Finance: Homes make for strong bonds
In recent years, with the decline of government grant, housing associations have increasingly turned to the capital markets by issuing bonds to raise the funds they need to realise their development goals
HOUSING associations are in rude financial health overall, according to the most recent quarterly survey conducted by the Homes & Communities Agency (see boxout). But, of course, that doesn’t mean everything is rosy in these cost-pressured times.
Capital grant for social housing is but a memory; what remains of Government funding tends to be allocated for the delivery of higher rent properties – the Affordable Rent model, say – or else intended to boost supply-side demand for ownership products.
The recent white paper has done little if anything to change that in real terms.
Housing associations, then, have become somewhat accustomed to seeking investment capital from other sources. Banks, of course, have long been a traditional source of lending, and remain an important source of funding, but in recent years organisations have begun making inroads into the capital markets by issuing corporate bonds.
Bonds come in two types. The public kind is offered openly to the whole investor market. These are traded on the London Stock Exchange’s Order book for Retail Bonds (ORB), which offers a transparent and regulated trading environment. The private variety, meanwhile, is negotiated directly with one or more investors.
Normally, the type of bond issued would depend on the size of financing required, explained Craig Moule, chief financial officer at Sanctuary Group. Public bonds are preferable for sums over £150 million as they are more cost-effective, this is because, by necessity, issuing them will incur greater costs.
Those additional costs are associated with book runners – the bank or banks that will offer the bonds to the market – as well as lawyers (to prepare the documents), valuers (valuing the property being charged). In addition, in order to issue public bonds, a rating is required from ratings agencies such as Moody’s or Standard & Poor, which, of course, adds a further cost.
For sums of less than £150 million, the private bond market may well be the better option, as the costs will be less, and an independent rating is not necessarily required.
“The requirement of both the public and private bond markets work well for housing associations generally, as they tend to look for long-term funding to match their long-term predictable rental stream,” said Moule.
He added: “As bonds generally have a longer maturity than is currently possible through bank funding, if a housing association is looking to match investment and capital repayments to their rental cash flow and reduce refinancing risk, then they do present a good option.
“However, if funding is mainly required to finance the development of housing for sale, shorter term bank funding may be the better option. If all the funds raised by a bond are not immediately required, there will be a negative carry cost to holding such funds as the interest earned on cash would be less than the interest cost on the bond.”
Sanctuary is what you might call an early adopter, having issued its first bond back in the mid-1990s, but in recent years a growing number of housing associations have turned to the capital markets to raise investment capital, spurred on by the Government’s reduction of capital grant these last six years or so.
“Bonds offer a more long-term funding option – up to 35years – than traditional banks are currently able to,” said Moule. “This fits well with the strategies most housing associations adopt, which is to develop affordable housing to rent for the long term. This means the rental income can match the interest and capital repayments on such bonds.
“Investors in bonds rely on the strong credit quality of housing associations, with relatively stable cash flows in a well-regulated sector. The stability means that generally fewer conditions are attached to securing funding through bonds than through a bank loan.
“Pricing for bonds is also very competitive when compared to other sources of funding. There are a number of reasons for this, including the credit quality assessed by the investors, the current low price of gilts (UK Government bonds) on which such bonds are priced, and the high level of demand from pension and insurance companies, which are the main purchasers of such bonds, for these long-dated bonds.”
For Metropolitan, which issued its debut bond in September 2015 to raise £250 million, there were additional advantages. By that stage, the organisation was well into what proved to be a successful turnaround of what had been a troubled business, so going to the market was a means of signifying confidence in its capability. Of course, there was a practical purpose too. The capital was raised to fuel its ambition to deliver 1,000 new homes a year; a target it is confident will be achieved in 2017/18.
“Metropolitan already had existing bank loan and private placement debt. After completing the financial turnaround of the business, an own-name capital markets issue was deemed the best way of demonstrating that the organisation was in rude financial health,” said Ian Johnson, the organisation’s executive director of finance. “Alternative funding structures were considered, but given our long-term funding requirements and the need to diversify our lender/investor base, we identified a bond issue as the best option for us.
“The rated bond has increased the profile and improved the perception of Metropolitan in the marketplace. Developers are more enthusiastic about working with us and, while investors recognise that we have no immediate need for additional funds, they are keen to receive up-to-date corporate information with a view to making future investments.
“Our number of investors has also increased, reducing an historic over-reliance on bank funding. The bond has provided long-term funding which is no longer available in the banking market.”
