The financial markets and outlook
Another month, another bank rescue. Sounding like the beginning of a Star Wars film, the First Republic has been rescued! Or has it fallen? Banking stress in the U.S. and Europe is a reminder of how quickly confidence can erode. The rapid response by authorities was reassuring but the impact on the financial system of rising interest rates and falling asset prices is still playing out, with the US regional banking market the current focus. Are we in a credit crunch?
Long term gilt prices have been relatively stable in recent months. Looking forward the UK Government will supply plenty, with £240 billion of issuance per year until 2028 expected. With the Bank of England no longer a buyer, will prices fall and yields rise further? Asset reallocation is to be expected in a higher interest rate environment. And the pension risk transfer market is predicted to be red hot for the rest of 2023. That means companies looking to lock in their defined benefit pension scheme liabilities with insurance companies who in turn look to buy appropriate assets to offset the liabilities. There is still £1.5 trillion of DB pension scheme promises on UK corporate balance sheets. So, some support for gilts is to be expected, and one silver cloud for the sector is the demand for direct investment in social housing, infrastructure, and regeneration projects. Whether the extra supply of gilts will be soaked up and the Government (and everyone else) can avoid higher borrowing costs is the question.
Spreads on housing association bonds for A+ and A rated credit are broadly where they were a year ago having fallen and stabilised since the autumn volatility. Markets are favouring stronger credit and A- credit spreads are notably higher than a year ago.
Pressure on the social housing sector and its response
The Regulator of Social Housing reminded us of the pressure the sector is experiencing in its latest quarterly survey report. The average 12-month interest cover (excluding all sales) over the last three years has been 131%. For the year to December 2022, it was 102%, the lowest ever recorded and for the year to December 2023 it is forecast to reduce to 93%. The December 2023 outcome is driven by increases in projected spend on capitalised repairs and maintenance (£0.9 billion) and interest payable (£0.4 billion), offset by increased net cashflows from operating activities (£1.0 billion). If it were not for the 7% rent increase and the sector showing agility to control operating cost, it could be a lot worse.
The Regulator confirmed that several housing associations have obtained loan covenant waivers in response to increasing investment in existing stock, with 26 reporting having agreed a waiver to exclude the exceptional costs of building safety works from loan covenant calculations, and 22 waivers being reported in respect of energy efficiency or decarbonisation works. In our own development appraisal assumption survey, we noted that most respondents now have decarbonisation beyond EPC of C in their base business plans.
Based on our recent activity with clients, the housing sector is currently focused on redefining strategy and bank restructuring rather than raising debt in the capital markets. Appetite from banks is steady with key lenders still committed to growing loan books. There is a clear sense of impactful strategic thinking by the sector, and preparation for the future.
Further banking stress, inflation not falling or the economy not performing as expected are examples of what can weaken the outlook. Some investments will be difficult to justify in the higher interest rate environment and there is evidence of weaker liquidity in M4 money supply. But so far it would appear this era will be remembered for the impact on the financial system and the economy of high inflation and interest rates.
Whether we call this a re-set, a credit crunch or anything else doesn’t really matter. What matters is cautious and strategic financial management. The importance of strong liquidity and prompt re-financing is as important as ever. With the possibility of further contagion, counterparty risk is a critical consideration requiring careful allocation of investment assets.
For more information on any of the topics mentioned, please contact a member of our team or email email@example.com