Download social housing bonds

SOCIAL HOUSING BONDS
The social housing sector is fundamentally undervalued with yields being driven upwards by market
inefficiencies. The weighted average spread above gilts on AA rated primary issues in 2012 has been
over 200bps providing significant opportunities for new investors.
Issuer
Issue
size
Moody’s
rating
Maturity
Spread over
gilts (bps)
TradeRisks’
role
250
Aa3
2041
198
Arranger
Radian
75
Aa2
2044
275
Arranger
AmicusHorizon
150
Aa3
2043
215
Hastoe
100
Aa3
2042
215
L&Q
250
Aa2
2033
157
Sanctuary
300
Aa2
2042
172
Sovereign
250
Aa2
2043
170
Arranger
Saxon Weald
225
Aa3
2042
248
Advisor
East Thames
250
Aa3
2042
250
Advisor
(£ms)
Circle
The social housing sector continues to have
significant borrowing requirements. Due to
a lack of funding from traditional sources
housing associations are increasingly issuing
public bonds, secured against social housing
assets, to meet financing requirements.
Market inefficiencies lead to wide spreads
over gilts
The weighted average spread of own-name
issues in 2012 has been 203 bps over gilts –
this is significantly higher than the spread
available on similarly rated corporate
bonds. In fact, the spread of some recent
issues has been comparable to unsecured
BBB corporate bonds. Furthermore, the
difference between the tightest spread
housing association bond and the widest is
not, in our view, justified by the perceived
difference in credit quality.
Given the stable income stream of housing
associations, implicit government support
and the strength of their collateral
comprising of fixed charges on their social
housing properties (whose values have low
correlation with residential property prices),
we believe the entire social housing bond
sector is fundamentally undervalued.
The wide credit spread over gilts of social
housing bonds relative to other sectors and
the wide divergence between them
(typically viewed as the “illiquidity
premium”) is driven by two factors:
1.
2.
Lack of transparency in the bond
placement process.
Lack of investors in the primary
market for these bonds.
The market for social housing bonds is
under developed. Issuance of bonds is
typically managed by the same banks that
Advisor
lent to housing associations before the crisis
at LIBOR +25bps for 30 years. The banks do
not underwrite any part of the issues and
allocate the bonds in a process that lacks
transparency.
Low risk of default and losses
All own-name bonds issued in the sector
have achieved Moody’s credit ratings of
between Aa2 and Aa3; with the exception
of one issue rated A1 in 2009.
This has allowed some large investors to
benefit from the social housing sector’s
reliance on them to ensure that bond issues
are fully subscribed. In some recent issues,
these large investors dictate both the price
and structure of the bond.
The large spreads on recent primary issues
indicate that the implied probability of
default on these bonds is up to 30 times
that indicated by historic default rates for
Aa rated bonds. This level of default cannot
be what the market expects from the social
housing sector. Therefore it is clear that the
large spread is driven by market
inefficiencies rather than credit risk.
There are also a number of structural issues
which prevent traditional fund managers
from investing in the sector.
1.
Passive managers – due to issuance
being smaller than £250m in size,
many of the bonds do not form part
of industry benchmarks against
which passive fund managers are
measured.
2.
Active managers – the secondary
market in housing association bonds
does not currently provide the
liquidity needed for some active
managers, who typically seek to
retain flexibility to buy or sell bonds
at short notice.
3.
Short-term performance – a
common trait for fund managers is
to be measured on short-term
performance.
This
does
not
encourage a buy-to-hold strategy
which is appropriate when liability
matching assets are available.
We expect around half of all housing
association bonds issued over the next five
years to be under £250m in size. The
structural inefficiencies outlined above lead
to a lack of competition in the primary
market for these bonds.
In the highly unlikely event of default losses
would be minimised as bondholders have a
charge over social housing assets, which are
valued using a prudent and stable
discounted cash flow approach and are to a
great extent insensitive to residential
property market fluctuations. Any shortfall
on enforcement of security will lead to the
investor becoming an unsecured creditor
for the remainder in what is a relatively low
geared sector.
Pipeline
16 of the largest 60 housing associations
have now issued own-name public bonds. In
addition we have also seen smaller housing
associations begin to follow their example.
Own-name bond issuance is on the agenda
for almost all of the largest housing
associations who have combined borrowing
and refinancing needs of 10bn over the next
3 years.
Aa2
Aa3
0%
20%
40%
60%
80%
100%
Pension Funds
(direct holdings)
Fund manager
(insurance group)
Fund manager (non
insurance)
A1
With a need for long term and secure borrowing in the sector, pension
funds are ideally placed to take advantage of high risk adjusted returns
by investing directly in housing association bonds.
1.
Low risk of default means bond cashflows can be relied upon
for liability matching purposes.
Substantial reward for illiquidity means that schemes can
afford to de-risk from equities without triggering a review of
employer contribution levels.
High quality bonds are available at durations which can match
long-term pension cash flows.
Lending is secured against social housing assets which have
stable and prudent values and are effectively insensitive to
property market fluctuations. This would allow trustees to
recover their initial investment in the unlikely event of default.
Can maximise returns by avoiding charges in pooled
investment funds (e.g. management charges, stamp duty)
which in some cases can amount to 50bps per annum.
2.
3.
4.
5.
£ bn
5.0
Issuer environment
The sector is fragmented with 170
individual housing associations having
fixed assets in excess of £200m.
A recent study by the Chartered Institute
of Housing concluded that costs,
performance and size are not directly
linked. This, and the aggressive approach
taken by lenders looking to use change
of control to force re-pricing of existing
loan facilities, act as deterrents to
mergers. There is currently little
expectation of significant consolidation
in the sector.
Investors in the sector
The market is currently dominated by a
small number of fund managers which
form part of insurance groups or
pensions buy-out providers. 90% of all
social housing bonds issued since 2008
were purchased by just 13 investors,
leaving significant opportunities for new
investors in the market.
Social housing bonds are often used to
support long term annuity contracts due
to their duration and high credit ratings.
The spread above gilts allows insurers to
4.0
3.0
2.0
make a healthy profit on annuity
transactions backed by these bonds.
Pension funds have similar liability
profiles to insurance companies and are
well suited to pursue buy and hold
strategies. A small number of larger
pension funds have recently entered the
market to take advantage of the high risk
adjusted returns by investing directly in
social housing bonds.
Inflation linked social housing bonds
Practicalities of bank led bond
placements mean that inflation-linking
has not been popular to date. TradeRisks
is working with housing associations who
are looking to place bonds directly with
pension schemes and insurers. One
benefit of this is the ability to link
coupons to inflation, which benefits all
parties.
1.
Housing associations benefit from
reduced debt costs in low inflation
scenarios, which offsets impact of
lower social housing rents.
2.
Pension funds wish to hold inflationlinked bonds to provide closer
matching
to
inflation-linked
liabilities.
1.0
0.0
2008
2009
2010
Background on the sector
Social housing is essential to the UK
economy. Around 4 million homes in
England are socially owned with 1.8
million households on the housing
waiting list.
Key features




