Rebecca Choong Wilkins and Lulu Chen

(Bloomberg) — When investor demand for Chinese property debt was approaching its peak back in 2018, a banker could pull together the makings of a multi-million dollar deal during a Saturday boat trip around Hong Kong’s harbor and barely look up from her drink while doing it.

Now, the $203 billion market—which once yielded several deals a week and padded portfolios across the world from Pimco to UBS—is all but dead. And offshore investors are swallowing almost all of the losses.

Chinese property junk debt has been one of the most profitable and popular corporate bond trades of the past decade, built on the back of the nation’s economic growth engine and introduced to the world via Hong Kong. Since the first bonds emerged in 1997, institutions like Credit Suisse Group AG and Goldman Sachs Group Inc. have brought international money flooding into an asset class where rewards were formidable and defaults extremely rare. In an era of negative-yielding assets, these bonds became a critical way for many global fixed-income investors to bolster returns. Even major pension funds and insurers bought in.

“Hong Kong was a window for the world to access China’s high-yield credit and witness the golden era,” said Andy Chang, who was a private banker at a large global institution in the market’s 2018 heyday. He has now switched gears to become chief strategy officer for financial advisory Hermitage Capital.

Only one major private developer had ever skipped its debt payments. Until last year.

But a government clampdown on the debt-saddled real estate sector has squeezed access to new financing since late 2020. Stalled property projects have sparked protests, with frustrated homebuyers in more than 100 cities refusing to pay mortgages for unfinished apartments. And the long-held assumption that the country would bail out its property titans crumbled when China Evergrande Group—whose 2025 bond had been one of the most liquid and widely traded in the world—defaulted in December. Having once traded as high as 105 cents, it now changes hands at a paltry 7 cents.

Read the Big Take on China’s sweeping mortgage boycotts

Now, defaults are picking up pace, more than $100 billion in market value has been wiped out and Hong Kong’s bankers have no deals to arrange. Fidelity International Ltd.’s China high-yield fund has lost 37% so far this year and its assets have dwindled to $985 million, less than half their mid-2021 peak. Value Partners Group Ltd.’s fund has lost 32%. After months of insistence that the worst was over, stalwarts such as BlackRock Inc. and UBS Group AG are leading a sharp cut in exposure to property bonds. Fidelity, UBS, BlackRock and Value Partners all declined to comment.

Doubts about the financial health of some companies began simmering years earlier. Evergrande, the world’s most indebted developer, has spent much of the past decade lurching from one liquidity crisis to the next. But few imagined the Chinese Communist Party presiding over such a dramatic, sector-wide collapse.

“No one could have predicted this. If someone tells you they predicted this, they’re a genius or lying through their teeth,” said Desmond How, fixed income chief investment officer at Gaoteng Global Asset Management Ltd.

How cut his teeth trading Asia high-yield credit at Lehman Brothers Holdings Inc. before its bankruptcy during the global financial crisis. He’s not the only one. Some of the US investment bank’s alumni have been at the center of the high-yield market ever since Nomura Holdings Inc.—a major player in Chinese junk debt—bought the firm’s Asia-Pacific business in 2008. Benjamin Fuchs, the chief executive officer of BFAM Partners (Hong Kong) Ltd., Li Ran, chief investment officer of L&R Capital Ltd. and Edwin Wong, CEO of SSG Capital Management Ltd. are all Hong Kong-based former Lehman employees.

Some funds now face mounting redemptions as clients pull cash after steep losses. BFAM’s assets have shrunk by about a third in the past year to just over $3 billion, Bloomberg News reported. One of L&R Capital’s funds had slumped by 18.9% this year as of May 31, Reuters reported.

Deal Frenzy

Real estate has been a vital source of growth for China since the 1990s, when the government ended decades of restrictions on private sales. The sector accounts for about a fifth of the country’s gross domestic product, and home ownership has become a core aspiration for many Chinese families. In recent years prices have soared alongside speculative buying, with new homes pre-sold well ahead of construction.

At the high-yield market’s height, Chinese developers did four junk dollar bond deals a week on average—raising more than $83 billion across 230 notes in 2019 alone. Credit Suisse, Deutsche Bank AG, UBS and debt arranger units at China’s Haitong International Securities Group Ltd. and Guotai Junan International Holdings Ltd. dominated the scene for the nation’s borrowers, a tight-knit club with about 200 core members, according to two bankers who didn’t want to be named discussing details of their deal-making. Haitong and Guotai Junan did not respond to requests for comment, while Credit Suisse and Deutsche Bank declined to do so.

It wasn’t just global investors that wanted in. Before the market collapsed, deals were especially popular among developer tycoons and their friends and family. When Evergrande sold $6 billion of bonds in early 2020, billionaire founder Hui Ka Yan purchased $600 million himself. His poker buddy and fellow real estate magnate Joseph Lau has bought into nearly every effort by the property giant to raise cash in public markets.

This pattern was typical of high-profile developers, bankers say. Sometimes private bankers would learn of forthcoming bond sales from their own clients, who’d heard from their real estate pals before deal terms hit the market.

QuicktakeRead More: Why China’s Developers Are Facing Mortgage Boycotts

On a 2018 junk boat trip in Hong Kong that included private bankers and debt arrangers, one attendee recalled how word spread of a popular developer coming to market with initial deal terms the following week. Between glasses of champagne aboard the gleaming white yacht—an upgraded version of the wooden trading vessels that are an iconic symbol of Hong Kong—a private banker onboard texted a couple of high-net-worth clients to let them know of the prospective sale. Within the hour, he had received queries from two other clients who wanted in.

