Evergrande: Tricky trade or trap?
Evergrande: Tricky trade or trap?
The last few weeks the media has been full of sensational Evergrande news. Some news outlets are even describing it as the “Lehman Brothers” of China! -injecting fear about a potential domino effect in the interconnected web of modern financial markets.
To properly gauge the impact of the situation, one important concept to evaluate is isolation!
China is still a rather closed economy:
- Links between Chinese and non-Chinese financial institutions is very limited
- China has a bigger out- than in-flow of foreign direct investments!
- Foreign companies producing and selling their goods in China works through a joint-ventures construction with ether local companies or the state (e.g. Volkswagen AG produces its VW and Audi brands in China, through a “Chinese Volkswagen” (legal name: Shanghai Volkswagen Automotive Company) which is only 40% owned by Volkswagen AG and 10% Volkswagen (China) Invest.
Western point of view
It’s time to take a chill pill and look at Evergrande as it is: A huge Chinese real-estate company, mainly operating within the borders of China.
Sure, there’s a mountain of debt issued to foreign investors, but an important note is that the same debt is not ideal for use as margin collateral at clearing banks. If it is posted as such, it will already have had a significant haircut applied – reducing the chances of cascading margin-calls, which is what usually causes the domino bricks to start falling.
Chinese point of view
The situation is indeed not great, as of the 14th of October it looks very much like the liquidity for new bond issues by the Chinese development sector is drying up!
Any experienced trader or speculator knows that even well-engineered and hedged positions can go belly up in a liquidity squeeze. Using a dramatic example: It’s like putting a group of people in a room, then sucking the air out. The leanest with the best lungs will last the longest, but eventually, nobody is left standing.
The developers with re-financings any time soon, can quickly find themselves in trouble.
Bailing out rich real-estate developers would simply be too painful for the CCP and would erode a lot of support for Xi Jinping. It’s also clear that the sector is running amok! Some of the projects are so grand that it’s in reality whole cities or massive districts. Some of those projects don’t work out as expected, and turn into the infamous “ghost cities of china”.
The decade long building boom has left lots of empty apartments in its wake. The number frequently referenced by researchers is 60 – 65 million (source: 13th of February 2019, NIKKEI Asia) in tier 2 and 3 cities (that’s all the >10 million inhabitants cities you have never heard about). There’s no data on what the apartments are worth or valued at, but through various sources, the indication is that the range is between 100 – 300k yuan, the range is most likely a normal distribution.
If an apartment that costs 200k needs to be paid over 20 years, that leaves a monthly payment of 833.3 yuan. The mortgage for the borrower needs to be no more than, say, 1/3 of income, which means the min. income should be 2500 yuan, this falls right in the middle of the 2.000 – 3.000 income group, for simplicity the proportion is just halved, leaving just 23.71% or 332.45 mil. of the population able to buy it. So, an empty apartment for every 5.32 financial eligible person!
| Proportion | Monthly income per person (yuan) | Population (mil.) |
|---|---|---|
| 0.05% | >20.000 | 0.7 |
| 0.56% | 10.000 – 20.000 | 7.84 |
| 4.5% | 5.000 – 10.000 | 63.28 |
| 11.2% | 3.000 – 5.000 | 156.95 |
| 14.8% | 2.000 – 3.000 | 207.35 |
| 26% | 1.090 – 2.000 | 364.02 |
| 42.9% | 0 – 1.090 | 599.92 |
Income distribution over population in both relative and absolute terms. (source: 2019, National Bureau of Statistics
Then I haven’t even mentioned:
- The “couples effect”, a family only needs 1 home
- Ageing and soon shrinking population
- There’s plenty of unused commercial real-estate space as well!
Show me the write-downs! - Nothing even closely needed to bring sanity back to the sector.
So, this is how I guess it works:
Mr D (developer) asks his friendly bankers at ICBC, CCB, ABC and BOC for a loan to a project in Shanghai. It’s granted as long as some of the money is used to develop parts of the country that’s underdeveloped (like tier 2 or 3 cities). Accepted let’s go! Mr D makes a kill on the Shanghai project, but not so much on tier 2 one, as it doesn’t sell. But it doesn’t matter, as long as just a few apartments are transacted every few months at a higher price, the valuation can be kept high and the loan alive with even a better solvency rating. As long as the margins on the good projects are as high as they are and the market, in general, is trending up, life is good and the bonuses are fantastic! This has strong similarities to a Ponzi scheme.
