Thought leadership for housing associations: Derivatives

Many HAs have an irritating out of the money fixed-rate which imposes pressure on the cost of debt. 4.5% may not look too burdensome until you add the margin over SONIA on the underlying loan. This probably takes it to 6.25%, a level that is far above a comparable fixing in the bond or PP market.

Rising rates have brought down Mark to Market (“MtM”) losses into a more affordable range. Meanwhile, opportunities have been created to realise MtM profits on other fixed rates/bonds.

This means that by actively managing their existing fixed-rate portfolios, HAs can capitalise on these market moves to reduce pressures elsewhere in the business and preserve short-term profitability.

Housing associations – unique borrowers in the fixed-rate bank market

The HA sector is an exception in its use of the banking markets, compared with corporates and utilities. Debt is often characterised by:

• Large exposures: With a small number of banks.
• Economic value: In low margin legacy facilities.
• High coupons: Fixed-rates on long dated debt transacted in a higher rate environment, with a steeper yield curve.
• Fixed-rate loans: Limited use of standalone derivatives, with the majority of fixed-rate bank debt structured on an embedded basis, with no explicit collateralisation of MtM exposures.

These characteristics create several challenges, particularly around older facilities with high debt service costs which create inefficiency in the treasury portfolio. In recent years, low fixed rates have meant that it has been economically punitive to refinance or restructure of legacy fixed rates, despite the benefits available on re-fixing or a move to variable rates, due to embedded MtM exposures.

However, over the last eight months, we have seen large shifts in the market where rates have increased across all maturities, dramatically reducing MtM break costs on early termination of legacy loans.

Restructure of inefficient legacy facilities

MtMs have fallen considerably since last August, as market rates have risen. This has created opportunities to restructure legacy facilities. Below we have outlined refinance options for a £10M 6.25% fixed-rate loan maturing in May 2027. Assuming a margin of 1.75% and a fixed rate of 4.50%, we would have seen MtMs fall by 37% on this instrument since August 2021. Shifts of this size will bring many MtMs into a range that can be accommodated by borrowers, either utilising excess cash balances or drawing down on liquidity to fund repayment. The table below shows the impact of replacing the old facility with either a private placement bank or a new 10-year fixed-rate bank loan.

Refinance options

Type	Existing fixed-rate loan	Private placement	Bank debt
Maturity	May 20, 2027	May 20, 2035	May 20, 2032
Tenor	5 years	13 years	10 years
Notional	£10,000,000	£11,086,021	£11,086,021
Fixed-rate/gilt	4.50%	2.16%	2.46%
CAS	11.93 bps	–	–
Arrangement fee	–	0.50%	0.25%
Margin/spread	1.75%	1.80%	1.25%
All-in rate	6.25%	3.96%	3.46%
MtM	(£1,086,021)	–	–
Annual cost	£625,000	£443,052	£385,971
Annual saving to original maturity	–	£181,948	£239,029
Change in interest costs	–	(29.11%)	(28.24%)
Change in borrowing to fund MtM	–	10.86%	10.86%

Both options reduce short-term pressure on the interest bill and offer significant benefits to interest cover for comparatively smaller increases in gearing.

Using positive MtMs to offset negative exposures

Borrowers may also be able to offset the upfront MtM cost by realising gains on other instruments in the portfolio.

HAs who have borrowed fixed-rate debt over the last three years are now likely to be sitting on:

• Bank facilities which carry a positive MtM in favor of the borrower, not the bank.
• Capital markets facilities which are trading at a discount to market, in some cases down to 65p in the pound.

Early termination of these instruments will book a MtM gain through the SOCI and help offset termination costs on other instruments.

For HAs who are running high cash balances and facing declining projected capex spend and slowing development programmes, this can offer an attractive opportunity to remove particularly inefficient pieces of debt while also de-gearing the portfolio.

Security benefits

For borrowers with security hungry legacy facilities, particularly those overcollateralised with debt service cover ratios, benefits will be larger still. Repayment of such legacy loans will allow release of excess charged security with the replacement debt, even accounting for new funding against MtMs, likely to free up significant surplus security. Where debt service captures bullet principal repayments at the end of facility life, this benefit will be largest.

Standalone derivatives and margin release

Finally, borrowers with standalone swap exposures under ISDAs will also be able to realise benefits of these market moves. Where credit support language has often in the past required additional posting of collateral to cover negative mark to market exposures, the opposite may now be true. Unusual as it may seem to many treasury teams, HAs with standalone swap exposures will now have the ability in many cases to themselves call for release of surplus collateral from charge – whether in the form of cash or property security – from the bank. In a climate of rising pressures on cashflow and significant moves in MtMs, this may be material and helpful for borrowers.