August 2018

August 2018

Commentary

Credit ratings has been a busy area in terms of social housing finance in July. Moody’s had a significant downgrading of the sector around this time last year (of 40 associations, prompted by a downgrade of the UK Sovereign rating to Aa2) but there has not been a great deal of ratings action since. Since that time, Standard & Poors has been seen as offering significantly stronger ratings, with the majority at A+ (equivalent to Moody’s A1) while the Moody’s representation slipped down with the downgrade to mostly A2 and A3. Effectively the Moody’s “bulge” went from A1/A2 to A2/A3.

Moreover, Moody’s more evident willingness to give triple-B ratings gave investors keen to invest primarily in single-A paper an opportunity for negotiating leverage with those below or at the outer edges of this ratings group.

At the time, Fitch had three ratings, two at A+ and one at A. But as we move into August 2018 there has again been movement on the ratings front, with five downgrades amongst the S&P social housing ratings in the last fortnight and two new Fitch ratings, both of large associations with active development pipelines, taking Fitch to five housing associations.

The new Fitch ones are L&Q and Notting Hill Genesis, at A+ and A respectively. If we focus on them first, Fitch now has three with ratings from one or both of the other agencies, as follows:

One point to note is that, from this admittedly small sample of three, the Fitch rating, if one takes the ‘outlook’ into account as well the headline final rating, is the highest in each case and significantly higher (two notches) than the Moody’s ones.

In terms of associations with ratings from the two of Moody’s and S&P, there is naturally a longer list, of seven (including L&Q again, being the only one with three), as follows:

As can be seen, between the two agencies with the larger numbers of ratings, the S&P one tends to be the stronger by either one or two ratings notches in all cases.

This is a slightly weak batch if anything for S&P with the four straight A ratings out of seven: across the S&P universe there are two AA- and 16 A+, then nine A, three A- and nothing below that. For Moody’s it similarly picks out a slightly weaker set of the rating universe in which there are two A1 associations and 12 and 18 at the A2 and A3 levels respectively then five Baa1 and one Baa2.

*Historical note: Genesis had had a rating of A+ from Fitch until discontinued in December 2014 (and earlier in the year it had, like others, been AA-); NHG also was briefly Baa1 with Moody’s, reflecting the previous A3 for Notting Hill and Baa2 for Genesis, before being withdrawn earlier this year.

The reason is presumably that it is the more active developers (and therefore perhaps more frequent issuers) which tend to pursue more than one rating and/or the larger ones which can justify the cost of doubling up and have a more commercially-orientated development programme.

The following chart summarises the position:

The recent negative S&P movement can be attributed fairly straightforwardly to their perceptions of sales risk exposure. Places for People went down to A- in June for the same reason. This basic rationale is fairly clear from the published ratings and from discussing with S&P. There is no published methodology change but an increasing view, signposted to some extent, that sales risk is seen by them as a significant risk for the more active developers. Moody’s have not taken the same recent action but their downgrade last September was very similar in motivation.

In terms of views on the sovereign and its ability to provide support to the sector, an element of all three agencies’ methodologies although with less impact for S&P in practice given the underlying ratings awarded, all are the same: the UK government is presently rated AA by S&P, Aa2 by Moody’s, and AA by Fitch.

In our advice to clients around ratings we typically try to bring out the areas where improvements can be made under the direct control of the borrower. Apart from simply a change in business strategy, the obvious example is often liquidity.

Although liquidity has a cost, an increased level of it is beneficial to the ratings assessment for all three agencies. This discussion remains a very important one. It is a pity to spend money ‘just’ keeping investors happy which could have gone on new homes or new kitchens; equally, facing a sudden liquidity shortfall if sales slow is a painful situation to be in and the reality remains that most housing businesses which run into financial trouble have run too close to the wind in terms of liquidity.

In terms of whether the agencies are “too harsh” on non-social housing activities whether that is building homes for sale or activities not related to housing at all, in fairness to them the social housing sector has really quite high ratings, slightly higher than many investors really see as justified if one goes by bond pricing.

