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Daniel Molnar

Daniel Molnar
Senior Associate, MSCI Research

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After Evergrande: Bond Liquidity of Chinese Property Developers

  • The credit spreads of top Chinese property developers have increased dramatically in recent months, reflecting the distress of the sub-industry.
  • Our analysis finds that bid-ask spreads have substantially understated the total transaction costs for this group.
  • Transaction costs were as high as 2% at the beginning of November, a significant addition to the 32% drawdown of our model portfolio since June 2021.

As one of China’s largest property developers and one of the most indebted companies in the country today, China Evergrande Group had a recent close brush with bankruptcy that generated considerable interest and concern among global investors.1 Other Chinese issuers have also suffered considerably over the past few months. In this time of distress, how has market liquidity responded?

To shed light on the Chinese property-developer sub-industry, we created an equally weighted model bond portfolio of the four largest issuers, after excluding Evergrande.2 These four issuers together have nearly USD 40 billion of debt outstanding in offshore bonds. The exhibit below shows the average credit spreads for this model portfolio against spreads in the broader Chinese offshore corporate-bond market.

Evergrande’s potential default may have had a spillover effect on other issuers, with credit spreads of the leading issuers’ offshore bonds widening dramatically between June and November 2021. Although not as significant, spreads on high-yield bonds also rose substantially over this period. In contrast, spreads in the investment-grade segment have remained at a roughly consistent level.

 

Distress Among Chinese Property Developers

Source: MSCI analytics based on IHS Markit data

 

Market Drawdown for Model Portfolio of Top Chinese Property Developers

Source: MSCI analytics based on IHS Markit data

 

Accounting for Transaction Costs

As seen in the exhibit above, increasing credit spreads resulted in a 32% drawdown in our model portfolio between June 2021 and the beginning of November. But institutional investors may have faced additional losses when exiting these positions. We used MSCI’s RiskMetrics® LiquidityMetrics® to estimate the cost of liquidation within one day for different trade sizes, which can be seen in the interactive exhibit below.3

In our methodology, these transaction costs consist of bid-ask spread and market impact.4 The market impact is the extra cost above the half bid-ask spread and a measure of how much transaction prices may be impacted by larger trades.

In our analysis, we found that increasing bid-ask spreads did not show the full extent of worsening liquidity: For a larger trade size of USD 5 million, the market impact contributed more than half of the total transaction cost. Transaction costs may have roughly tripled for larger trade sizes during the period of our analysis and resulted in an additional 2% loss on top of the market drawdown.

 

Transaction Costs for a Typical Bond in the Model Portfolio

 

Source: MSCI analytics based on IHS Markit data

With increasing credit spreads and market drawdowns among Chinese property developers, the situation was exacerbated by deteriorating liquidity conditions over the past few months. Our case study showed that transaction costs can be a meaningful contribution to portfolio losses. Our analysis has focused on Chinese property developers, but it may have lessons for other areas of the market that may experience distress, and highlights the importance of tightly integrating liquidity into risk management.

 

 

1“Evergrande Gave Workers a Choice: Lend Us Cash or Lose Your Bonus.” New York Times, Sept. 19, 2021.
“Evergrande: the bond and interest payment deadlines to watch.” Financial Times, Nov. 3, 2021.

2We included only bonds that were consistently quoted through the analyzed period. The final model portfolio contained 49 bonds.

3Knipl, Diana, Bohak, Andras, and Hollo, Laszlo. 2019. “Integrating Trade and Quote Market Data into Fixed Income Liquidity Research.” MSCI Model Insight.

4The bid-ask spread is the roundtrip cost of buying and selling a certain security. We assume that one half of this may be attributed to the purchase and the other half to the sale of the bond. The market impact is the extra transaction cost above the half bid-ask spread resulting when the size of the trade exceeds the typical quote size.

 

 

Further Reading

Chinese Government Bonds: Higher Yield, Less Risk?

Liquidity and correlation in the Chinese credit market

Bond Liquidity: How Bad Was COVID?

What Can Liquidity Tell Us About ETF Prices?

Should bank-loan investors worry about liquidity risk?