Category: Market Insight

Market Update

• January CPI was flat at 4.0% against expectations of 4.2%. The market reacted with the 5-year and 10-year swaps increasing by c. 10bps on the day of the announcement. 
• The 10-year swap rate (3.8%) is pretty much where it was after the last month’s ‘surprise’ CPI release. It was at 3.8% almost exactly a year ago too. It peaked in August 2023 at 4.7% and has bounced from the December 2023 low of 3.2%.  
• Wage inflation was down from 6.7% in November to 6.2% in December, a sharp fall, but analysts expected a fall to 6%.
• Natural gas and power futures are down almost 10% in the last month, so a materially lower energy price cap from April 2024 appears ever the more likely. It has certainly been a mild winter.
• The SONIA curve remains remarkably flat with the 3.8% to 3.9% range from the 5-year through to 30-year swap rates.
• New issue premiums have decreased significantly in recent weeks with some bond issues reporting premiums as low as 0 bps. This is quite unusual. 
• The news that the Affordable Homes Guarantee Scheme has increased to £6bn and is extended with flexibility to invest up to 50% in existing stock is an encouraging opportunity for the sector. 

Implications for our affordable housing clients

The flat SONIA curve means clients can hedge over a tenor that suits their loan portfolio and swap rates remain attractive. Why take the risk of variable rates, particularly when you can reduce short term interest costs and remove that risk buffer? 

High investor demand and very low spreads creates opportunity for long term covenant light funding. 

Latest client activity

1. Interest rate risk analysis: Using Resi Analytics, we’ve conducted thorough analyses of the interest rate risk buffers in our clients’ 2023 FFRs. The results showcase a spectrum of risk appetites, from no risk buffer to a cautious outlook.
2. Strategic deal closures: Following strategic reviews and lender negotiations, several deals are set to close before year-end (31st March 2024). These initiatives aim to bolster liquidity headroom and improve covenant definitions. It is a busy time of year for banks, advisors and lawyers. 
3. Active advisory on various fronts: Detailed strategic thinking is vibrant across our client base, we’re actively advising clients on strategic asset disposals, hedging strategies, covenant changes, and the impact of combining business plans.
4. Private placement mandate launch: Amidst high investor demand and low spreads, we’re gearing up to launch an active private placement mandate. We anticipate increased private placement activity in 2024, providing valuable opportunities for our clients.

To learn more about our work in the affordable housing sector, click here.

For more information, please contact Paul Stevens or John Tattersall.

January in numbers

• December CPI of 4.0% surprised to the upside against expectations of 3.8% and the market reacted with the 5-year and 10-year swaps increasing by c. 20bps on the day of the announcement.
• Expectations for rate cuts probably got a bit ahead of themselves, and following the correction, the market now expects the Bank of England to begin cutting in late summer 2024 steadily down to 3.5% in 2026 where it is expected to remain for some time.
• Regular wage inflation of 6.6%, down from 7.2% in the prior 3 months, was in line with market expectations, and energy prices are expected to fall in the spring. The Bank of England is unlikely to be too concerned.
• The SONIA curve remains remarkably flat at 3.8% from the 5-year through to 12-year swap rates.
• The Government has launched the consultation on Awaab’s Law with a proposal that providers must investigate hazards within 14 days, start fixing within a further 7 days, and make emergency repairs within 24 hours.

Implications for our affordable housing clients

1. Trouble in the Red Sea and connected geopolitical events are upside risks to inflation and interest rates. Predicting further volatility would not be a particularly brave call. It is important to include a risk buffer within the floating rate assumptions in the business plan.
2. The flat SONIA curve means clients can hedge over a tenor that suits their loan portfolio and swap rates remain attractive. Why take the risk of variable rates, particularly when you can reduce short-term interest costs and remove that risk buffer?
3. Housing Organisations should consider the benefit of longer dated and covenant light debt capital market funding, particularly when funding long term investments. Activity has been picking up in recent months.

