Photos of people crowding around China Evergrande Group’s headquarters in Shenzhen, demanding repayment on loans and financial products, is all too familiar.
Analysts don’t predict that the collapse of Evergrande Group will spawn the devastation of the collapse of Lehman Brothers in 2008—but the rippling effect is already well underway.
Evergrande is one of China’s largest real estate developers with hundreds of projects across 234 cities. It’s also the most indebted company in the country, with debt of more than $300 billion, equalling 2% of China’s GDP, and approximately $19 billion of distressed bonds outstanding as of last week. The vast majority of U.S. investors don’t have direct exposure to Evergrande in their portfolios. Even so, the company’s collapse could send ripples throughout the entire Chinese real estate sector—not to mention the rest of Asian markets. (Here is a look at how exposed U.S. investors are to Chinese markets)
It already has. Since Evergrande’s liquidity problems were first publicized in late 2020, the value of MSCI’s China Real Estate Index, which tracks the performance of the real estate sector, has tanked:
The key consideration for investors is whether these losses will be a near- or -long-term event.
Investors don’t need to be on the edge of their seats here: Volatility is standard—particularly in emerging markets. Additionally, most of the potential fallout will happen locally in China, according to Michael Cembalest, Chairman of market and investment strategy for J.P. Morgan Asset Management.
“The vast majority of pain and disruption and dislocation that comes from Evergrande will be dealt with within China itself, because most of the capital, the loans, the mezzanine, equity are organically sourced within China,” he says.
At the same time, it’s important for investors to know what’s in their portfolios and also regularly evaluate who they’re entrusting to manage their dollars. U.S. asset managers have radically divergent strategies towards China’s real estate sector right now.
Who’s most exposed?
Even funds with comparatively outsized portions of Evergrande equity or debt have limited exposure to the real estate giant itself. No U.S. bond fund has more than 5.18% of its assets in Evergrande bonds, and no equity fund has more than 0.80%, according to Morningstar Direct data.
Over the last year, Evergrande was downgraded to a lower quality credit as its become more at risk of defaulting on its obligations—triggering its removal from a host of bond funds.
“A lot of [portfolio managers] sold or really significantly trimmed their exposures in the latter part of last year,” says Mike Mulach, a fixed income research analyst at Morningstar.
Even within the realm of bond funds, 5.18% is an exceptionally high allocation, relatively speaking. Here are the 11 bond funds that are most exposed:
Evergrande is hyper-leveraged, and it has been in trouble for some time now. And last year, Chinese regulators said they would get stricter with debt limits imposed on heavily indebted companies. The severity of Evergrande’s liquidity problems were first publicized in September 2020, but it has begun to miss interest and principal payments in the last two months, throwing its stock into freefall as it failed to meet payments in time. That was enough to temporarily hit markets across the rest of the world.
Evergrande’s missed coupon payments aren’t an immediately horrific event. There is a 30-day “grace-period” window for the company to still make good on those payments. The big question is whether it will. Meanwhile, credit agencies are downgrading the company’s notes (Now C, from CC). The company needs to come up with more than $4 billion in coupon payments and outstanding bonds by April 2022. (Here is a more-complete timeline of the company’s troubles.)
Apart from Evergrande being a big company, it’s also a big real estate company, which is an important sector in the Chinese markets. About 70% of Chinese household wealth is invested in property. Evergrande’s collapse could significantly slow that sector down.
“Most investors aren’t going to have a lot of exposure directly to Evergrande. I think a lot of the concern around this has been contagion,” says Mulach. “It’s such a big company. It’s unwinding so much debt that they’re worried about how that impacts the rest of the Chinese real estate market” as well as other sectors it was involved in.
Mulach and a team of Morningstar analysts analyzed how major emerging market managers are thinking about Evergrande, and the rest of the real estate sector right now. Here are some of their findings:
Ashmore: Ashmore is one of the largest holders of Evergrande debt. Ashmore Emerging Markets Short Duration Institutional (ESFIX) has more assets allocated to Evergrande than any other fund in the bond market. The asset manager is forecasting there will be an orderly debt restructuring rather than a liquidation, and it’s not anticipating a regulatory crackdown on the rest of the real estate sector.
Barings: Barings has avoided Evergrande for years in favor of companies that are more diversified in their sources of funding. The asset manager focuses on specific sectors of Chinese real estate, such as rental and urban renewal properties. Barings anticipates volatility, but not long-term losses in the Asian high-yield bond market.
