Record China Builder Downgrades Don't Tally With Rallying Bonds

  • S&P took 15 negative actions on Chinese developers this year
  • Sector's `immediate problem is the interest payments:' Natixis

Just as Chinese builders’ dollar bonds deliver twice the returns of Asian junk notes, S&P Global Ratings is predicting record downgrades. That discord hasn’t gone unnoticed among investors.

S&P took 15 negative actions on China’s developers this year through May 6, versus 12 in the year-earlier period, and it foresees unprecedented ranking cuts in 2016. Moody’s Investors Service said on Tuesday that 44 percent of the builders it rates either have negative outlooks or are under review for downgrade. A Natixis SA survey of listed companies last week ranked real-estate companies as the least able to repay their debts.

While Chinese builders’ dollar bonds returned 14.5 percent in the past year, compared with the 7 percent average for Asian junk debt, much of the gains were due to a lack of new supply as the companies were allowed to access the onshore market. Instead of using the cheaper funds to improve their finances, many property tycoons went on an acquisition binge that rests on the assumption the housing market will keep on booming.

“A fair number of Chinese dollar junk bonds are trading at or near all-time highs with a weakening macro backdrop in China and companies themselves seeing pressured margins and leveraged balance sheets,” said Swee Ching Lim, portfolio manager at Western Asset Management Co. in Singapore. “A reduced pace in primary issuance coupled with companies calling back secondary bonds is a significant tailwind keeping prices in check, but the nagging question remains as to how long this will last.”

Average yields on China dollar junk bonds have fallen more than 2 percentage points from a high in August last year to 8 percent, according to a Bank of America Merrill Lynch index in which developer bonds have a 66 percent weight.

Among the developers S&P downgraded in the past month are Evergrande Real Estate Group Ltd. and Greenland Holding Group Co., the two most indebted of 198 listed Chinese builders. There is a 7.2 percent probability Greenland will miss payments in the next 12 months, the highest among Asia’s biggest developers and up from below 1 percent a year ago, according to the Bloomberg Default Risk model that tracks metrics including share performance, liabilities and cash flow. Evergrande ranks second at 5.6 percent, the model shows.

“The operating environment for Chinese property developers has significantly improved, but many developers have rushed in to purchase more land parcels or make new investments,” said Christopher Yip, an analyst at S&P in Hong Kong. Along with lower profitability, that “hurts their leverage positions before they have a chance to get better.”

Record Debt

Debt of the 198 listed builders grew 31 percent in the past year to a record high of 3 trillion yuan, according to Bloomberg-compiled data. The median gross profit margin declined by 5.7 percentage points to 26.4 percent in the past three years. Developers’ nationwide sales will moderate to single-digit percentage growth for the 12 months ending May 2017 from 16.6 percent in 2015, according to a May 10 Moody’s report.

The developers generated enough earnings before interest and taxes to cover 1.8 times of their interest expenses in the past year, plunging from 2.9 times two years ago, Bloomberg data show.

“Many people focus on leverage but frankly Chinese builders’ immediate problem is the interest payments,” Alicia Garcia Herrero, chief economist, Asia Pacific at Natixis, said at a press briefing in Hong Kong last week. “Do we see a crisis? No. Helping the real estate sector, banks are lending 4.5 trillion yuan in the first quarter, which is what they lent at the peak of the 2009 stimulus.”

Natixis analysis of the 3,000 biggest Chinese listed companies shows developers accounted for 21 percent of China’s total corporate assets in 2015, up from 8 percent in 2004, while their liabilities to total equity doubled since 2008. Garcia Herrero warns against investing in the sector, even though it won “breathing space” with the first-quarter credit binge, the housing-price recovery and planned tax reforms.

“Every time you see the credit binge in China at the very beginning it can be very appealing,” she said. “The question is whether you get people who will ride it. I think that the story is so clear now that I doubt many people will buy into it.”

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