Thought leadership for housing associations: Liability management (part 2)

Look at prices as well as yields – Impact of falling bond prices

Most commentary on pricing in the bond market focuses on yields and spreads. However, in this note, we wish to talk about the actual “price” of the bond (e.g., the level that it trades as a percentage of face value). The impact on rising gilt yields and widening spreads has been dramatic. Expensive mark to markets on old legacy bonds have fallen while recent issues are now trading materially below their face value with the chance that prices may fall further, especially when the Bank of England's (BoE) Asset Purchase Scheme is reversed in the autumn. Over the last four to five years, the steady fall in interest rates has allowed HAs to use public bonds as their principal source of drawn debt in increasingly flexible and imaginative ways; creating EMTN programmes or launching an initial transaction which they can then increase on several occasions through taps and the sale of retained bonds – taking advantage of short-term market opportunities or meeting limited requirements for additional debt.

This means that they could average down bonds with existing 3.5% to 4% coupons, by tapping them quickly and efficiently at lower rates as gilt yields fell. In the process they were able to lock into significant security efficiency – the sale of £10 million 3.75% 25-year bond on a yield of 2% raised c. £13.4 million in cash but only used £10 million's worth of security.

This worked well in a bull market – but the move to a bear market has changed the dynamic.

Issuing in a bear market

Over the last two years, dozens of bonds have been raised with low coupons where the movement in rates over the last five months means prices are now well below par. If, for instance, the coupon on the example above was 2.75%, the cash raised today would be under £8.7 million. The table below highlights where a few of the more recent issues are now trading, and he graph shows how falling prices accelerated.

	Coupon and maturity date	Amount sold at issue	Price at issue	Price as of 25 May 2022
Guinness	2% 2055	£400 million	£99.40	£73.65
Platform	1.625% 2055	£350 million	£97.87	£65.90
Hyde	1.75% 2055	£400 million	£97.15	£66.44
Clarion	1.25% 2032	£300 million	£98.95	£83.07
Aster	1.41% 2036	£250 million	£100.00	£78.74
PA Housing	2% 2036	£300 million	£99.67	£84.57
Flagship	1.875% 2061	£250 million	£97.41	£68.09
Anchor	2% 2051	£450 million	£99.51	£72.71
Clarion	1.875% 2051	£300 million	£97.59	£69.96

This means tapping these bonds is now security inefficient so any bonds retained from more recent issues may be dormant for some time. This is disappointing for many issuers as these facilities had made the bond market a ready source of long-term liquidity in manageable amounts on a regular basis. For borrowers with multiple issues, it argues for issuing taps or retained bonds on higher coupon issues, a change in emphasis on the management of their bond portfolio.

However, it raises a greater problem for those with only one low coupon issue. Do they now need to issue a new bond in benchmark size or use other sources of long-term debt like bank loans, Private Placements, or Aggregators to meet their smaller funding requirements? Several banks are now offering longer term facilities; while private placements may prove more cost efficient than trying to issue a new sub benchmark public issue. In either case it changes the approach to managing new funding requirements.

Liability management

Falling prices may limit flexibility on fund raising, but they also create opportunities for borrowers with low coupon issues where they:

• are looking to restructure other high legacy fixes whether on bonds or swaps.
• have surplus liquidity.
• are concerned they are over-fixed.
• are looking to improve security efficiency.

Frequent issuers in the bond markets actively manage their portfolios of bonds in the same way they manage other liabilities:

• issuing when rates are low or spreads are tight.
• buying back bonds which are “cheap” relative to their curve.
• sometimes replacing old bonds with off market coupons with new on market issues to improve liquidity on trading.

This is effectively managing the maturity curve, covenant and security, and overall exposure to fixed and floating rates (often in combination with the swap market).

The right to buy back or redeem bonds early

Generally, modern documentation allows a borrower to:

1. Exercise an early redemption option giving the issuer an absolute right to redeem all or some of its bonds early ("Spens clause").
2. Buyback bonds by tender in the market or by private treaty.

It also sets out whether repurchased bonds can be held in treasury or must be cancelled. If a bond has only a few months to run, it may be worth exercising the Spens clause especially if the contractual discount rate for calculating the early redemption amount is attractive. Earlier this month, A2D, redeemed half its November 2022 bonds paying 1.01684 rather than the face value + the last coupon payment of 1.02375 per £1 nominal.

The Spens clause in more recent documentation may be “modified” where the discount rate includes a margin, slightly lowering any penalty on redemption. “Modified Spens” or “Modified Make-Whole” is typical in private placements. However, if U.S. or other offshore investors hold the sterling denominated PP notes there may be additional redemption terms allowing them to claim any swap break costs.

A strategy for utilising profits on redemption at a discount

Buying back bonds or notes at a discount should result in an accounting profit. However, the buyback profit could be used for further liability management – to cancel facilities which are still out of the money and carrying high termination costs. The buyback profit could be set against the premium to buyback an old aggregator bond or to terminate a high embedded fix on a bank loan.

Managing the standing of the borrower in the market

Buybacks in times of market stress provide liquidity in an issuer’s bonds and enhance your standing with investors, generally underpinning the appeal of your name as a premium borrower. Issues to consider are:

• What will the buyback do to performance of the rest of the bonds outstanding in the market – will it take them below benchmark size (£250M) for example?
• Market perception – HAs don’t usually do this. Does the buyback add or destroy liquidity and will it impact a return to the market?
• Ensuring that any action taken cannot be interpreted as market manipulation.

Other considerations

Apart from the financial and credit impact, there are a number of factors to consider when embarking on a buyback:

1. How much to buy and what premium to pay, if any?
2. Should buyback be via a tender or opportunistic purchase in the market?
3. Will the bonds be cancelled or held in treasury for future re-sale?
4. What will it do to the fix/floating mix?
5. Accounting treatment of the premium or discount (especially where debt was originally issued above or below par).
6. Regulatory obligations and announcements.

Practicalities

Chatham is the leading capital markets adviser to the sector and has direct access to the public bond markets and investors. We can assist you to assess the benefits or otherwise of retiring debt in this manner, the likely costs and how easy or difficult it would be to buy back the securities.

In the next note, we will look at another way of benefitting from recent low coupons to lock in attractive floating rates via the swap market.