Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

It's one of those things that everyone fears and no one wants to talk about. For the past two years, high-yield investors in Asia have been enjoying steady gains thanks especially to Chinese homebuilders, which account for more than a third of the region's junk debt. Prices for their bonds rose or held in place even as their ability to repay deteriorated.

The reason for the counter-intuitive move was supply and demand. About two years ago, Chinese policy makers started removing curbs on real estate financing, including limits on onshore loans and bonds, that had been in place since 2010. The chart below shows domestic debt sales by homebuilders that had previously issued dollar notes:

Homeward Bound
China's developers have reduced offshore issuance in favor of selling debentures at home
Source: Bloomberg
* Data refers only to companies which have outstanding dollar notes. All values converted to yuan for comparability.

With negative rates in Europe and Japan making high-yielding bonds more valuable and the supply of developer notes dwindling, the sector's dollar debt rallied, buoying Chinese junk-rated paper.

America (I've Got Some Real Estate Here in My Bag)
Dollar-denominated Chinese high-yield debt has been good to investors over the past two years
Source: Bloomberg, Bank of America Merrill Lynch

All the while, the capacity of these developers to service their debt was worsening. Take one of the most important gauges of the ability to meet obligations, the ratio of earnings before interest and taxes to interest payments. The median number for the 34 Chinese developers with large amounts of dollar debt has dropped from almost 4 to 1.86. 

Troubled Water
The median amount developers with dollar debt make from operations is now less than twice the interest they pay on their debts
Source: Bloomberg

That helps explain why Moody's Investors Service downgraded three times as many companies in the group this year as in 2015. Rising leverage combined with soaring prices for land and property have prompted the likes of S&P Global Ratings and Citic Securities to call for a return of the type of curbs instituted in 2010.

There's movement on the regulatory front, too. Some exchanges have banned highly leveraged local government financing companies from selling bonds, Caixin reported Aug. 30. At the time, the financial news website said similar measures were being studied for developers.

That's the kind of action that could derail this Chinese junk rally. If real estate companies find that again their best or even only option is to sell bonds offshore, supply could quickly outpace demand.

Investors in Asian junk debt need more than ever to pay attention to the regulatory news in China. The key variable to watch is not the direction of home sales or prices, but how much homebuilders will need dollars.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at

To contact the editor responsible for this story:
Matthew Brooker at