According to Dave Johnson, group head of treasury at Together Housing Group, there are numerous benefits in accessing the capital markets. The organisation issued its first public bond in December 2012 for £250 million with a 2015 retained element of £50 million.
“They are generally light on covenants that would affect the operational aspects of the business,” he said. “In addition, they are a good source of funding and one of the only sources of long-term debt (c30 years) which matches our business model and social housing appraisal requirements. At the time of issue, it was also a cheaper form of financing.
“Bonds are also security efficient as the asset cover tends to be lower than the current bank funding arrangements. They can be used as a good source of long-term hedging as part of an organisation’s overall Treasury strategy on interest rate risk management.”
There are risks involved with the capital markets, of course, much the same as any source of finance. “They can be less flexible than bank debt if you want to change during the tenure term,” Johnson added. “Although agreements can be altered, it is more administratively prohibitive.”
Moule added: “Throughout the life of the bonds, interest and capital must be paid in accordance with the agreement and other conditions stipulated within the documentation met or, ultimately, the bond holders can demand their money back and default the entity that issues the bond.
“As there are usually multiple bond holders, amending any conditions within existing bond agreements can be difficult and would take time. It is also costly to repay bonds early, as investors rely on such bonds to run to maturity.”
Covenants may be light, but they remain something to bear in mind; just one of a number of additional factors to consider, Metropolitan’s Ian Johnson points out. “Bond issues are quoted on regulated and public exchanges and therefore there are additional governance risks and reporting requirements,” he said.
“As with other types of debt, bonds have covenant packages and naturally there are requirements to ensure the payment of capital and interest. There is also the risk of a credit rating downgrade: while this would not impact the cost of existing debt, it would push up future credit costs – market sentiment, reputation, secondary trading volumes and liquidity could all be negatively impacted.
“To mitigate these risks, management needs to be alive to any changes in financial and information requirements, and to dedicate sufficient resources to investor relations management.”
Going to market isn’t for every organisation, of course, even if such a step is within their reach. But for those that do, there are some pointers to bear in mind.
“Ensure that you recognise the time it takes to complete the initial process of securing a credit rating and to get the bond prospectus and documentation completed,” advises Metropolitan’s Ian Johnson. “A bond issue is not a quick and easy source of funding and creates additional long-term requirements in terms of investor briefings, Regulatory News Service (RNS) announcements, and annual ratings reviews.
“A bond issue will also require significant time commitments from senior staff and board members to prepare for presentations to ratings agencies and investors – and to demonstrate an understanding of the issues of particular significance. Ultimately, a bond issue may not be right for every organisation, but in our case it has helped us to secure our development programme for the future, enabling us to deliver more much-needed homes at a time of chronic shortage.”
Dave Johnson, group head of treasury at Together Housing Group, said: “If you are thinking of accessing the bond market, ensure that you have your property security package ‘oven ready’ for charging to the Security Trustee, and also have an extensive view of your business and financial plan for presentation to investors as part of the road show before issuance. Finally, plan well in advance: it’s surprising how resource intensive the whole process can be from start to finish, especially if it’s your first time.”
Obviously, these tips are shared to provide a taste of what’s involved in going to the bond markets; any organisation interested in pursuing this form of funding should, of course, seek proper independent legal and financial advice. But as a source of funding, it is evidently enjoying a growing popularity; among housing providers and investors alike.
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The housing association sector remains financially strong, as of the second quarter of 2016/17, with access to over £14bn of undrawn facilities in place, according to the HCA.
The sector has raised £1.1bn in the quarter from banks and capital markets. As a result of bonds issuance and operating cash flows, it had cash balances of £5.9bn, forecast to reduce to £3.9bn over the next three years as cash is used to fund planned capital expenditure.
Other highlights of its private finance situation were:
- The sector’s total agreed borrowing facilities are £81.5bn, of which £57bn (70%) is bank loans
- £67.2bn has been drawn, leaving undrawn facilities of £14.3bn
- 96% (June 96%) of providers forecast that current debt facilities are sufficient for more than 12 months
- New facilities agreed in the quarter totalled £1.1bn. Bank lending accounted for 22% of the new funding in the quarter; capital markets, including private placements and aggregated bond finance, contributed 76%; the remaining 2% was local authority lending
- Of the £81.5bn agreed facilities £76.7bn has been secured and £2.4bn of facilities do not require security. There are further agreed facilities of £2.5bn where security is not yet in place
(Source: Homes & Communities Agency Quarterly Survey for Quarter 2 (July to September) 2016/17)
This article first appeared in the February/March 2017 print edition of Housing magazine