Thought leadership for housing associations: The increasing importance of credit ratings
While investors have always attached some significance to credit ratings for housing associations (HAs), other factors have played a more important role: the size and business model of the borrower, geographic focus, strong investor relations, and good new issue management. As a result, A3/A- borrowers like Clarion have often traded in line with A+/A1 or A2 rated entities.
With the move by both Moody’s and S&P to place a significant number of A3/A- entities on negative outlook this has changed. Despite tentative changes to Solvency 2, institutional investors are assuming that any downgrade into Baa/BBB territory will lead to the need for extra capital backing on the bonds.
This has led to a steady underperformance of the lower rated HAs, a process exacerbated by credit concerns over the second half of 2022 arising from the impact of higher inflation, health and safety expenditure, mould, and the rent cap on margins, which was highlighted by the reduction of a sizable number of borrowers by the regulator from V1 to V2.
To reflect this, we have re-organised our rankings for tier 1, 2, and 3 borrowers on a basis which has been specifically linked to ratings for the first time:
- tier 1 – limited to A+/A1 and A2 borrowers
- tier 2 – made up of a mix of borrowers with ratings in excess of A-/A3
- tier 3 – composed of A-/A3 borrowers, generally on negative outlook
This paints a very clear picture of widening spreads between tier 1 and 2 borrowers on one hand, and the tier 3 borrowers on the other, demonstrated by the charts and bar graphs below.
The underperformance of the tier 3 borrowers is underlined by the bar charts which trace the differentials between the various tiers over 2022.
The deterioration in the performance of weaker rated credits was particularly noticeable from September onwards — and may reflect the panic selling by pension funds as they attempted to meet the collateral calls on their LDI exposures. Disposing of the weaker rated credits first would make sense — particularly if it involved larger more liquid issues.
It coincided with the worst of the spread widening on corporate bonds. However, the steady tightening in HA spreads during November, December, and into January has failed to reverse the trend with a clear indication that a super league of favoured borrowers (tier 1) has started to emerge, with even well-rated tier 2 borrowers struggling to keep pace.
For reference, we have included a list of the borrowers at the bottom of this piece, together with both their credit and regulatory ratings.
What can be done to address the issue?
There are several important messages for borrowers:
- Any descent into Baa/BBB territory is likely to have a material adverse impact on both the volume and cost of funding.
- While the effect on an individual HA borrower may be limited if it forms part of a wider downgrade in the sector, it will still limit the number of investors or funds willing to buy the bonds and impose a spread premium of between 25–50 bps per annum on the cost of new debt. This is best highlighted by the performance of utilities by comparison with HAs over the last two years, as shown in the charts below. Note that utilities used to trade inside HAs on spread until three years ago, despite having weaker ratings.
- Modelling the cost of debt needs to take account of the impact that any downgrade caused by the business plan could have on the rating.
- While a move from A+/A1 to A/A2 is only likely to have a 10–15 bp impact on the pricing of new debt:
- A move from A/A2 to A/A3 will cost an additional 25–30 bps. This needs to be priced into the future cost of debt.
- Those borrowers currently sitting with A-/A3 negative outlook rating need to devote significant attention to how they can stabilise or improve the situation.
- Business plans need to be drawn up with an understanding of their implications for ratings.
- Detailed analysis of the ratios that make HAs vulnerable needs to be undertaken to see how these can be improved. Sometimes this comes down to the detailed presentation of numbers, though the restructuring/refinancing of expensive and inefficient debt can also play an important part. Whatever the cost of a refinancing, if the impact is a 1–2 notch upgrade in rating (as has happened to our clients in the past), this needs to be incorporated into any calculation of benefit.
- Finally, borrowers need to remember that good ratings involve so much more than figures; building a relationship of trust through a strong proactive relationship with the agency and showing an ability to hear and respond to concerns can also be beneficial.
Tier 1-3 composition
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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.
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