Housing associations are nonprofit organisations that provide
low-cost housing to key workers
and people in need. They own
residential properties which yield
an inflation linked rental income
(September RPI + 0.5%) the
majority of which is supported by
government through housing
benefits.
Social housing accounts for 18%
of total housing stock in England.
Rating agencies deem the social
housing sector to be implicitly
guaranteed by the government.
Housing associations have large
portfolios of social housing
residential properties which they
use as collateral for their bonds.
2011







2012
There has only been one default
in the past and lenders suffered
no loss as a result.
Strong regulation via the Homes
& Communities Agency.
Housing associations have total
debt of around £45bn.
Rental income of £12bn per year.
Social housing rents are lower
than market rents – up to 60%70% lower in areas of high
demand – which supports strong
demand.
Government grants to housing
associations exceed £43bn.
Long waiting lists for social
housing properties.
Banks have traditionally provided a
significant share of lending to the
social housing sector through long
term debt facilities. However,
1.
the
financial
crisis
has
highlighted the risks to banks of
long term lending funded by
short term borrowings, as banks’
cost of funds has risen
dramatically and left them with
long term loans at margins well
below their own cost of funds;
2.
changes being introduced as a
result of Basel III will impact long
term lending through higher
capital
and
liquidity
requirements and lower maturity
mismatching.
This has led banks to withdraw from
long term lending.
We do not expect this situation to
change given the overall direction of
regulatory policy making bonds the
natural means of funding.
ABOUT TRADERISKS



An FSA regulated corporate finance and investment firm whose
housing association clients represent around half of the social
housing sector (measured by rental income or debt).
A leading adviser on social housing bonds, advising on more than
half of the public bond issues since 2008.
An active promoter of non-bank end-user platforms for funding
and hedging.
For more information about accessing opportunities in the social housing
sector:
Tom Paul
[email protected]
020 7382 0992
Tim Humphrey
[email protected]
020 7382 0959
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