Investing in Chinese illiquid credit amid liquidity concerns

BlackRock and Natixis have made liquidity issues a talking point as more investors commit to illiquid credit for higher yields.

BlackRock, the world’s largest asset manager by assets under management, says liquidity and the pricing of credit in China will be significant concerns over the course of next year, according to its Investment Institute 2018 Global Investment Outlook press conference held on Tuesday in Hong Kong.

The institute compared different income strategies and their average weekly excess return dividend with the volatility of returns during 2017 (ending in November), which showed that USD-denominated Asian illiquid credit strategies delivered higher risk-adjusted returns compared with core asset portfolios elsewhere.

For instance, the Sharpe ratio of Asian illiquid credit strategies for 2017 stood at around 2.2, well above 0.6, the ratio for the past five years.

The search for yield amid a relatively low base rate environment has driven many income investors into riskier credit strategies. Cheaper cost of funding has also encouraged corporates to actively issue debt instruments.

“[We have seen] a very strong use of [debt] instruments this year, in Asia specifically this year has been the record year of supply coming through in the markets and this has been the biggest year for debt issuance that we have had,” Gregor Carle, head of fixed income product strategy at BlackRock, said on Tuesday.

“That has happened because companies have CDO opportunities to refinance with relatively low rates, so if you are a corporate treasurer or CFO, taking advantage of those opportunities are important because if you look at your interest cover and how a lot of senior management manage their debt balance – if they can owe debt [with] far less [fees] than before – we see more debt maturities coming up,” Carle added.

“They will try to refinance ahead of future maturities if rates are low, and that is a good practice,” he noted.

BlackRock Investment Institute projects that corporate credit fundamentals are resilient globally, given investment grade corporate leverage metrics with decreased multiples of 1.5x as of June 2017, compared with 1.8x recorded during 2013 and 2014.

However, this does not necessarily mean that corporates will take on more debt to meet demand for expansion.

“The key drivers of a high level [net debt to EBITDA] ratio would be how leveraged the balance sheets are relative to the level of cash flow they have got, and given the availability of liquidity that means that in terms of the ‘funding cost for debt’, it still remains pretty low, but given the growth that we have got, many corporates are experiencing strong cash flows which is what is driving the EBITDA part of that equation,” he added.

Carle thinks that a slowdown [of economic growth] would be symptomatic of a change in the need for liquidity.

“And if we see growth fall off then that EBITDA component will change and that would be what would make this [net debt / EBITDA] ratio move more likely, and then you can potentially see corporates increasing their debt so that they can meet their working capital requirements,” he noted.

“It’s an ongoing environment where we still have a lot of management in the region who remember a recent crisis, and are not willing to manage their companies in a particularly aggressive fashion – particularly given the concern that they might have about how long this growth trajectory might still continue,” Carle said.

Natixis, a French investment bank, points out in an annual publication that Chinese economic growth remains robust with a positive bias towards large corporates.

Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis said: “Local government in China swaps debt and securitised loans from banks’ balance sheets, which helps it to carve out loans from banks’ balance sheets”.

“Loan growth is decelerating but it is still robust given the 15 percent growth rate of total social financing this year, compared to the 10 percent growth rate of nominal GDP growth, year-on-year,” she added.

Total social financing includes off-balance sheet forms of financing, including loans from trust companies and bond sales.

“This indicates that its financial industry is leveraged and massive securitisation is happening in the Chinese banking sector,” she noted.

Funding costs for Chinese banks are higher due to tighter monetary policy and targeted lending, which benefits state-owned commercial banks at the expense of others, including smaller and private banks, according to Natixis China Banking Monitor 2017.

It points out that debt-to-equity swaps and securitisations from those banks are also shifting loans and risks to other parts of the financial system.

“The CDO market is really a proper market because it allows investors to hedge,” Gary Ng, Asia-Pacific economist at Natixis, told PDI.

“One of the problems that the Chinese financial market – if you call it a market – has is that we cannot price risks given the transparency issue,” Ng added.

“Also, if you are investors, it seems that you perceive the risks that you are taking, but in reality, some investors think that returns are guaranteed. If things go wrong, they still think that they are all going to be bailed out,” Ng noted.

“Another question is do you know the real risks given different rating standards between Chinese and foreign rating agencies? This leads to one conclusion: It is very hard to assess risks in China, basically,” he said.