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Market Update

Thought leadership for housing associations: Embedded swaps and SONIA

March 5, 2021


There is emerging evidence that the way the housing association sector hedges its interest risk will change in the coming year. Currently, most are able to fix the debt through an embedded swap (a fixed-rate loan or “FRL”). FRLs account for the majority of fixed-rate borrowing for most small to medium sized housing associations – with the rest made up of capital market funding. The inability to hedge on an embedded basis has implications for housing associations’ risk management strategies and Treasury Management Policies.

Fixing debt using embedded swaps has several benefits for housing associations:

  1. It is quick and easy to execute.
  2. There is no stand-alone derivative, hence it leaves no footprint in the reported accounts.
  3. FRLs are not subject to margin calls in response to movements in underlying interest rate markets.

However, recent discussions with lenders have revealed that some banks may no longer provide FRLs for new fixed-rate borrowing following the transition away from LIBOR.

So far, two major lenders to the sector have indicated that they will not be able to provide embedded swaps on a SONIA basis. In one case, the lender is currently unable to provide them for operational reasons, but believe they will be able to by the beginning of the new fiscal year. The second lender, however, has taken a policy decision to no longer offer embedded swaps at all (even on a LIBOR basis).

As readers will be aware, LIBOR, as the variable interest rate, is scheduled to be discontinued by the end of 2021 and most UK bank lenders will no longer offer LIBOR loans from 31 March 2021.

Implications for housing associations

While currently there are only two lenders that we are aware of who cannot provide embedded swaps, it is quite possible that others are also facing similar problems. The bank who has ceased providing any embedded hedging is one of the larger lenders to the sector. Even if the rest of banking market does not follow suit, there will be wide ranging implications for the ways that the sector manages its interest rate risk.

Changes to hedging practices

This development is less of a concern than it would have been just a few years ago. The sector has significantly increased its use of capital market funding, increasing from around 33% of the total outstanding debt in 2017, to almost half last year.

Source RSH, Chatham Financial

As capital market funding is typically fixed-rate, housing associations are already hedging a large proportion of their interest rate risk via this debt source. If 45% of the average housing association’s portfolio is fixed-rate capital market funding, then the proportion of the portfolio that needs to be made up of fixed-rate bank funding will have nearly halved (assuming a minimum of 60% of the portfolio needs to be hedged).

However, the sector wide average is not reflective of an individual housing association’s position. The figures are skewed by larger housing associations that issue regularly in the public bond market, with many small to medium sized housing associations having little or no capital market debt, relying more heavily on embedded swaps to meet their hedging obligations.

For these organisations, there will be a requirement to either replace any lenders that cannot provide embedded swaps or move to standalone derivatives.

Standalone derivatives: some considerations

Standalone derivatives (which include swaps, caps, and floors) require their own documentation – an ISDA. This will require scrutiny from the management team, as well as incurring third party legal and advisory fees. There is also a requirement that the details of all standalone derivative transactions be reported under the European Market Infrastructure Regulation (EMIR). However, under the EMIR Refit, in the case of housing associations, the responsibility for the reporting can now be delegated to the financial counterparty.

Standalone derivatives must also be included in the annual accounts as an asset or liability, depending on the mark-to-market value. Changes in this value will go through the SOCI. This can be addressed by hedge accounting, which is conducted to test and confirm the effectiveness of the hedges. However, this may result in further costs as many organisations will require a third party to conduct the hedge accounting work for them due to the complexity involved.

Standalone derivatives are also subject to margin calls. This means that if a negative mark-to-market breaches a particular threshold, there will be a requirement to deposit security (which can be in the form of property or cash) within a defined timeframe. This means mark-to-market valuations need to be tracked closely and possible margin calls to be taken into account when forecasting available liquidity.

Many housing association treasury policies explicitly prohibit the use of standalone derivatives. For these organisations, if embedded instruments are no longer available, it may be necessary to update rules and policies to allow for standalone derivatives. Any changes will also need to account for the added complications discussed above to ensure that the risks inherent to the instruments are managed appropriately. This should include training for the finance team and Board.

It should also be noted that standalone derivatives also come with several benefits above embedded hedging:

  • They offer more flexibility than the embedded option as they are negotiated as a separate agreement and are therefore not tied to the underlying facility agreement.
  • They present the opportunity to “shop around”, as you are not tied to using your lender as the counterparty – resulting in potential cost savings.

What does this mean?

Existing embedded swaps

Firstly, these banks, while no longer offering new embedded swaps, recognise that they cannot do anything about those already outstanding. The question arises, what will happen to them? This has not been fully disclosed by the banks, but the assumption is that the fixed rates will stay the same with no impact on cashflows, and no need to update accounting. Complication will arise if borrowers wish to terminate the loans early. At this point, the break costs would need to be determined as if the embedded swap was a standalone LIBOR derivative that had been converted to SONIA (further details on this can be found here).

The main questions surround how the sector will react to the change in position from lenders.

Refinancing existing facilities

For many organisations, it may be simpler to refinance away from lenders that are unable to provide embedded swaps. This could be done through the capital markets or with a bank that continues to provide embedded instruments. However, this will require paying break costs. We might then see a shift in market share trends as other lenders are able to fill the gap, and potentially an increase in the number of private placements and aggregator taps, as smaller borrowers access the capital markets.

Use of standalone derivatives

Even with an increase in capital market utilisation from smaller housing associations, there will likely remain a need to fix bank debt. While some will refinance lenders unable to provide embedded derivatives, we expect the main change to be an increase in the number of housing associations using standalone derivatives.

This will be documented separately and may require amendments to treasury policies. However, so long as the instruments are treated properly, there is no reason that the sector cannot adapt to the changing funding landscape.

Next steps

Learn how this might affect you

The first thing is to review your lender exposures and how this might affect your ability to hedge your debt in the coming years. This should include actively engaging with your lenders to establish what their position is. A large number of housing associations will have the lender in question in their portfolio, and some may have it as their only lending partner.

This should be considered against forecast movements in your hedging position to highlight potential requirements for other hedging strategies. Below, we have listed five considerations to take into account:

  1. Projected drawdowns of floating debt and its impact on hedged position
  2. Update valuations on legacy fixed-rate debt to gain understanding of total exposure
  3. Capacity to fix non-impacted bank debt
    1. Also, put in mitigations if currently non-affected lenders experience similar issues
  4. Opportunities to refinance debt using:
    1. Fixed-rate capital market funding
    2. Non-affected lenders
  5. Ability to use standalone derivatives
    1. Review treasury policy to establish restrictions (see below)
    2. Review unencumbered security and liquidity to confirm capacity to meet margin calls

Review your treasury policy

Particularly for those heavily exposed to these lenders, it will be necessary to review your treasury policy to determine what is permitted in terms of standalone financial instruments.

We would also advise exploring, not only what would need to change in the treasury policy to allow for standalone hedging products, but what would need to be amended in both your policy and treasury processes to ensure the risks are managed appropriately.

This may involve setting limitations on standalone instruments and ensuring that other hedging solutions are considered first.

Keep the finance team (and Board) prepared for the changes

Finally, these changes are coming into effect imminently, meaning it is necessary that treasury teams are aware when considering monitoring their treasury risks and reporting them to Boards. Moreover, there is a need to ensure that boards are properly briefed on the implications for your organisation’s hedging strategy.

This will involve training for both Boards and treasury teams to make sure your organisation is prepared.


This material has been created by Chatham Financial Europe, Ltd. and is intended for a non-U.S. audience. Chatham Financial Europe, Ltd. is authorised and regulated by the Financial Conduct Authority of the United Kingdom with reference number 197251.