What will happen?
Most of the loans given to developers are from state-owned banks, which ultimately means the government is on the hook. The opportunity for the CCP to deflate the looming real-estate bubble. Putting the high-flying real-estate elite in their place. Become the hero of hundreds of thousands of common people currently in limbo. Last but not least; participate in the party you anyways are paying for.
It can’t be spelt out more clearly; we will see some form of nationalization! Most likely it will be called the less scary word: restructuring, essential it will be the same.
How to play it?
To keep it concise I’m here focusing around the Evergrande spectacle, and only on the fallout of the USD denominated debt. I believe it’s going to get a lot worse before it gets better, so holders of Evergrande debt is going to have a hard time. Of the most interesting holders is:
- Vontobel Holding, VONN: It’s not clear who ultimately owns the bonds, but exposure is large relative to the company’s size (I own OTM puts on this one!)
- Prudential Financial, PRU: Insurance, they make a return (or not) on their capital while it’s lying as a reserve.
- Abrdn, ABDN: Same as PRU
- Ashmore Group, ASHM: Apart from having a lot of exposure to Evergrande, they have mainly exposure to the region.
- St. James’s Place, STJ: Exposure to Evergrande and seemingly an unaffected stock price.
On October 18-19 the company will be declared in default, due to the expiration of the 30-day grace period from the first missed payment deadline. However, many tricks can, and probably will be used; like paying a fraction of the instalment, to show goodwill, and begin talks with the creditors.
It will probably turn into a theatre, I do expect some changes at the latest end of November, where so many grace periods will have passed that the theatre has to come to an end.
The silver-lining
As I believe It’s very unlikely Evergrande is going to recover; start paying its bondholders, deliver all their half-finished projects on time and celebrate the successful turnaround with fresh dumplings at year-end. As stated previously, I think we will see some form of nationalization. This is where things can get REAL interesting! Following quotations is taken straight from the “Offering Circular” of EVERRE 8.250% 23Mar2022 Corp (ISIN: XS1580431143)
“Events of default”
“The 2018 Indenture contains certain customary events of default, including default in the payment of principal or of any premium on the 2018 Notes when such payments become due and payable, default in payment of interest which continues for 30 consecutive days, and other events of default substantially similar to the Events of Default under the 2018 Indenture. If an event of default occurs and is continuing, the trustee under the 2018 Indenture or the holders of at least 25% of the outstanding 2018 Notes may declare the principal of the 2018 Notes plus a premium and any accrued and unpaid interest to be immediately due and payable. Upon the occurrence of certain specified events of default, the principal of, premium (if any), and accrued and unpaid interest on the outstanding 2018 Notes will automatically become and be immediately due and payable without any declaration or other act on the part of the trustee or any holder."
In short: Once Evergrande defaults, creditors can demand 25% of the principal + interest to be paid immediately.
This would be great for the CCP, a cheap way of getting rid of foreign investors.
“Change of control”
“Upon the occurrence of certain events of change of control and a rating decline, we will make an offer to repurchase all outstanding 2018 Notes at a purchase price equal to 101% of their principal amount plus any accrued and unpaid interest, if any, to the date of repurchase.” This refers to the more commonly known bond feature “Change Control Put”, which forces a payment to the creditors in case of a merger, amalgamation, consolidation, transfer of ownership, transfer of control (big change in the Board of Directors). There’s 1 caveat though! At least 1 rating agency need to rate the bond D(ecline). As of 14th of October, Fitch’s rating is C, just so slightly above D.
On the Bondsupermart Factsheet for XS1580431143, there’s a more detailed explanation of this feature for this exact bond.
Hedge funds arrive to the party!
Marathon Asset Management recently made headlines by jumping into the Evergrande bonds in a very public way. I believe they are simply looking at 2 things, the bonds are now so cheap that they trade at or below asset value, so your money is technical “more or less secure”, but you have this enormous upside in the form of the “Change Control Put” feature.
Dedication
If you are interested in the Evergrande / China play-out, I urge you the read about André Kostolanys trades with distressed debt of nations especially the ones in D-Mark and the defaulted debt of the Russian Czar, therefore If this trade could be dedicated to anyone, it would be to André Kostolany!