We do sometimes find clients slightly obsessed with “social housing lettings income cover” in particular (“SHLIC”), which is an important element of the Moody’s framework and the only explicit “income cover” metric apart from the rather obscure “volatility” one which brings in the standard deviation of returns over a few years and, with the best will in the world, needs a fair bit of judgement to interpret. But it is not an unreasonable area to focus on as it seems to attract a level of focus within Moody’s as well as outside.

For S&P, there is no one measure which captures the core social housing lettings business so specifically; the EBITDA-based income cover metric they use is not quite so tightly defined and tends to produce higher ratios. But from the commentary published in the last week or so they also have clearly been looking at the significance of non-social housing income and within the S&P methodology the level of reliance on revenue from market sales as a proportion of total revenue does feature.

In terms of whether any of this should lead to action by rated associations, we do not generally advise clients to take a mix-and-match approach when they already have ratings: “ratings shopping” brings its own risks as methodologies change over time. Indeed, it used to be that Moody’s were more favoured from this perspective. It seems more worthwhile to focus on a clear business strategy narrative for the rating agency or agencies used and also for investors directly.

Having said that, staying relatively well clear of triple-B is a good thing and if HAs were to start to look outside the UK more (particularly perhaps the larger ones), it would be rational to assume that such investors might be more inclined to take ratings at face value, so the lessons of the ratings trends are in our view different for different borrowers.

Questions of ratings agency strategy form part of corporate finance strategy more generally and if nothing else, recent developments make it more of a three-way choice for associations looking at taking on a rating or another rating than it has sometimes felt in the last few years.

Financial Markets and Economics Overview

July has brought further mixed economic data, coupled with tariff impositions, cabinet exits (and World Cup exits) and continued political turbulence. In the UK, monthly GDP data showed positive momentum growing and rapid employment gains. However, June retail sales came in well below consensus with a 0.5% reduction and Q1 labour market data showed a modest deceleration in pay growth. July also saw sterling fall to a twelve month low against the US dollar, reaching 1.2958, however recovering to 1.31 by the end of July. Sterling also fell against the Euro, but not to such an extent. The slide of Sterling appears to be a reaction to both poor UK economic data and further uncertainty surrounding Brexit.

Brexit continues to dominate headlines with the Brexit White Paper becoming publicly available. This was largely met with quiet optimism. July also saw President Trump visit the UK with some dissent on Brexit due to the lack of a clean break in Europe. This tone was later softened in a speech with Theresa May.

The beginning of July saw trade tensions increase between the US and China, with plans to impose a 10% tariff on $200bn of Chinese imports (effective from the end of August 2018). Despite this, US Q2 annualised GDP growth accelerated to 4.1% from 2.2% in Q1, continuing its strong economic performance.

The beginning of August saw the BoE increase interest rates by 25bps to 0.75% from 0.5% as anticipated. This is the second rates hike in the UK in 9 months, with MPC members unanimously voting for the increase. Inflation forecasts were also revised up, indicating that further rate hikes are likely. The 2020 forecast for UK GDP growth remained unchanged at 1.7%. Overall, the MPC’s outlook remains relatively constant, with the economy remaining resilient, with disappointing productivity growth resulting in a necessity for further increases in interest rates over the coming years. For the first time, the BoE has published its own interpretation of the “neutral rate” for UK interest – between 2 and 3% – but lower in the short term due to various factors including increased risk aversion, continuing fiscal consolidation and overall tightening of fiscal conditions.

UK annual house price growth, as shown in the Nationwide House Price Index, bounced back in July to 2.5% from 2.0% in June. Annual house price growth has remained within the range of c.2-3% over the past 12 months, suggesting little change in the balance between demand and supply in the market. Subdued economic activity and ongoing pressure on household budgets is likely to continue to exert a modest drag on housing market activity and house price growth this year, though borrowing costs are likely to remain low. An increase in rates will impact those with floating rate mortgages, however, the majority of UK mortgages are on a fixed interest basis at c.65% (Source: UK Finance).

Interest Rates

Inflation

Capital Markets

Bank Credit