China’s “Three Red Lines” policy initiative drives credit improvement across Chinese HY property bonds

14 April 2021

by Eric TSO, Fixed Income Analyst, JK Capital Management Ltd., a La Française group-member company

China’s “Three Red Lines” policy initiative drives credit improvement across Chinese HY property bonds

For much of 2020, one of the dominant themes for the Asian HY market was the government’s introduction of the Three Red Lines (or TRL) policy for Chinese property companies. After many years of robust growth in the sector, the government realized that the systemic importance of real estate companies for both the domestic economy and the health of the financial system meant ensuring stability for the sector was a key priority for policy makers. As we previously reported here, the idea behind the TRL initiative was to persuade the sector to improve its balance sheet health and debt coverage capabilities. Three key performance tests were introduced and for property developers to continue to enjoy free access to debt funding markets they would need to bring their financials in line with these metrics. The policy was first announced in August 2020 and therefore the 2H20 earnings reports have given us the first glimpse to how this policy may have actually impacted financial performance and management discipline. Hence this year’s reporting season has given the market significant insight into the trajectory of the sector for the medium term.

We have closely scrutinized the financial performance of key China HY property holdings in our JKC Asia Bond 2023 portfolio which represent some of the largest and most systemically important property companies in the country. Our conclusion is not only that there has been a clear observable improvement in credit health in 2H20 but that we believe this can be directly linked to the TRL introduction.

The main idea of the TRL policy was to reduce leverage, improve debt coverage and increase liquidity. The study of our portfolio holdings’ 2H20 results shows some interesting trends. Firstly, there was a strong acceleration in contract sales which is arguably the first leading indicator of operating cash flows. Admittedly contract sales in the sector has been on a growth path for several years, however the rate of growth in 2020 was particularly strong and impressive considering the 1H saw significant disruption from COVID shutdowns.

A second observation is across the sector we saw a material decline in gross margin.  Of course, margin compression is not normally positive as it generally indicates land prices have risen faster than average selling prices and certainly the depressed performance of property companies’ equity prices in recent months reflects this. However, while historically lower margins would usually cause managements to slow down their contract sales (to protect their profitability), in 2020 this does not appear to be the case. A combination of strong contract sales and lower margin trends together indicates a broad-based acceleration of the liquidation of land banks and prioritization of cash flow over earnings. For credit investors and particularly those holding short duration paper this is positive as it significantly improves near term debt service liquidity. Furthermore, we also saw many developers slow down their new land capex in 2020 again to the benefit of free cash flows.

So what has been the impact of these trends on the sector’s overall balance sheet gearing and, more importantly, performance against the TRL policy test? As the tables below show, the execution of credit improvement has been broad-based, in our view.  For the first TRL test (Adjusted liabilities / assets) 90% of the companies saw an improvement between June 2020 and December 2020. For the second test (net debt/equity) 81% saw and improvement and for the third test (unrestricted cash/ST debt) 86% saw improvement. In terms of the TRLs themselves - which are measured from green (passing all three tests) to yellow (passing two), to orange (passing one) and red (passing none) – 10 of the 21 companies under our study saw an improvement in ranking by at least one notch and 4 companies (namely Sunac, Powerlong, Ronshine and Hopson) improved by two notches.  It is perhaps unsurprising therefore that March was the first month, since the COVID crisis that rating upgrades in the China property sector exceeded downgrades.

Admittedly there has been some underperformers, (Yuzhou and China Aoyuan some notable examples) and we have seen some volatility in those bonds as a result. However, over the long term we continue to believe these trends should prove to be credit-positive as they demonstrate the developers’ willingness to follow government policy to reduce leverage in the sector even if it means some short term impact on earnings growth. We also welcome the fact that some of the most highly geared developers in the sector, such as Evergrande, Kaisa, Sunac and Guangzhou R&F have been some of the most aggressive in reducing debt.

Our positive view has been shared by S&P, who in their recent report “S&P Global Ratings: Chinese Developers’ Discipline is Policy Induced” drew the similar connection between improving debt growth levels and liquidity position to the “Three Red Lines” policy. According to the report, it is projected that more than 90% of developers will be able to fulfil two of the three requirements by the end of 2021, with at least half fulfilling all three of the red lines.

China property, given its scale and volatility, will always be a highly sensitive sector for Asian HY investors however as the sector has traded cheaply in recent weeks, we continue to see this as an opportunity for the market as fundamentals continue to improve.

Table 1: Change in “TRL” credit metrics for key property developers in our portfolio (between June 2020 and Dec 2020)

Portfolio Company

Change in Adjusted liabilities/assets

Change in Net debt/Equity

Change in Unrestricted cash/ST debt

Evergrande Group

-1.9%

-46.0%

0.11

China SCE Group Holdings

-7.7%

-10.0%

0.33

China Aoyuan Group

-2.0%

3.0%

-0.12

Shimao Group Holdings

-2.3%

-5.0%

0.1

Future Land Development

-2.0%

-4.0%

0.56

Guangzhou R&F Properties Co.

