Prior to 2020, Chinese properties were a large part of the Asian Fixed Income (AFI) and Asian High Yield (AHY) universe. They dominated the issuance action and drove the wider direction of the AFI markets. As of December 31, 2019, China credits and Chinese property constituted c. 54% and 37% of the JACI Non-Investment Grade Index1 respectively. Moreover, its high yield nature was appealing to Asian fixed income investors seeking regular and high-income payouts at that point, the concentrated country and sectorial exposure notwithstanding.
All this changed abruptly in 2020 with the rollout of the “three red lines” policy that was intended to address excessive leverage in China’s property developers. The heightened regulatory posture was in-line with what would later be known as the government’s “common prosperity” drive, and this expanded to other areas like tech and education.
The increased scrutiny led to tightening credit conditions within property developers, mounting liquidity issues, halted construction projects, weaker home pre-sales, mortgage boycotts, delayed home deliveries, and a general weakening of sentiment towards the sector. Reports of rating downgrades, and credit defaults intensified, impacting even the larger property developers and State-owned related names.
Measures were subsequently introduced to stabilise the market, such as reducing mortgage rates and easing of home purchase restrictions, but investor confidence had already eroded. With the onshore and offshore funding channels narrowing or even closed, this sector has since become a smaller part of the wider AFI universe, impacting investors behaviour towards this market in the process.
Today, as of end November 2023, China credits and Chinese property names constitute c. 25% and under 7% of the JACI Non-Investment Grade Index2 respectively, a significant decline from its heydays.
China’s policymakers increased scrutiny on the real estate sector was meant to be a balancing act aimed at managing systemic risk, while also upholding measures to ensure the long-term health of the property market and housing affordability.
While its resolve to execute structural reforms to pivot away from an over-reliance on this credit-intensive sector should not be underestimated, investors may have underappreciated the far-reaching consequences of the prolonged correction in the housing market, on both the wider economy and financial stability. The impact of the correction has extended to related upstream and downstream sectors as well – such as furniture companies and construction entities. This ripple effect has further dampened private sector confidence. Additionally, the negative wealth effect stemming from weak property sales and declining property prices has created a negative feedback loop, weighing on China’s domestic consumption and reinforcing deflationary pressures.
Another lesson gleaned from the Chinese property saga is the overdependence on Chinese property developers for yields. The tumultuous period since 2021 underscores the issue of sector index concentration risk, which has accumulated over time. With the downturn and high concentration risk in the sector, this has led to many investors in this space underperforming. The experience from this episode highlights the need for investors to diversify – even amidst a backdrop of ultra-low interest rates, where the inclination to chase higher income and yields were very high.
The home and cultural biases of Asian fixed income investors was also evident, in that investors in this space were to some extent coloured by China’s then robust growth figures, which disproportionately directed them to favour Chinese property bonds. This led to significant issues when the sector underwent a downturn.
With Chinese properties no longer being the cornerstone for high-yield bond issuance in the AFI market, we must confront the new reality that the income attraction of this space as a standalone has receded. Investors who used to access this space for its high-income potential may need to reevaluate their approach.
How should one construct an Asian credit portfolio that is still high-income oriented? First, it is critical to recognise that the Asian credit and AHY markets have irretrievably changed. Excluding China property, the AHY index currently has sector concentration in Macau gaming (at 10%) and Indian renewables (at 7%)3. Although the weightings are lower than what China Real Estate’s weight was during its peak, the current opportunity set is not sufficient to build a sufficiently diversified AHY portfolio.
In our view, we need to spread our risks over multiple fixed income segments and functional buckets (organised along their income generation potential capacity) – i.e. one bucket that classifies instruments by their ability to generate consistent and stable income (Income Stabilisers); another that groups income-paying securities by their low correlation traits (Income Diversifiers); and another bucket which comprises of high-conviction income-paying securities (Income Generators). The approach is then to adopt a conscious high income-oriented mindset via allocation across these functional buckets by considering each bucket’s income contribution attributes on its own merits, and how it can complement the investor’s wider portfolio. This can be executed via a flexible, best ideas, multi-manager, team-based approach. This way, one may potentially build a high-income paying portfolio that is diversified across multiple income streams, and not disproportionately reliant on one sector.
Over a cycle, we believe this approach of diversifying income generation sources, should outperform an investing method that is concentrated in HY assets. This approach has the added benefit of taping into different economic cycles and opportunities. The adoption of a team-based decision-making processes further strengthens and enhances the final outcome. A diverse team provides a variety of perspectives, challenges the status quo and reduces individual biases. This approach leads to more balanced decision-making framework, reducing the impact of overconfidence and heuristic biases. Relative to a concentrated HY approach, global diversification with an Asia core as a focus will be key.
1 Source: JP Morgan Asia Credit Index (JACI), December 2019
2, 3 Source: JP Morgan Asia Credit Index (JACI), November 2023