Thought leadership for housing associations: Funding in a rising interest rate environment

Scenario 1

The Bank of England is controlling inflation through a moderate increase in interest rates is showing to be a successful strategy.

• Bank base rate rises steadily to peak at 3.5% in the first and second quarter of 2023, before falling back thereafter to between 1.5%-2%.
• After rising further over the next 12 months, the all-in cost of medium-term fixed-rate debt declines with Gilt yields falling to 2-3% and HA debt to between 3.5%-4.5% in 2024 and 2025.

Credence is lent to this by a review of the rates available over the last 10 years.

Scenario 2

Inflation becomes far more heavily embedded in the economy with rising wages chasing rising prices.

• Bank of England struggles to control the situation with higher, longer rises in the base rate.
• All in cost of medium-term fixed rate debt continues to rise to reach at least 5-6% during 2023 and 2024 (and possibly longer) and remains elevated for a period thereafter.

This means that yields revert to pre-2012 levels, with the last 10 years seen as the exception rather than the norm.

In his speech to the central bankers on 29 June, Andrew Bailey heightened the risk of the latter, though probably as a way of justifying the move to 0.50% rate hikes starting in August.

The problem is that these two financial scenarios are taking place against the background of a global financial situation which could also fluctuate between two extremes:

• A resolution to the situation in the Ukraine over the next 12 months after which energy prices decline and there is a slow move back towards normality.
• At its most extreme, a continuing problem in the Ukraine exacerbated by the problems that may arise in the eurozone as attempts to control inflation trigger difficulties with sovereign debt in Greece and Italy.

At present, most Housing Associations benefit from strong liquidity and high levels of fixed-rate debt. However, with elevated maintenance expenditure (COVID-19 catch up, health and safety, and net zero carbon) and significant development programmes, this situation will slowly change over the next two years.

• Liquidity will decline to a point where there is a requirement for new funds by 2024-2025.
• The ratio of fixed to floating-rate debt starts to deteriorate if all new funds are drawn down floating rate.

This raises the question of whether Housing Associations should be taking preemptive action on their borrowing programmes and if so, what are they best advised to do?

The first thing to say is that the cost of fixed-rate debt has already moved sharply against HA borrowers. The table below traces the move in the cost of debt between the start of 2022 and today. It shows a sharp increase, particularly on the capital market debt where rates are now at levels last seen in 2014.

It raises the question of whether Housing Associations really want to lock into long dated fixed-rate debt at current levels. Much of the pain on legacy debt for Housing Associations in the period between 2012 and 2021 arose from long dated transactions that carried coupons or fixed-rate swaps at levels that turned out to be substantially higher than subsequent market rates and were expensive or difficult to unwind.

This leaves us to several observations:

The cost of medium-term bank debt is now unusually attractive by comparison with other sources of funding. Spreads are unchanged, or actually tighter, than six months ago, with greater flexibility on covenants. They offer a significant pricing benefit against the capital markets at present. However, this is unlikely to continue over the long term, as the banks’ own cost of funding rises and HAs approach them for increasing volumes of debt.

Consider fixing more debt now – but only for relatively short periods, sufficient to see the HA through the worst of the potential interest rate rises, say for a 3 to 5-year period. While swaps are 1.25%-1.5% higher than the current level of SONIA, they are still below what the market expects the peak to be on bank base rate. Using shorter dated fixes provides the HA with protection against the current cycle of rising rates, while minimising the risk of being left subsequently with debt at well above market levels.

Incorporate the cost of delay in executing any new funding into your analysis. With the cost of fixed rate debt rising at 20-40 bps per month, rapid execution has a real pricing advantage. Those borrowers with retained bonds (above par) and EMTNs have an advantage here; while because it does not require security to be pledged in advance, MORhomes can fix the cost of debt in under a month when some other alternatives may take 3-4 months. Private placements with existing lenders can also be arranged quickly with the rate fixed ahead of finalising documentation, while swaps on existing bank lines can also be executed rapidly.

Review the attractions of AHGS as a source of relatively cheaper funding, particularly if it drops the EBITDA-MRI Interest Covenant over the summer. When HAs were trading on spread of between 80 and 110 over the Gilt in December 2021, AHGS was pricing at an all-in of 50 bps, equaling a saving of between 30-60 bps. AHGS is probably now priced closer to 60 bps all-in, but HAs are trading at between 125 and 170 bps in the secondary market, equaling a saving of 65-110 bps, to give an all-in rate of 3.31%.

As we have said in our previous thought pieces, a bear market for bonds brings a whole range of different issues to look at in the management of the debt portfolio. Chatham would be delighted to engage with you as you address these and bring its expertise in the financial markets to the benefit of your organisation.