Private credit should escape Evergrande fallout

Were the Chinese property developer to default, it would be the high-yield market in the immediate firing line.

Alarm bells are ringing. With Chinese property developer Evergrande Group seemingly on the brink of default, some are comparing it with Long-Term Capital Management, the $126 billion US hedge fund that came close to collapse in 1998. In the event, LTCM was bailed out. Had it not been, many think it would have triggered a global financial crisis a decade before the actual GFC came along.

But is Evergrande of the same magnitude? A report from S&P Global hints it may not be far off. Pondering whether an Evergrande default would lead to either “a tidal wave of defaults swamping the credit markets” or something more like “ripples from a pebble in a pond”, S&P thinks the fallout will be somewhere in between. Not wholly reassuring.

S&P does not expect the Chinese government to step in and provide direct support to Evergrande, preferring to stay at arm’s length from a private company in a highly commercialised sector. But the report says it may be forced to step in “if there is a far-reaching contagion causing multiple major developers to fail and posing systemic risks to the economy”.

The issue of contagion is one considered by Hong Kong-based fund manager Zerobridge Partners in a newsletter published this month. The firm notes the dramatic impact that an Evergrande default would have on the high-yield bond markets, given that Evergrande’s US dollar bonds account for 16 percent of China’s dollar high-yield bond market and 11 percent of Asian dollar high-yield bonds. Zerobridge calculates that the default rate for the former market would increase from 4 percent to 20 percent and, for the latter, from 3 percent to 14 percent.

With high yield tending to be identified as the liquid, public market equivalent of alternative credit, is it feasible that contagion may also spread to the latter? Zerobridge doesn’t think this is likely, pointing to liquidity provided by both private equity firms and monetary policy, together with a diversified industry structure – unlike the Asian high-yield market, which is dominated by issuance from 10 large Chinese property developers, of which Evergrande is one.

The firm believes that private credit may enhance its standing as an access point to Asian credit risk for international investors, partly because the banks are likely to retreat from regional lending due to the public market volatility. This will leave “plenty of opportunities for private credit managers to generate mid-teens returns on productive senior secured loans”, reasons Zerobridge.

If this upbeat assessment proves accurate, it would not be the first time private credit has emerged in a stronger position from a crisis.

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