Latest client activity

1. Hedging transactions for interest cost savings: Centrus has successfully advised several clients through hedging transactions, saving interest cost in the tightest years and creating additional headroom and certainty in our client’s business plans.

2. Strategic support for Newlon Housing: We provided analysis and advice to Newlon Housing on options as a £50m swap matured and supported through the execution of a new 10-year swap that closed in December at 3.6% plus margin.

3. Successful £400m public issuance for Sovereign Network Group: Sovereign Network Group completed a £400m new public issuance this week, pricing at 108 bps over gilts and a coupon of 5.5%. SNG are A3 Moody’s / A S&P rated, and the pricing highlights investor demand and the benefit of scale. Centrus provided advice on the transaction

4. Advising on mergers in a growing trend: We are currently advising on 6 mergers and note an accelerating trend of non-profit Housing Associations seeking to improve financial resilience and sustainability by combining resources.

To learn more about our work in the affordable housing sector, click here.

For more information, please contact Paul Stevens or John Tattersall.

Reduction in spending on new affordable homes

Multi-year analysis conducted by Centrus has revealed that UK housing associations are having to make difficult decisions, with a significant reduction in the spending on new affordable homes for 2024 onwards. 

Plans drawn-up last year cut expected investment for 2024 by 9%, or £1.5bn, compared with the previous year’s forecast, while funding over the coming decade was cut by £20bn, or 15% (Centrus, 2023).

John Tattersall, Managing Director at Centrus, shared his thoughts on the research with The Financial Times, encouraging policy-makers to provide radical support to a “resilient” and “mission-focused” sector. 

“The substantial decrease in spending on new home delivery is driven by three core challenges; increased costs of building, increased costs of debt, and competing priorities. 
 
Assuming the election next year results in a change of party, we are likely to see affordable housing shoot up the political agenda – and rightly so. Housing associations are unsung heroes in the UK. Social housing is held to extremely high standards of tenancy conditions relative to the private sector. While charging lower rents, providers are working tirelessly to deliver high quality homes for people in need while navigating an economic landscape which is especially tricky given their business models.” 

John Tattersall, Managing Director – Centrus

Click here for Joshua Oliver’s article in The Financial Times.

As the dust settles on two recent Centrus-advised mergers between Abri and Silva, and Sovereign and Network Homes, Centrus considers the role mergers have historically played in the affordable housing sector, and why, particularly given ongoing economic and political volatility, the theme of consolidation is likely to remain in focus into the future. 

Navigating the perfect storm – why might housing associations wish to merge?

As Winston Churchill opined, “the further backward you can look, the farther forward you are likely to see”. Indeed, the practice of UK housing associations merging appears not novel, but cyclical, with each burst of activity more pronounced, with ever greater calls on finite financial resources.

Understandably, during significant uncertainty, such as that caused by the pandemic or the 2008 financial crisis, housing associations had very little time to peruse the sector for potential partners, instead focusing on the immediate concern of getting their own houses (pardon the pun) in order.

Furthermore, while we don’t possess a crystal ball, consolidation looks set to continue, with the total number of UK housing associations decreasing nine per cent in the past decade alone, according to statistics from the Regulator of Social Housing.

For an increasing number of housing associations, this landscape has forced at least consideration of mergers and the appeal of ‘combining and conquering’.

Partnering with an organisation with complimentary geographies and ambitions is an attractive prospect for some, particularly where resources may be stretched thin. The benefits of a merger will vary and be specific to the organisations involved. However, as a general rule, the key advantages of undertaking such an exercise include:

1. Economies of scale, efficiencies and bargaining power

Often the primary driver behind any merger, and the most obvious benefit, is the resulting pooling of resources to achieve economies of scale. The newly merged organisations will benefit from sharing administrative and operational platforms, reducing duplication, eliminating costs and improving efficiency.

Furthermore, the newly formed, larger, housing association may have greater negotiating power via balance sheet strength and an enhanced credit profile, offering improved outcomes with investors, rating agencies, suppliers and local authorities.

There is a risk of diseconomies of scale. When considering a merger, entities must carefully evaluate how the combined organisation will operate and the pathway to that outcome.

