The real estate sector often stands out in terms of credit spreads, showcasing differences that significantly exceed those found in other industriesFactors such as policy frameworks, market sentiments, and the frequency of bond defaults play crucial roles in shaping these disparitiesAs the performance of the real estate industry declines, the credit spreads of lower-rated private real estate companies are likely to expand rapidly, while the divide within state-owned enterprises becomes pronounced.

Credit spreads, essentially the gap between the yield of corporate bonds and a risk-free rate, reflect both credit risk premiums and liquidity premiumsCredit risk premiums indicate the potential losses from defaults or extensions, while liquidity premiums represent the risks associated with an inability to liquidate bonds at reasonable prices in the short term

This article delves into the historical patterns and current landscape of credit spreads, with a spotlight on the real estate sector, revealing the dynamics that underpin the excess spreads of real estate bonds when compared to overall industrial bonds.

The nature of credit spreads is often cyclicalA prime example is the three-year corporate bonds, which have exhibited distinct cyclical characteristics since 2008. At a macroeconomic level, the fundamentals of the economy dictate corporate profitability—the long-term ability to service debt—while the stance of monetary policy influences refinancing abilities in the short-runAs these abilities improve, credit risks decline, causing spreads to narrowOn a meso-level, imbalances between supply and demand for credit bonds further affect spreads; in times of high demand and low supply, investors lower their expected credit risk and liquidity premiums, consequently tightening credit spreads

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Conversely, exaggerated supply rates lead to increased yields and expanded spreadsThese fluctuations are due to the cyclical nature of economic fundamentals, monetary policy, and the delicate balance of credit bond supply and demand.

On a micro level, unexpected credit risk events can rapidly shock the market, resulting in broadening credit spreadsPrior to 2018, there was a relatively low occurrence of defaults, especially before 2014 when a guarantee principle was prevalent in China's bond marketHowever, post-2018, the scale of defaults has surged into the hundreds of billions, leading to a normalization of defaults that has recalibrated prior expectationsAny individual event of unexpected credit occurring now tends to elevate credit risk premiums, resulting in a more modest oscillation of the credit spread curves.

Given that credit spreads demonstrate cyclical tendencies, particularly post-2018 with the typicalization of defaults, this analysis concentrates on their shifts after that period

Historical data reveals that the top points of credit spreads frequently align within the 60% to 70% percentiles, accounting for approximately 22%. On the other hand, the lower points predominantly reside within the 10% to 20% percentiles, comprising 30%, followed closely by the 0% to 10% percentiles at 23%.

As it stands, current credit spreads hover near historical lowsFor instance, by the end of February 2024, the credit spreads for three-year AAA, AA+, and AA-rated corporate bonds were found at just 4.7%, 0.4%, and 0.8% percentiles, respectivelySince the second quarter of 2023, a pronounced imbalance between demand and supply has driven significant contractions in credit spreadsFactors such as a slower-than-expected recovery in the domestic economy leading to reduced bond issuance by firms, and the restrictive measures against increasing local government debt have contributed to this phenomenon

On the demand side, substantial recovery in wealth management numbers has resulted in continued appetite for institutional investment in credit bondsCoupled with a generally loose monetary environment and declining yields on safe assets, institutions are notably turning to lower credit-risk investments to enhance returns, leading to a competitive bond market.

The real estate sector inherently has characteristics of lengthy development cycles and substantial capital demandsSince 2008, amidst several real estate booms, many companies in the sector have rapidly expanded using significant leverageSome real estate firms have also transferred pre-sale proceeds from homes to accelerate the turnover of other development projects, exacerbating cash flow mismatches and increasing credit risksAs a result, credit spreads in real estate have long been elevated compared to the overall industrial debt spreads.

In August 2020, the Chinese central bank and the Ministry of Housing and Urban-Rural Development imposed "three red lines" regulations aimed at constraining external financing capabilities for real estate companies

As China's economic growth slowed and revenue forecasts dimmed, home purchase demand dropped sharply in the second half of 2021, leading to a deterioration in the internal funding abilities of real estate companies and amplifying the risk of defaultsDespite a regulatory easing at the end of 2022, persistent weak sales and high default rates have led to continued elevation of credit spreads in the real estate sector above those in industries such as steel, cement, and construction materials.

The declining fortunes of the real estate market have heightened disparities among companies, with resources increasingly consolidating around stronger entitiesConsequently, lower-rated private firms face substantially wider credit spreads than higher-rated companiesMoreover, negative incidents surrounding leading private companies have severely eroded market confidence, prompting many investment institutions to completely withdraw their interests from all private developers, further hampering these firms’ financing abilities and amplifying their credit spreads.

As the real estate sector remains weak and fiscal pressures loom, disparities in credit spreads among state-owned enterprises have begun to increase

Given that external ratings are poorly distinguished, the credit spreads of state-owned firms are classified using a proprietary rating system where scores of 1 to 5 are deemed investment-grade, and 6 to 8 are classified as speculativeNotably, after November 2023, speculative-grade state-owned enterprises exhibited marked broadening in their credit spreads while trends began to diverge from those of investment-grade counterparts, with the spread gap widening by 43 basis points as of February 29, 2024.

Calculating the excess credit spread by subtracting overall industrial credit spreads from those of real estate provides insight into the factors influencing this excess, branded as “excess spread.” Over recent years, this excess spread has been notably driven by the policy environment, market conditions within real estate, and the defaults associated with real estate bonds.

Monetary policy plays a pivotal role in financing capabilities

A loosening of monetary conditions generally leads to lower financing costs for companies, stabilizing funding chains and easing credit risk, thereby compressing credit spreadsWhen interest rates are lower as a whole, investors often shift towards riskier assets to increase yields, which can lead to a more significant contraction in spreads for sectors with higher-than-average spreadsFor instance, in the first half of 2020, in order to mitigate the adverse economic impacts of the pandemic, the People's Bank of China implemented unexpectedly aggressive monetary policiesThis resulted in the excess spread for real estate diminishing from 102 basis points at the end of 2019 to 65 basis points by June 2020.

Regulatory measures significantly affect the survival and growth of companies; tighter industry policies can widen excess spreads, whereas relaxation can reduce them

For example, in May 2018, the Ministry of Housing made it clear that the government's commitment to housing being primarily for living and not speculative profit would not waver, signaling a strict continuation of regulatory policiesIn this constrained environment, excess spreads in the real estate sector remained high throughout 2019. Conversely, the implementation of the "16 financial measures" in November 2022 re-enforced support for financing in the sector, which subsequently led to a narrowing of excess spreads.

During periods of healthy market activity and strong sales, real estate companies experience improved cash flow, which translates into lower credit risks and, accordingly, narrower excess spreadsIn contrast, sluggish market conditions lead to widened excess spreadsFor instance, between the second half of 2020 and the first half of 2021, despite the enforcement of regulatory measures, the resilience of market sales kept excess spreads at a low average of only 44 basis points

Yet, in the second half of 2023, even with ongoing policies easing, the persistent weakness in sales resulted in broadened excess spreads when compared to the earlier months.

An increase in real estate defaults leads the market to demand higher premiums for potential risks, which subsequently broadens excess spreads in the sectorThe rise in credit spreads may further reduce the net financing amounts for these firms, compounding the risks of default and ultimately exacerbating the excess spreads of real estate bonds.

Ultimately, credit spreads reflect a complex interplay of macroeconomic, intermediate, and microeconomic factorsThe overarching economic fundamentals, monetary policies, and supply-demand dynamics of credit bonds contribute to their cyclical fluctuationsMeanwhile, unexpected credit risk events have a pronounced impact at the micro level