“At the time there was a craze, and everyone was trying to snatch up China high-yield credit,” said Hermitage Capital’s Chang. “It was a complete sellers’ market. The property developers had all the say and power.”

Chang described once taking a few minutes to check whether he could get a better price for a bond his client was interested in. He called his colleague, then got in the office elevator to visit him in person—and by the time he reached his workmate’s desk, the bond was sold out at the target price.

High-net-worth clients could easily double their assets on China junk bonds at that time, said Chang. Returns were about 50% from 2012 to 2015, and about 12% from 2018 to 2019. The asset class was so popular there was a premium in pricing of about 8%.

“I told clients that they would be basically sacrificing the first year of returns if they paid that much, but people were so crazy about it,” he said.

Hefty trading volumes were the norm, although the Chinese junk market was considerably smaller than its US counterpart. As a private banker, Chang saw one client put more than $70 million into bonds, including a significant proportion of junk debt from issuers such as Evergrande and Co.

How said his biggest years were 2015 and 2016, when he was at Nomura trading $30 million to $40 million a day. “Those were good times,” he said.

Common Prosperity

Just a few years later, the industry’s food chain is falling apart.

The first inkling of change came in the second half of 2020. China’s “ three red lines” policy set leverage benchmarks that developers had to meet in order to borrow more money. Only a handful of developers were included at first but within months, it had claimed its first casualty.

Then in 2021, China introduced a centralized process for buying land in dozens of cities. Suddenly the plots for sale were bigger and firms had to pay up front. Only the largest developers could afford to replenish their land banks for future projects.

How and many others initially interpreted these reforms as the government’s way of ensuring the industry was sustainable. It wasn’t until he heard the slogan “common prosperity”—embodying President Xi Jinping’s unsparing campaign to narrow the nation’s persistent wealth gap—that How realized a crackdown was underway.

For nearly two years, China’s developers have taken a battering that threatens to be an even greater drag on the nation’s economy than its zero-tolerance Covid-19 measures. Home sales for China’s top 100 developers have slumped for 12 months straight. Defaults hit a record last year that 2022 is expected to surpass, with high-profile failures at some of the nation’s biggest builders driving more than $25 billion of delinquencies since January.

And traders lulled into a sense of security by years of juicy rewards and virtually no defaults are suddenly reckoning with credit crisis after credit crisis. Yields are still at historic highs of more than 25% and returns have been negative for 11 months, the longest stretch on record.

One banker employed by one of the top five deal arrangers estimated that between 2018 and 2019 he worked on 200 to 250 deals a year. In January last year, he covered 20 deals in a single week. Business is now so slow, the banker said, that he has time to work out and pick up calls from friends.

Only one developer has sold a high-yield bond without any type of extra credit enhancement this year and dollar bond sales in Asia have fallen about 38% so far in 2022, compared to a year earlier.

“It is a complete collapse of confidence in both the physical and capital market, as well as in the developers, that led us to where we are today,” said Jenny Zeng, co-head of Asia Pacific fixed income at AllianceBernstein. Authorities need to restore confidence across the entire economy, she added.

Confidence Collapse

Nearly all the losses in debt markets have been heaped on international investors. That’s weighing on the financial complex that supports China’s overseas debt market.

Banks like Standard Chartered Plc and UBS have seen high-profile departures from their trading desks. Former star traders are bracing for years of merely trying to recover losses, with little prospect of the generous bonuses once on offer.

Many junk bond investors are based in Hong Kong, whose status as a gateway between mainland China and the rest of the world is already under pressure due to strict pandemic-control measures and a crackdown on political dissent. Global creditors are facing the realities of a market where hidden debt, backroom deals and poor governance are the norm and nasty surprises can wipe out the value of a bond in a matter of days.

Even as the pool of survivors shrinks, investors remain vulnerable to sudden lapses in confidence.

While Evergrande triggered fears of an industry meltdown, it was a default in October by the much smaller Fantasia Holdings Group Co. that showed the rules of the game were being rewritten. The firm shocked investors by defaulting on dollar debt just days after repaying a private bond and only weeks after making assurances that it had sufficient working capital. Market watchers were left worrying that developers’ willingness to repay—rather than their capacity—would increasingly determine offshore investors’ fate.

And the pool of real estate companies at risk is still expanding, particularly as China’s stop-start Covid lockdowns persist. Government-backed firms were assumed to be immune until late June, when a partially state-owned developer announced a surprise extension on a bond that then fell more than 50% in less than a week.

At least $736 billion owed to creditors may still be at risk of restructuring or a haircut, Bloomberg Intelligence calculates.

Social Unrest

In July, a new crisis hit China’s real estate market as tens of thousands of people withheld mortgage payments on homes that developers, including Evergrande, have yet to complete. The first widespread social unrest since the start of the crackdown highlighted the growing frustration of ordinary Chinese homeowners who have poured their life savings into property. A “preliminary restructuring plan” that Evergrande has promised to deliver by the end of July has yet to appear.

Offshore bond holders are at the mercy of policy makers scrambling to quell dissent. China is weighing a plan to seize undeveloped land from distressed real estate companies, using it to help finance the completion of stalled residential projects. If approved, creditors stand to lose claims on some of developers’ most valuable assets.

For now, the days of heady debt-fueled expansion by private developers is over. The offshore real estate credit market is set to become dominated by state-run firms earning modest returns, under authorities that are quick to clamp down on speculation.

“While it’s the end of an era, it’s not the end,” Chang said. “This market will come back one day, albeit looking a lot different.”

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