In a 7 May speech about debt in the post-financial crisis global economy, Sir Jon Cunliffe, deputy governor for financial stability at the Bank of England, noted that emerging nations now account for a quarter of total global debt where they had once accounted for just an eighth. The single biggest contributor to this change, he said, was China.

As the China-US trade war heats up further – and with Keith Wade, chief economist with UK asset manager Schroders, predicting China’s export-focused economy will suffer the most as covenant quality deteriorates across Asia – you could be forgiven for thinking that Asian distressed debt and special opportunities were a dangerous bet.

But that is not what Robert Petty of Clearwater Capital says. Instead, the firm’s Hong Kong-based chief investment officer is bullish on opportunities not just in the Middle Kingdom, but across the broader region.

“In Asia the distressed debt opportunities are predominantly in China and India, but for very different reasons and types of investment,” he says. “Both countries have compelling valuations and interesting market opportunities.”

We weigh up some of the pitfalls and potential upsides from deploying an Asian distressed debt strategy, particularly in the region’s two largest economies: China and India.

1. Weakening covenants

According to research published by Moody’s in May, covenant quality in Asia is worsening this year and Chinese borrowers in the property sector are leading the charge.

These borrowers have refinanced their debt and thereby achieved greater flexibility in terms of making restricted payments and risky investments. Credit facility carve-outs are also becoming more prevalent in the covenants of Chinese property bonds. Moody’s found that 40 percent of these bonds, in the 12 months to the end of March, included carve-outs.

Property developers, such as China Aoyuan Group, also gained some flexibility to make investments beyond the parameters to which they had previously been restricted. These parameters are typically included in covenants in China property bonds or loans. This means that if the issuers want to make investments in other companies with the borrowed money, they need to do so in a permitted business, such as core property development.

The situation is not likely to improve. A separate report, published by Moody’s chief credit officer Annalisa DiChiara, noted that, as of the end of March, Asian high-yield corporates had $196 billion in debt that was due to mature through 2021. She added that $246 billion of corporate debt was set to mature across the region by 2023.

2. Regulatory focus on bank NPLs

When the Reserve Bank of India issued its controversial circular on stressed assets on 12 February last year, requiring lenders to declare loans as non-performing assets on the first day of default, it shook the banking sector.

All but two Indian banks posted losses for 2018 as a result of having to make provisions for NPLs, leaving the sector open to private capital investment.

In China, the central bank recently cut the amount of cash that banks must hold as reserves for the fifth time in a year, giving lenders additional leeway to offer cash to small and medium-size enterprises. Even so, Clearwater’s Petty says mainstream lenders are at a massive capital disadvantage when compared with asset management companies. The result is that the predominant source of capital in the NPL sector will be private, whether domestic or international.

“The players in the Chinese NPL market are the AMCs, and then private capital sources like us, either from onshore or offshore,” says Petty. “The capital weighting for NPLs on a bank balance sheet is prohibitive and, conversely, Chinese regulators have given a lower risk rating to the AMCs for holding non-performing assets.”

3. Legal uncertainty in India

In a speech to domestic banking executives in June last year, the RBI’s deputy governor, NS Vishwanathan, said the 12 February circular had been intended to bring clarity to the issue of non-performing assets in India, which remains an opaque market for investors.

Vishwanathan cited the establishment of the 2016 Insolvency and Bankruptcy Code as the basis for the change in policy designed to speed up the collection of debts. He said the reforms had solved one of the main problems faced by private debt investors in the Indian market.

“The code is both process-oriented and time-oriented,” he said. “It is process-oriented, in that it lays down, in detail, the various steps that need to be followed once a borrower is admitted for insolvency. And it is time-oriented because it specifies strict timelines for insolvency resolution, failing which the borrower would have to be taken into liquidation.”

However, in practice, the RBI’s circular has provided anything but clarity, and a recent ruling against it by the Supreme Court has further muddied the waters. The lack of precedent-setting legal cases has meant that the introduction of the bankruptcy code has, in many ways, made the market less accessible to international investors. One fund administrator active in the region told PDI that although many of its clients were looking at opportunities in India there remained uncertainty over several aspects of the code, and particularly around how long the process will take.

“There is hesitancy from third parties and outside managers, simply because the laws on tax, and the underlying debt are not as fair or as clear as other jurisdictions,” said the fund administrator. “Investors are more comfortable with India, but what drives activity in the sub-continent is the economic fundamentals, and growth is not as fast as has been expected.”

4. The potential for high returns in China

China’s big banks may be out of the market for NPLs, but an April report from Moody’s noted the increased cost of capital faced by the country’s big six banks this year, despite their underlying ratings remaining stable and positive.

The explanation for this is the secular increase in the cost of capital across China’s credit markets over 2018 as authorities looked to rein in the country’s shadow banking system.

It is this repricing of credit in the Chinese economy that is the most important factor in its attractiveness to private-debt players, says Petty. Choosing the underlying asset is critical, with real estate in first- or second-tier cities mostly offering returns in the mid-teens.

“With the rate rise that took place in the second half of last year for onshore Chinese assets, and in the credit markets generally, combined with the fact that the domestic institutions are full of NPLs, we are seeing some interesting selective transactions,” Petty says. “Some of these are twice as attractive as they were around nine months ago and are therefore in high double-digit returns.”