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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 DISCLAIMER This document has been prepared by TradeRisks Limited, a firm authorised and regulated in the UK by the Financial Services Authority. It is provided exclusively to you for personal use and for information purposes only. It must not be reproduced, forwarded or published, in whole or in part, for any purpose. Nothing in this document shall be interpreted as an inducement, a recommendation, an offer to sell or a solicitation of an offer to buy investments. Any prices or quotations contained herein are for information purposes only. Nothing in this document constitutes investment or any other advice nor should it be relied on in making an investment or other decision. 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