I have recently got round to reading “1421 The Year China Discovered the World”. It is a fascinating theory that, during the Ming dynasty, the Chinese navy visited America, Antarctica, Greenland and Australia.
What is certainly true, is that in the early fifteenth century China’s society was far in advance of anything in western Europe. Interestingly, there were glimpses of an equivalent Belt and Road policy back in the 1400s.
The insularity of China in the following 500 years has now been reversed and we face a world with two economic and political superpowers. This eastward shift has been reflected in how we invest. Over the last 10 years we have built out our global credit capability. In the past this would have centred on US and European debt – but no longer. Currently, we manage about $1bn in emerging market credit, covering Asia, Africa and Central and South America. This is a challenge, as we need to consider both corporate and country risk. Conversely, our analysts relish the breadth of analytical opportunities and new challenges.
But investing in Chinese companies has its challenges – as investors in Didi discovered last week. The IPO was undermined, post launch, by China deciding to restrict use of the ‘ride hailing’ app. A broader warning about companies listing overseas confirmed that investing in Chinese assets has risks. However, as economic momentum moves away from Europe we cannot ignore the new opportunities, even if we are faced with a different set of risks.
And something interesting has been happening in recent months. The spread between US and emerging market high yield has been widening and is now at its widest since H1 2020 – Chinese high yield bonds are mainly responsible. Since the start of May, Asian high yield credit spreads have widened by 106bps to around 8% and, within this, Chinese high yield has widened by 200bps – to over 10%. This is important as Chinese issuers make up nearly 20% of leading emerging market high yield indices.
Last week my colleague Dilawer Farazi highlighted to me two examples of Chinese credits under pressure. In the first case of China Evergrande, one of China’s largest real estate developers, the equity has fallen a third in 2021. In addition, its longest dated US dollar bonds are trading in the low 60s, down 20 points year-to-date. Despite deleveraging for the last 12 months it remains highly indebted, reflecting large offshore bond issuance. Chinese Government rules encouraging deleveraging within the real estate sector means the pressure on the company will continue.
The other example is China Huarong Asset Management – a majority State-Owned Enterprise (SOE). It is a distressed debt asset manager, established in 1999 in response to the 1997 Asian financial crisis. It missed its 31st March deadline to file 2020 financials, and the 180-day limit to publish financials under the terms of its bonds has also passed, though it has a further 60 days (end of August) to cure. Bonds currently trade below 70 and how the Chinese government deals with Huarong is significant – with investors watching to see if the government is willing to bail out over levered SOEs, or whether it will allow large ones to fail (as it has allowed smaller ones to do in both 2020 and this year).
The wider Chinese credit spreads will restrict issuance but there remains approximately $17.5bn of offshore debt maturing at Chinese high yield real estate issuers in the rest of the year, with a further $3.5bn in callable or puttable bonds. The question we have to ask: is this a buying opportunity? Our emerging market strategy has been underweight Chinese real estate, but we think this sell-off could be an opportunity to selectively add to positions.
Cash and government bonds
It was a strong week for government bonds. UK 10-year yields went below 0.55%, following the lead set by US treasuries. Increased concern about the spread of the Delta variant and signs that the inflation spike was not being maintained helped push 10-year US yields below 1.25%. Global real yields fell further, with 30-year UK yields hitting -2.22%. The move lower in yields has taken me by surprise but we retain a preference for short duration strategies relative to benchmark.
To support the slowing growth theme, UK output data for three-month data to May came in at 0.8%, quite a bit weaker than the expected 1.5%, with UK GDP 3.1% below pre-pandemic levels. The data showed contraction in manufacturing output (transport equipment hit by microchip shortages) and a further fall in construction activity, offset by stronger services. However, rather surprisingly, the May data showed that a number of services sectors saw flat to slightly negative growth. As my colleague Melanie Baker said – this doesn’t look like an economy starting to fire on all cylinders.
Sterling weakened early in the week, with the US dollar rate moving below 1.375 at one point. Cash rates remained very subdued and finding good quality banks offering decent three-month rates remains a challenge for our Cash team.
Issuance remains higher than expected for this time of year – with companies taking advantage of low all-in costs. Several new bonds caught our attention in the sterling market: Reality Income, Investec, Flagship (social housing), Retail Charity (secured on a loan to Golden Lane Housing) and Welcome Trust.
There was a new high in high yield indices over the week as US treasury yields moved lower. I remain of the view that, relative to government bonds, credit remains attractive. However, new issues are being priced quite aggressively and it is important to remain focused on credit fundamentals.
It is a damp start to the week – literally and figuratively – let’s hope the Olympics can inspire.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.