After a slightly hectic January, kicked off by our new office flooding when the contractors turned on the taps, we’re starting to get a sense of how people feel about 2020. It seems likely that high / low [*delete as appropriate] politics will continue with the Brexit standoff entering its next phase and the soap opera of US politics likely to get ever more exciting / tedious [*you get the drill] through 2020.
But turning to the real world and clients’ business plans and financing strategies, one clear funding opportunity would appear to be to hit the ground running on accessing the capital markets. Gilt yields are down… issue spreads are down… and borrowers are in a strong position in terms of setting financial covenants regardless of format.
Readers will likely be aware that it is standard in public bonds to offer only an asset cover covenant for secured debt, with just a very limited number of HA bonds with an income covenant. Whereas in private markets – i.e. private placements – investors have tended to look for stronger covenant protections. This is driven by a range of factors including the way in which some borrowers have approached bilateral negotiations (i.e. what they have prioritised once the discussion gets to brass tacks) and the expectations on the part of some investors for banking-style protections. US investors often approach covenant negotiations from the perspective of looking to match existing banking covenants and the borrower needs a robust stance and clear advice to navigate this. We see this sometimes in the UK market but we continue generally to maintain the line that corporate covenant suites and other restrictions
which apply to short term, variable rate bank debt may not be appropriate for long-dated capital markets debt with punitive make-whole provisions in the event of pre-payment.
The graph to the right shows a small selection of RP downwards pricing trends, with the gilt going lower and the spreads tightening. The graph shows only public bonds but the trends are broadly the same in the private market. The serendipitous aspect to this is that with rates this low RPs should be able to plan reasonably confidently at least in relation to rented housing, but there is current uncertainty around income metrics – which a confident borrower can sidestep given the strength of investor demand.
The covenant uncertainty comes from the fact that a key medium-term business risk for many RPs is the level of future spend on fire-related and climate-change-related investment in existing properties. Both use cash and increase gearing, but both would typically be capitalised in a social housing context where properties are carried at historic cost. This makes any form of private placement income covenant which treats improvements or capitalised repairs spend as a deduction a lot less attractive. In the current market most borrowers (assuming reasonable credit quality) can even in a private deal look to adopt an income covenant which takes a “glass half full” view of such spending by leaving it on the balance sheet.
It is reasonable to expect a sensible discussion with bank funders, and probably the majority of capital markets investors, if spend of this nature presents a covenant challenge and particularly if it is mandated by the regulator or legal requirements. Nonetheless, these issues will play out over time and if there is a funding need in the current year it would be as well to avoid adding to any potentially-sticky covenant negotiations.
This doesn’t of itself meet the business planning challenges. But financing choices are always a balance of business and market factors and at present the latter point towards the institutions if the business plan underpinning for long-term debt is there.
Issuance in January was relatively quiet but Clarion raised £350m at a cracking spread of 98 bps on a 15-year tenor, with a coupon of 1.875% which comfortably takes the prize for lowest coupon ever in the sector. Clarion also have chosen to firm up on the ESG front and the bond is issued within the context of a “Sustainable Housing Finance Framework” with a range of commitments such as achieving certain SAP ratings by 2025 and reducing fuel poverty.
Financial Markets & Economic Overview
The Bank of England left interest rates on hold at 0.75% with the Monetary Policy Committee voting 7 to 2 in favour of unchanged policy (the same split as the previous two updates). BoE Governor Carney cited signs of a bounce in post-election economic activity as justification for staying on hold. As markets had seen the decision as a close call, sterling appreciated modestly on the news to $1.31. Many investors continue to bet on cuts later in the year, with
markets pricing a more than 75% chance of a reduction by September. The probability of the BoE cutting rates increased after the central bank last week downgraded its view of the underlying prospects for the economy to the lowest level since the second world war. Combined with the flight to safety resulting from the equity market sell off due to Coronavirus, gilt yields have fallen materially over the month, with the 30 year gilt yield falling from 1.33% at the end of 2019 to 1.04% at the end of January 2020.
UK CPI inflation was 1.3% in December, down from 1.5% in November and is the lowest level since November 2016. This was longer than expected and well below the 2% target. The figures simply add to the growing sense of unease many market analysts feel when considering the outlook for the UK economy.
UK GDP fell 0.3% in November after a fall in consumer spending and a downturn in manufacturing before the election. Most major sectors of the economy except construction recorded a drop in output. The long-term picture for the economy continued to be one of relative weakness.
However, early indicators of activity for January suggested a rebound in services, with the services PMI pushing up to a 16-month high of 52.9. Along with the manufacturing PMI rising to 49.8, just shy of the 50 mark, this contributed to the composite PMI rising to 52.4 – the highest since September 2018. These results are consistent with a quarterly pace of GDP growth of about 0.2%, suggesting that the economy is still running below trend.
Nationwide’s house price index indicated that property values were 1.9% higher in January than a year earlier, up from 1.4% in December and the fastest annual growth since November 2018. The main drivers are healthy labour market conditions and low borrowing costs, which appear to be offsetting the drag from the uncertain economic outlook.