How will Evergrande’s fall-out affect the global bond market?

EVERGRANDE, China’s largest financial concern, has made international headlines again. Concerns of a potential default sparked fears of an acute spill-over impact on global credit markets.

Consequently, major credit markets were hit by a blanket of pessimism, and some suffered persistent selling over recent weeks. As the saga unfolds, we assess the scope and degree of spill-over domestically and globally to uncover potential impacts on major credit markets.

Comparing credit spread between China high yield (HY) and China Investment grade (IG) offshore US dollar bonds, we noted a divergence in spread levels starting in June 2021 as news regarding Evergrande became progressively dire.

During this period, the spread of China HY offshore bond index exploded higher while the spread of its IG counterpart tightened (Chart 1).

Chart 1: Credit spread of China HY offshore bonds has exploded higher while those of IG offshore bonds have barely reacted

This divergence is significant and, in conjunction with the spread tightening of China IG bond index, suggests an absence of material stress within China IG offshore bonds.

Credit spread of the latter remains low and does not reflect funding stress that may be triggered by the Evergrande fall-out. Moreover, the spread has started to retrace lower after a brief widening following the barrage of bad news from Evergrande.

A detailed look at the changes in credit quality of China’s corporate issuers highlights the reason for an absence of spill-over into the IG bond market.

Year-to-date (YTD), numerous HY issuers have been dealt with credit rating downgrades (by rating agencies) while IG issuers were concurrently receiving more upgrades and fewer downgrades. In other words, China’s HY issuers are seeing a deterioration in credit quality while those of IG issuers are ameliorating.

A closer look at yields of the largest players within China HY offshore bond index suggests that credit stress, at the moment, is largely contained within the property sector while non-property sectors are not implicated.

There is an observed distinction in yields across China HY bond sectors – yields of property bonds have surged (reflecting mounting credit risks) while those of non-property bonds remain largely unaffected.

An in-depth look at the largest constituents of China HY offshore bond index show that (i) yields have been relatively flat and below YTD high for Bank of Communication and Lenovo bonds – both of which are non-property bonds whereas (ii) yields for property bonds such as those from Kaisa Group Holdings, Sunac and Evergrande have skyrocketed, making YTD highs.

At the current moment, we also see muted direct impact on China sovereign bonds with its credit default swap (CDS) further suggesting little systematic risk. While the spread of China CDS has risen, suggesting an uptick in default risk, it remains low relative to history.

In our view, these are signs that the sovereign bond space is not yet facing significant stress and ultimately, systemic risk from the Evergrande fall-out.

Broadly, DM credit markets do not have direct exposure to China bonds. Credit spreads for US HY and IG bonds barely flinched when Evergrande’s possible default made news over the past couple of weeks.

The same observation can be made for European HY and IG bonds during the same period. In fact, for the HY and IG segments of both regions, spreads remained near their all-time low during this period, implying low embedded credit risk.

With no direct exposure and an absence of credit stress, we expect DM credit markets to be least at risk to a spill-over even if Evergrande defaults.

For EM hard currency debt (EMD), the underlying exposure (to China bonds) is only 3-4% to agency and sovereign bonds which are widely considered safer given their stronger credit quality.

EM HY bonds, on aggregate, possess a slightly higher underlying exposure of 4-5% to agency and corporate bonds. That said, we are unconcerned as the direct exposure is only at an estimated 0.2%.

Across EM credit markets, there was a brief spike in spreads for EM HY and EMD. However, in our view, the degree of these moves is considered mild given that spreads for both segments remain low relative to history after widening. Therefore, we see little signs of stress within EM credit markets and alongside the relatively small direct exposure, we expect minor risks to a spill-over for EM credit markets.

Within the Asian bond space, we see a divergence between IG and HY credit spreads (Chart 2) mirroring the China bond space. Spread for Asian IG bonds have barely reacted and are showing little signs of stress as the exposure to China bonds are primarily via the safer corporate IG bonds.

On the contrary, credit spread for Asia HY bonds have surged to around 110 bps (basis points) since September and is currently at 930 bps (as of Oct 4), exceeding levels observed during 2018’s US-China trade war and 2015’s China market turbulence.

With the Evergrande saga still ongoing, we expect the situation to remain fluid and thus a wider scale contagion remains possible albeit at a low likelihood. That said, as we move ahead, we expect the impact from the Evergrande fall-out to be contained domestically within China HY bonds.

Intervention by Chinese authorities plays an integral part and we are seeing attempts to ring-fence spill-over impacts. Consequently, we are also not expecting any major spill-over to China IG bond markets, both onshore and offshore.

Globally, we expect minimal spill-over to major credit markets and such implication will be limited by the exposure to China bonds. Global credit markets have yet to show material signs of stress after the Evergrande fall-out and spill-over fears are gradually abating.

Among major credit markets, Asian HY bonds are more at risk due to their higher underlying exposure to China bonds. However, at the moment, we are not overly concerned given the smaller direct exposure to Evergrande bonds and our expectation that risk will be contained within the China property sector.

 

iFAST Capital Sdn Bhd provides a comprehensive range of services such as assisting in dealing, investment administration, research support, IT services and backroom functions to financial planners.

The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.

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