-1.5%

-47.0%

0.16

Sunac China Holdings

-3.5%

-53.0%

0.47

KWG Group Holdings

-2.2%

3.0%

0.16

Yuzhou Group

-1.9%

18.0%

-0.15

Ronshine Group

-3.9%

-22.0%

0.23

Kaisa Group Holdings

-4.3%

-34.0%

0.54

Central China Real Estate

-0.8%

-21.0%

0.16

Times China Holdings

1.0%

-7.0%

0.53

Logan Group Company

-6.2%

-6.0%

0.4

Powerlong Real Estate Holdings

-3.3%

-6.0%

0.24

Agile Group

1.1%

-12.0%

0.14

Fantasia Holdings Group

-3.0%

-4.0%

-0.14

Hopson Development Holdings

-0.8%

-12.0%

0.4

Modern Land (China) Co.

-1.4%

-11.0%

0.09

Redco Properties Group

-0.5%

12.0%

0.41

Zhenro Properties Group

-0.6%

-7.0%

0.03

Source: Citi Research

Table 2: Change in “TRL” rating for key property developers in our portfolio           
(between June 2020 and Dec 2020)

Portfolio Company

June 2020

Dec 2020

Evergrande Group

Red

Red

China SCE Group Holdings

Yellow

Green

China Aoyuan Group

Yellow

Yellow

Shimao Group Holdings

Yellow

Green

Future Land Development

Yellow

Yellow

Guangzhou R&F Properties Co.

Red

Red

Sunac China Holdings

Red

Yellow

KWG Group Holdings

Yellow

Yellow

Yuzhou Group

Yellow

Yellow

Ronshine Group

Orange

Green

Kaisa Group Holdings

Orange

Yellow

Central China Real Estate

Yellow

Yellow

Times China Holdings

Yellow

Yellow

Logan Group Company

Yellow

Green

Powerlong Real Estate Holdings

Orange

Green

Agile Group

Orange

Yellow

Fantasia Holdings Group

Yellow

Yellow

Hopson Development Holdings

Orange

Green

Modern Land (China) Co.

Orange

Yellow

Redco Properties Group

Yellow

Yellow

Zhenro Properties Group

Yellow

Yellow

Source: Citi Research

————————————————————————————————————

Associated risks: capital loss, counterparty, default, liquidity, operational, country-risk-China, Credit, currency, derivatives, emerging markets, interest rate, investment fund, management, market.

The investment objective of JKC Asia Bond 2023 is to achieve high income, over an investment period of 7 years from the launch date of the sub-fund. Synthetic Risk and Reward Indicator: 4 on a scale of 1 to 7, seven representing the highest risk / rewards profile

Associated risks: capital loss, counterparty, default, liquidity, operational, country-risk-China, Credit, currency, derivatives, emerging markets, interest rate, investment fund, management, market.

The investment objective of JKC Asia Bond 2023 is to achieve high income, over an investment period of 7 years from the launch date of the sub-fund. Synthetic Risk and Reward Indicator: 4 on a scale of 1 to 7, seven representing the highest risk / rewards profile.

Informative Document for professional investors only as defined by MIFID II. The information contained herein is issued by JK Capital Management Limited. It is provided for informational and educational purposes only and is not intended to serve as a forecast, research product or investment advice and should not be construed as such. The information and material provided herein do not in any case represent advice, an offer, a solicitation or a recommendation to invest in specific investments.  To the best of its knowledge and belief, JK Capital Management Limited considers the information contained herein is accurate as at the date of publication. However, no warranty is given on the accuracy, adequacy or completeness of the information. Neither JK Capital Management Limited, nor its affiliates, directors and employees assumes any liabilities (including any third party liability) in respect of any errors or omissions on this report. The opinions expressed by the author are based on current market conditions and are subject to change without notice. These opinions may differ from those of other investment professionals. Under no circumstances should this information or any part of it be copied, reproduced or redistributed. Prospective subscribers are urged to carefully and independently review the legal and business documentation, including the latest prospectus (which should be read prior to investing), Key Investor Information Document (KIID) and the annual and semi-annual reports, particularly with regards to the risks involved, and to seek appropriate professional advice where applicable (including regulatory and tax aspects) in order to determine the ability of the product to achieve predefined investment objectives. Published by JK Capital Management Ltd. - a limited company - Rm 1101 Chinachem Tower, 34-37 Connaught Road Central - Hong Kong – company number AEP547 - regulated by the Securities and Futures Commission of Hong Kong.

JKC Asia Bond 2023 is a sub-fund of La Française Lux (a Luxembourg SIVAV). The prospectus of La Française LUX was approved by the CSSF (www.cssf.lu) on 2021-03-05.

In relation to the investment strategy mentioned in this document, the latest prospectus, the KIID and the annual and semi-annual reports (whose latest versions are available free of charge on www.la-francaise.com or from our local paying agents (see below) have been published containing all the necessary information about the product, the costs and the risks which may occur.

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This is a marketing communication. In Switzerland, the representative is ACOLIN Fund Services AG, Leutschenbachstrasse 50, CH-8050 Zurich, whilst the paying agent is NPB Neue Privat Bank AG, Limmatquai 1/am Bellevue, P.O. Box, CH-8024 Zurich. The basic documents of the funds offered in Switzerland as well as the annual and, if applicable, semi-annual reports may be obtained free of charge from the representative. Past performance is no indication of current or future performance. The performance data do not take account of the commissions and costs incurred on the issue and redemption of units. Please be aware that this communication may include funds for which neither a representative nor a paying agent in Switzerland have been appointed. These funds cannot be offered in Switzerland to qualified investors as defined in art. 5 para 1 FinSA.

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