Doug Goodwille from Kayne Anderson speaks to Drew Meredith from The Inside Network on market thinkers.
While a surging gold price is on hold as the world adjusts to a Trump presidency, all the factors that saw its price rise more than 50 per during his first term in office – trade disputes, fiscal deficits and geopolitical tensions – are almost certainly guaranteed the second time around.
Evergrande and the threat to passive indexing
Evergrande Group (HKG: 3333) has dominated headlines, news bulletins and investor psyches in recent weeks, with long-held concerns about China bubbling to the surface once again. Put simply, Evergrande is China’s largest property developer, and a group that has been central to the boom in Asia’s credit markets in recent years.
The group has also been central to the massive boom in China’s property market, responsible for some 1,300 projects in 280 cities across the Middle Kingdom. The company is considered high-yield, in that it has a credit rating well below investment-grade, at CC. In recent months the group has come to the attention of global investors due to what appears to be its impending default.
Most media clearly understand the scars left by the GFC, with many referring to an Evergrande default as China’s “Lehman moment,” referring to the collapse of Lehman Brothers in September 2008, which left US financial markets teetering above the abyss, and helped to trigger a global recession. While this analogy likely overstates the potential impact of the group on the Chinese economy, it is by no means immaterial. The company has over US$300 billion ($411 billion) in liabilities which according to reports is around 2 per cent of the entire Chinese economy. China’s property sector represents around one-third of economic output.
The potential default and collapse has been on the cards for several months, or even years according to many experts, with the group simply running too fast and relying on constant access to capital. The slowing economy and tighter monetary policy in 2020 seemed to be the initial trigger. Many of the group’s bonds are now trading at around $30 compared to a $100 face value, with investors facing a 70 per cent loss.
But the big question many are asking is, who was buying Evergrande bonds in 2020 and 2021 – and more importantly, why – as the situation became more difficult. The answer, in most cases, is quite simple. The Chinese property market makes up about 1.5 per cent of the Global Corporate High Yield Index, with Evergrande itself representing 0.6 per cent of the index. What this means is that any funds, exchange traded funds or investors seeking to track this index were forced to buy and hold Evergrande debt solely due to its significant size in the benchmark.
Two of the biggest holders (and recent buyers) were Blackrock, the largest asset manager in the world and issuer of iShares, and HSBC, both of whom run the larger high-yield index-tracking strategies. So it wasn’t an active decision or one based on valuation that saw both firms adding to their existing Evergrande holdings; rather, they were forced to do so.
The way that passive investing works is that for every dollar invested into an ETF, the issuer of that ETF must go out and buy a proportionate share of every bond or share in said index. So, if a High-Yield index-tracking strategy was seeing inflows due to it forming part of a broader portfolio of investments, Evergrande saw its bonds being purchased. This is clearly a risk that many investors and advisers fail to appreciate in the never-ending trend towards low-cost strategies.
Low-cost makes sense, it is easy to justify to an investor and you are guaranteed to never underperform the index, because you are tracking it. But it brings significant questions around diversification, risk management and appropriateness for retirees who have shorter investment timeframes and generally less tolerance for volatility.
Another issue raised by the growing issuance of Evergrande bonds is the nature of the index itself. In bond markets, as in equity markets, the bigger you are, the more flows you get. That means that the largest, most-indebted borrowers gain the most capital flows; the US Government being the perfect example.
And don’t think governments or corporate treasury teams aren’t fully aware of this. These groups aren’t sitting on their hands and just issuing bonds, i.e., new debt, whenever they need it. Rather they are highly active in seeking mispricings, seeking to raise funds at the most opportune time and the maturity length that benefits them most.
The same can be said for the falling quality and ratings of the major bond issues. As an index-tracking ETF, particularly operating in high-yield, where ratings range from BBB- down to the unrated level, you have no control over who is issuing debt. That means a flood of C-rated issuers may enter the market, which you will be forced to buy.
While cost is no doubt important, the Evergrande issue highlights the risk of focusing only on one thing. Passive indices clearly have a role to play, but by no means are they the low-risk, one-stop solution that many view them as.