BlackRock: The asset manager is generally hesitant towards Chinese debt in 2021, but it has added Evergrande debt to five strategies this year, due to its belief that there will be a distressed exchange (which means that creditors will swap out their obligations for cash, new debt, equity or a combination of the three) or that a state-owned company may take over the real estate giant.
BlueBay Asset Management: This asset manager also holds Evergrande debt in its bond portfolios. It plans to add other high-yield bond issuers into the mix after the market stabilizes some.
HSBC: HSBC sold its positions of Evergrande in early September but is bullish on Chinese real estate due to attractive yields on bonds issued by below-investment-grade property developers as well as their belief that China’s monetary policy will will boost the sector. The asset manager anticipates that trouble may lie ahead for other over leveraged property developers and that the Asian banking sector could suffer as a result, due to significant exposure.
Pimco: The asset manager has been cautious of Evergrande for the last two years. It held a .20% allocation of the Evergrande bonds in its Pimco Emerging Markets Bond (PEBIX) coming into 2020, but has done away with that exposure as the year has gone on. That’s when China got stricter around debt limits for companies with high leverage. Pimco is optimistic about Chinese real estate in general, due to strong housing demand. The asset manager is still investing in Chinese developer bonds active in coastal and urban markets that Pimco perceives to have practical debt loads.
TCW: The TCW Emerging Markets Income (TGEIX) fund held more than 1% of its portfolio in Evergrande in April 2020 but had cut that exposure by about half by year-end, then fully exited by Aug. 2021. It’s waiting on the sidelines to see how the situation plays out, then plans to buy high-quality developers that sold off.
T. Rowe Price: The asset manager has purchased Evergrande debt on occasion. The T. Rowe Price Emerging Markets Bond (PRXIX) purchased some Evergrande bonds during the COVID market selloff in 2020, but had sold all of its positions in six months. The asset manager has sold off most of the positions in other Chinese property companies that it had purchased since. It plans to deleverage the real estate sector for its future investments.
UBS: UBS had reduced its holdings of Evergrande bonds in its actively managed funds, but maintained its holdings in its fixed-term bond funds. The asset manager predicts that the Chinese government will get involved and the real estate developer will keep operating. It’s not expecting this to have a notable impact on the rest of the Asian high-yield market.
The Evergrande debacle serves as a good reminder to investors of the risk emerging markets pose on portoflios.
“This happens,” says Mulach of the emerging market bond market. “Every year there are defaults.”
Of course, risk can also mean more alpha. It all comes down to what you’re comfortable with—and picking asset managers you trust.
WEEKLY CHART
After all the bond talk, let’s take a peak at which equity funds are most exposed to Evergrande stock, too:
JARGON, EXPLAINED
“Bond default”— Companies, governments, or municipalities that issue bonds are required to make regular payments to their lenders. A default occurs when they aren’t able to make those contractual payments, signaling serious financial trouble. Bondholders and issuers can restructure the terms of the debt, so that the issuer is able to meet its obligations and avoid a default. If that doesn’t happen, the issuer will have to liquidate their assets and re-distribute those funds accordingly, meaning that bondholders may lose a chunk of their initial investment.
DON’T MISS THIS
You’re probably well aware of Bitcoin’s carbon emission problem, but do you know about the cryptocurrency’s other environmental headache? Bitcoin miners dumping are dumping their IT equipment to get the latest and greatest machines, creating a huge e-waste issue. My colleague Shawn Tully walks us through the implications here.
Have an investing query you’d like to see addressed? Send me your thoughts and feedback below. Thanks for reading.
Jessica Mathews
Twitter: @jessicakmathews
Email: jessica.mathews@fortune.com
More finance coverage from Fortune:
- What are stablecoins? Your guide to the fast-rising alternative to Bitcoin and Ethereum
- Americans’ credit scores hit another high point amid the pandemic
- Pandora’s sparkling comeback powered by stimmy checks and lab-grown gems
- Procter & Gamble has a brand problem
- Why the “unloved” U.K. stock market is still singing the Brexit and COVID blues
Welcome to The Dividend, Fortune’s new weekly investing column, available exclusively to subscribers. Each week we’ll dig into an area of the market that’s making headlines and help you figure out what deserves a place in your portfolio—and what doesn’t.