2. Financial stability and improved risk management

Combining the financial resources of two or more housing associations can result in greater financial stability, providing a more secure foundation for delivering housing services and investing in property development and maintenance.

Additionally, there is a reasonable expectation of risk diversification across a larger number of properties, potentially reducing exposure to specific challenges or risks in a single geographic area or property type, such as flood risk.

Again, careful due diligence on the asset base of each partner is required to ensure the resulting portfolio of homes achieves the aspirational profile.

3. Improved service delivery and development capacity

Mergers can enable housing associations both to increase their development capacity and to provide and invest more into a broader range of community services for tenants.

The combination of cost savings and enhanced bargaining power achieved via merging may unlock additional building capacity for the merged entities to deliver new affordable housing units.

However, in a larger organisation, the distance between the tenant and the board may increase; careful consideration of operational structure is needed to ensure due focus remains on delivery for tenants.

Challenges

Overall, the case for mergers appears strong.

The saying about laws being like sausages (best not to see how they are made), applies to mergers as well. Mergers are complex, representing a substantial undertaking for all stakeholders and are not to be undertaken lightly.

While mergers can offer excellent benefits, this requires careful planning and execution.

Achieving the merger may require lender consent solicitation initially, while unlocking maximum capacity may need financial covenants and corporate controls to be reshaped.

Both can engender potentially complex and expensive negotiations with lenders. These can result in treasury costs, and ensuring they are outweighed by savings is a critical test of a business case.

Cultures will need to be harmonised, tenant concerns surveyed and allayed, while employee stakeholders will see significant disruption, but potentially a broader range of career development opportunities.  

The resulting, larger entity will naturally be more complex, and it is reasonable to expect some short-term administrative challenges to ensure all parties are comfortable, from governance and risk management perspectives.

However, it is important to ensure that this is transient; any long-term drag on decision-making speed can result in poor responsiveness, worse outcomes for tenants, and undermine any business case.

Mergers also have the potential to result in overextension during execution, where the level of effort required to deliver the process is too big for the existing personnel to achieve effectively.

This is where the selection of experienced advisors can be critical to ensure that lender negotiations are successful, and the loss to EV (with EV representing the present value of existing borrowing versus a like-for-like replacement at current market rates) is minimised.

Key success factors

1. Choose the right partner

Easier said than done, but the success of any merger depends first and foremost on selecting the right merger partner. A shared vision, culture and geographic focus are key to reducing the risk of integration issues.

2. Evaluate the business case early

Careful planning, effective communication and a clear understanding of the objectives of any merger are vital. A key step in merger execution is constructing an outline business case which should define the ‘merger ambition’ and assess to what extent the merger may deliver this.

It’s also important to ensure that the interests and needs of tenants and communities are at the forefront of the merger process. Ongoing tenant engagement is paramount (often formally required) throughout the process to ensure they feel their needs are heard and any dissatisfaction avoided.

3. Get the right support

Depending on the entities involved and the legal mechanism opted for, the transaction can take between six and 18 months to complete. During this period, there is likely to be an operational drag on day-to-day business, with deal-fatigue a real risk.

Mergers are not insignificant in terms of cost and will require specialist support from financial, legal and operational advisors to execute effectively. Selecting the right professional partners is important.

Creating resilient businesses

Mergers are not a universal cure for operating pressures. They have, however, been used successfully to create more resilient businesses that are greater than the sums of their parts.

Organisations should be prepared not only to proactively consider mergers, but also how to respond if approached, as many neighbouring entities will be pondering the same conundrum of how best to navigate their current challenges.

This article was originally published in Social Housing Magazine on 31st October 2023.

Introduction

Over the past decade, management of interest rate risk has predominantly involved embedded fixes on fixed-rate loans and typically long-term fixed rate funding from debt capital markets (DCM).

Hedging was a relatively benign topic when rates were at record lows. Following the substantial increase in interest rates over the past two years, HAs may fear ‘locking-in’ at relatively high rates.

