International bondholders indicated here on Friday that they have not received the US$83.5 million payment they are due today from beleaguered property developer China Evergrande Group (HK:3333 and EGRNY).
I'll cover some long and short equity plays based on the Evergrande situation later in this article. But the stock and bond performance of the company itself should concern overseas investors.
With Evergrande promising it would pay the coupon on an onshore bond issued inside mainland China, international holders of its offshore high-yield debt risk being treated like second-class citizens. Evergrande has not defaulted yet, technically, because it has a 30-day grace period on the past-due payment. The money was due at noon here in Hong Kong on Friday, midnight U.S. time. But we're mincing words here.
It can't pay its debts. Simple as that.
The stock has been abandoned by all but the most aggressive day traders as equity investors risk leaving being left with nothing. A staunch ally, Chinese Estates Holdings (HK:0127 and CESTY) property tycoon Joseph Lau, said on Thursday he had sold off a hefty chunk (equivalent to 0.8% of all shares outstanding) of his Evergrande holding at a heavy loss and might sell the remaining 5.7% of Evergrande equity he has left.
Evergrande shares tumbled another 11.6% on Friday in Hong Kong. They bounced 23% like a dead cat on Thursday morning when trading resumed after the Mid-Autumn Festival holiday on Wednesday. They are at the end of the week still 83% down in 2021.
I had indicated there could be an arbitrage play on Evergrande's U.S. shares on Wednesday and that proved to be right. EGRNY soared 46% in U.S. trading on Wednesday, when the Hong Kong market was closed. Now the U.S. listing will be moving in reverse, and fast. It already surrendered nearly 21% and will surely fall heavily again today.
The impetus for the dead-cat bounce was a statement from Evergrande's operating business in mainland China, Hengda Real Estate, which said it had "resolved" the US$35.6 million coupon payment due on Thursday for its Shenzhen-traded September 2025 bond. Parent Evergrande remained mum about its offshore obligations.
Have regulators encouraged Evergrande to make good on its debts to domestic investors in China while leaving international bondholders that have less legal recourse swinging in the breeze? Or is the company prioritizing a smaller payment that it actually can settle while holding off on this week's US$83 million and another US$47 million next week in coupon payments that are due on its offshore bonds?
It's not clear. It's not even clear what it meant by "resolving" the onshore payment. Banks are in talks to roll over debt and are preparing to write it down. By the end of this year, Evergrande will owe bondholders US$600 million. A trip to the barber for haircuts looks likely.
Fallout beyond Evergrande
Evergrande is very large, the biggest Chinese developer by 2020 sales, and was extremely aggressive in its leverage. So it has been a high-profile victim of Beijing's push for deleveraging.
But the property sector as a whole faces fallout from a flood of credit slowing to a trickle. Evergrande disruption spilling over into other developers, the banking sector and the land sales that fund local governments could shave between one and four percentage points off China's overall economic growth, T.S. Lombard says in a note "Trading Evergrande's Downfall."
The independent research house is already cutting its forecast for Chinese growth to 8.2% year-on-year in 2021, down from 8.5%, and to 5.3% from 5.5% in 2022. It says risks are definitely "skewed to the downside," relying on what level of government intervention we see.
"The real estate sector share of China credit and growth is in terminal decline," write the T.S. Lombard authors, Rory Green, the head of China and Asia research, and Andrea Cicione, the head of strategy. That's a seismic shift. Property is the largest single private industry in the Chinese economy, around 14% of the entire country's output.
The Chinese government can backstop the Evergrande risk. The question, at a time the Chinese Communist Party is talking about "common prosperity" and equitable distribution of wealth, is how much it wants to bail out rich property tycoons, which will only encourage them to continue taking on too much debt. Moral hazard and fat cats on one side, socialism with Chinese characteristics on the other.
There's more than one rumor doing the rounds that Evergrande will be nationalized and split up. A report in Asia Markets, quoting "sources close to the Chinese government," said it could be split into three separate units in a restructuring underpinned by state-owned enterprises. Sounds like a plan.
Those nitty-gritty details will be played out, but the big issue is that all developers in China need to cut back on borrowing. That hampers their ability to build. Some must sell off properties at fire-sale prices.
How do you play that?
The long and short of it
Lombard picks out three stocks to go long and three stocks to go short. The long positions benefit from increased infrastructure spending, which Chinese local governments would need to step up to offset problems in the property sector. Jobs for the boys.
China Railway Group (HK:0390 and (CRWOF) ), China Tower (HK:0788 and CTOWY) and ZTE (HK:0763 and ZTCOY) are the long positions.
China Railway, despite the name, is the world's largest construction company by sales, with a specialty in infrastructure and civil engineering.
China Tower is the product of the merger of the communications tower businesses of the Big Three Chinese mobile phone companies -- China Mobile (HK:0941), China Telecom (HK:0728) and China Unicom (HK:0762), all now forced to delist in New York.
ZTE sells telecommunications hardware and software, which runs the gamut from network parts for carriers to smartphones for consumers. ZTE has been in and out of the news due to its run-ins with U.S. authorities. It describes itself as "state-owned but privately run," its state ties resulting in a ban on U.S. companies exporting to it. The ban was lifted, only for the Federal Communications Commission (FCC) in 2020 to adjudge it a national security threat.
Luoyang Glass (HK:1108), Royale Home Holdings (HK:1198) and Haier Smart Home (HK:6690 and HSHCY) are the short positions. They all supply home furnishings or materials that go into new properties.
Luoyang Glass makes, yes, you guessed it, glass! It is based in Luoyang! Actually, one of its specialties is ultrathin glass for organic light-emitting diode (OLED) screens and touchscreens. It is also a big producer of float glass, made by floating liquid glass on molten metal -- the kind of exceptionally flat glass you need for apartment windows. It sells mainly to the Chinese domestic market.
Royale Home Holdings makes home furnishings, working mainly with commercial customers and property developers. It does sell to consumers, too, but mostly licenses its brand to franchise holders who run stores.
Haier Smart Home is the listed business of the giant Chinese electronics maker Haier. It absorbed the home appliance business of sister company Haier Electronics in December 2020, bringing Haier's fridges, washing machines, water purifiers, air conditioners and kitchen appliances all under one umbrella.
The long positions should benefit from infrastructure spending on clean energy and the electric grid, and as 5G goes into 6G and smart devices take over the world. The materials and home-furnishing suppliers suffer as developers suffer in selling their homes. The downside risk to the shorts would be if there's a relief rally from Beijing's action to stabilize the Evergrande situation.
"For this reason, we set tight stop losses and will look to use any rally as an opportunity to re-enter the trade at a better price level," Lombard explains. "We are long-term bearish on the Chinese property sector."
Evergrande owes an enormous US$300 billion in total, which would amount to 1.8% of China's entire economy. Its "second-order" and "third-order" effects on suppliers, lenders, other property developers and ultimately consumer confidence in the Chinese pre-sale method of financing apartment construction would all be under threat.