China’s crackdown: Asia’s enduring appeal for convertible bonds

 

Starting with the suspension of Ant Group’s¹ IPO in November 2020, the surge in regulatory risk for China companies has intensified, encompassing the internet, tutoring, food-delivery and property sectors. But amid the volatility, we believe a long-term perspective is justified: in time, the new rules can bring benefits that support the appeal of Asia for convertible bond investors.

China’s policy crackdown stepped up in July as ride-hailing firm DiDi was pulled from app stores on data-security grounds, all companies in the after-school tutoring (AST) were sector forced to operate on a not-for-profit basis and food-delivery companies required to pay workers above the minimum wage and provide insurance. Mortgage rates also rose in the Shanghai market as regulators moved to cool the property sector.

The government actions saw the Hang Seng index fall 6.8% from 23-28 July but rebound 3.3% on the 29th after the authorities held calls with Wall Street and China banks. Contagion beyond Hong Kong and China seems unlikely: the Hang Seng is down more than 8.3% month-to-date while the Taiwanese index is marginally negative, and the S&P 500 and Stoxx Europe 600 rose slightly by 0.2% and 0.5% respectively from 23-29 July².

 

Portfolio implications

China and Hong Kong exposure represents about 7% of our global portfolio and includes holdings in food-delivery firm Meituan, e-commerce group Alibaba, internet giant Tencent and farming-technology platform Pinduoduo³. In our Asia portfolio, exposure to China and Hong Kong accounts for 48% of the total equity sensitivity. The impact of the market sell-off has been eased by the following characteristics of our strategy: diversification by country and theme, the absence of any exposure to the AST sector, and the fact that our overweight to the China internet sector is built on what we believe to be resilient, quality names like Tencent and Alibaba. Both firms have A+ credit ratings from S&P and expected year-on-year gains in operating profit of 21% and 27% respectively over the next three years⁴.

 

Short-term pain, long-term gain?

Increased regulatory pressure has hurt sentiment towards large, high-growth names in the technology and consumer-cyclical sectors. We do not believe that the authorities aim to stifle entrepreneurship, but take the view that they are implementing policies that will incur short-term pain for the sake of longer term gain.

Essentially, the government appears to be seeking to align its regulatory regime with changes in industries and sound global practices. Until last year, some China tech platforms were operating under very light regulations, and the stronger protection of consumer data now required is essential for long-term competitiveness in the global market. Better conditions for gig-economy workers are also supportive of sustained growth and have a clear social dimension. So too do the AST rules, which will prevent the aggressive marketing and pricing exercised by some tutoring firms, which have contributed to inequality in education – especially during the disruption caused by the pandemic.

It’s important to not lose sight of the bigger macro picture, too. China monetary policy remains supportive, with the central bank likely to keep interest rates persistently low, while the reduced reserve requirement ratio will support SME and personal loans. And, as Asia progresses towards generating an estimated 50% of global GDP by 2040⁵, the region – and China in particular – will become increasingly meaningful in portfolio allocations.

 

Outlook for Asia convertibles

We expect the China and Hong Kong markets to stabilise as investors’ focus reverts to China’s macro fundamentals. In our view, convertible bond investors should continue to find opportunities to access growth sectors reflected in the region’s equity markets with less volatility.

Given the strong primary issuance in the past 18 months, the universe offers exposure to themes that are supported by China’s current Five-Year Plan, including technology independence through semiconductor and renewable-energy production, and healthtech innovation. For example, R&D specialists Wuxi Apptec and Pharmaron are two issuers we favour in the medical sector⁶.

Such opportunities are complemented by the characteristic asymmetry of the asset class, which pairs the potential for equity upside with the defensive benefit of a bond floor. In our view, Asia convertible bonds are attractively valued relative to history – particularly since those issued by China and Hong Kong firms have recently sold off aggressively – and this should persist throughout the current volatility, providing the potential for attractive entry points.