The downwards sloping yield curve has increased attention on varying funding tenors as well as hedging alternatives.

Interest rate risk still needs to be managed and with lower capital markets issuance volumes, HAs are increasingly looking at bank hedging options as these risk management tools return to the fore.

In this article, we explore some of the different hedging strategies HAs can consider on a ‘standalone’ basis using the International Swaps and Derivatives Association’s (ISDA) master agreements, to mitigate risk and optimise treasury positioning.

We do not comment on embedded hedging and/or an increasing trend for some banks requiring this to be transacted in loan linked ISDA agreements.

Interest Rate Swaps

Interest rate swaps are one of the most common and simple hedging options.

A swap removes interest rate variability on a floating rate loan, exchanging a variable interest rate for a fixed one over the duration of the swap.

Executing a swap has the advantage of mitigating interest rate risk, but it is important to note there is a cost and there are complexities that need to be considered.

Swaps are typically executed with banks under ISDA master agreements (with a credit support annex) and collateral is typically required by the bank counterparty in the event interest rates fall.

From a collateral perspective, there is normally an unsecured threshold above which you allocate a pool of security and if this provides insufficient cover there would be a need for cash collateral.

Availability of unencumbered assets and efficient use of security, plus potential exposure to cash calls, are key considerations.

Swap rates are currently highest at the short end, with the Sterling Overnight Index Average (SONIA) forwards peaking in 12 months, before gradually falling to long-term levels of circa four per cent.

An HA needs to consider when to start the swap, as forward starting swaps can avoid the SONIA peak altogether.

For example, while the seven-year swap rate might be 4.4 per cent, a seven-year swap starting in two years could offer a more favourable four per cent.

In this example, interest rate risk would apply to the HA for the first two years and so funding requirement, liquidity and interest exposure should be assessed before entering a transaction.

Interest rate caps – mitigating downside risk

Interest rate caps offer an alternative hedging option, permitting borrowers to protect themselves from rising interest rates while retaining the benefit if rates fall. Caps are typically executed with banks under ISDA master agreements.

Under an interest rate cap, the borrower’s interest rate remains floating but only up to a specified cap level, above which they are effectively fixed.

The borrower pays a premium for this protection, typically as an upfront cost, though some banks may allow this to be deferred and spread over the term of the cap.

The cap level (strike) and tenor determine the premium paid and can be set based on how much interest rate increase can be absorbed by the business plan. The higher the cap level is, the less interest rate protection and hence the cheaper the premium.

A key benefit of caps that have been paid upfront is if rates rise above the strike or the interest rate volatility increases, it can become a financial asset, however if rates or volatility fall, there is no liability.

For this reason, and unlike for an interest rate swap, the credit risk of the borrower is not a consideration when a bank assesses pricing for a standalone cap. Therefore, often credit approval processes are faster (or not required) and notional appetite is greater.

It is important for borrowers to carefully balance and assess the required cap level and associated premium versus forecast interest rate exposure.

Interest rate collars – balancing risk and premium

To reduce the premium associated with an interest rate cap, a common strategy is for a borrower to enter an interest rate ‘collar’, where an interest rate floor of the same duration is entered into to offset the cap’s cost.

By optimising the combination of floor and cap levels, a borrower can significantly reduce the cap premium paid.

It is possible for a nil premium to be achieved, depending on risk tolerance and specific hedging objectives.

It is important to note that a collar is similar to swaps in some respects, and can be a liability if the floor becomes worth more than the cap.

Conclusion

Given the ability to manage interest rate risk more flexibly, it is perhaps no surprise that interest rate swaps, caps and collars are gaining prominence.

As with any hedging product, decisions should be made following careful analysis of a loan portfolio, the risks associated with the product, and the impact of future scenarios such as prepayment costs if hedging were closed out prior to maturity.

ISDA agreements can provide a number of benefits, but they also come with risks that require careful consideration.

For more information on any of the solutions discussed, please contact Jonathan Spearing.

The article was originally published in Social Housing Magazine in August 2023.