chen. He also observed that foreign investors typically favour a deal size that ranges from Rmb500 million to Rmb1000 million ($77.4 million to $155 million). If a deal is too big, the work becomes extremely complex, he said.
Even with teams in place, sourcing the right assets could prove challenging. According to Lau, pricing is one of the critical challenges for foreign investors who may not have the experience and insights to structure the assets to achieve optimal returns.
For instance, “if an AMC overpays for NPLs it bought from a bank, its asking price may be too high for other investors,” said Lau. The situation is now aggravated by travel restrictions due to the pandemic, preventing foreign investors from doing the required due diligence and finding the appropriate local partners.
FROM 10% TO 40%
Investors are also remain eager to buy into China's offshore high-yield bonds, particularly from property borrowers. Debt manager SC Lowy has been among the investors leading the charge.
“In early 2020, our allocation to public bonds was approximately 10% out of our overall investment [portfolio]. This figure surged to around 30% to 40% lately as we are overweight on high-yield bonds in countries such as China, India and Indonesia since the pandemic,” said founder and chief investment officer Soo Cheon Lee.
In general, SC Lowy’s Lee is bullish about growth in public bond and private lending markets across Asia in the next two years. In 2019 and 2020, the firm invested in and out of more than $20 billion and $25 billion in loans and bonds, respectively. He didn’t provide breakdown figures or target return.
However, Lee warned that investors need to be selective regarding their investment targets. Most notably, he says they should look into a property company’s refinancing ability.
“Fundamentally, companies may need time to recover from the pandemic and deal with all the refinancing pressure,” he said, adding that the offshore high-yield corporate bond market has seen growing liquidity and bond prices have recovered to pre-Covid-19 levels. “Cash levels and debt repayment ability are important criteria to consider when choosing the property company."
In 2020, China’s bond issuance stood at $37.7 billion, which was the second-highest level on record, according to a Moody’s report published on January 26. China property accounted for 76% of the total, the report said.
“Liquidity and refinancing risks have picked up among those small-scale, low-churn homebuilders with concentrated land banks and funding channels amid tightened funding regulations and policy curbs on the property sector.” Shuncheng Zhang, associate director of China corporate research at Fitch Ratings, told AsianInvestor.
Although the repayment pressure in the property sector is expected to increase this year, overall China offshore corporate bond defaults this year should be largely in line with the level in 2020, Zhang said.
The amount of Chinese corporates’ US dollar bond maturities, including those puttable, will likely stay around $93.5 billion throughout this year, compared to $73.1 billion for the full-year of 2020. The increase is largely attributable to homebuilders and local-government financing vehicles, which usually have sufficient refinancing resources, said Zhang.