January 2018

January 2018

Commentary

Happy New Year to all readers! We thought that we would offer, in the commentary to our first monthly report of 2018, some thoughts on the relatively technical area of restructuring existing liabilities. Don’t worry, we have plenty of exciting topics ahead – think of this as part of a low-calorie intro to the new year but also as one where large amounts of money can be at stake …

In the social housing sector there is typically relatively little ‘churn’ of liabilities, whether that means restructuring of hedging relationships or “liability management exercises” for bonds. Most of the refinancing transactions Centrus advises on are negotiations with lenders over terms of quite old (i.e. pre-recession) bank debt, often necessitated by a merger or some other form of corporate or covenant restructuring rather than by considerations of strategy. But we think 2018 may see more focus on refinancing for the sake of aligning liabilities with strategy.

Housing associations are generally cautious of generating what for their bankers might be referred to as “transaction flow”, perhaps because of the accurate perception that transactions cost money. A hedge restructure is a negotiation away from a bank-friendly mid-market break cost and a liability management exercise is a negotiation away from the onerous spens or modified spens prepayment arrangements contained in most bond documentation.

However, to focus just on the negative misses the point. If circumstances change then strategy may need to change in response. In the world of housing association debt, economic circumstances have changed very significantly over the last decade with a relatively muted response from RPs in terms of pro-active management of relationships other than in some cases quite heroic attempts to hang on to valuable historic margins. We are entirely supportive of fighting to retain value where it does represent value, and have effectively supported many clients in this endeavour, but in some cases a bigger picture is emerging increasingly clearly.

For example, so long as there is a good level of hedging for the medium/long term, RP balance sheets can carry a lot of debt at current interest rates, much more than in 2007. Not all gearing covenants support that. Development for sale activity introduces a much higher level of commercial risk to the income statement with a risk of losses on sales or on investments in / lending to commercial subsidiaries; again, the interaction with corporate structure and interest-cover covenants can be quite nuanced. These are quantitative matters which can be understood at a principles level but also should be carefully considered as part of business plan stress testing.

If you would permit a side-step and look at other markets – in the last few months several of the major property REITs have made undertaken some fairly major restructuring of balance sheets to support strategic priorities. Key examples include:

  • British Land is buying back £85m of bonds, currently paying 5% or more and maturing in 2028 and 2035. The final price represents c.25% more than the face value. It appears that the uptake from investors was less than hoped for with the total issue size of the two bonds in question being £420m, but that reflects confident decision-making rather than failure in our view.
  • Land Securities offered in November to buy back more than £730m of bonds, in a combination of “as much as you want” and “all or nothing” offers across four bonds again all with coupons around the 5% mark. This was following a bond buy-back in September of c.£500m of bonds, at a cash cost of £673m, and the issue of new bonds at much lower coupons reflecting current market interest rates.
  • Hammerson have undertaken similar activity and there has also been share buy-back activity in the major REIT sector, led by British Land.

All of these are listed companies, with employees paid in part on the basis of share price movements and a different set of influences than housing associations. But it would be wrong to perceive the drivers entirely in terms of questions of agency problems. The funders for these businesses have made clear a desire for predictability and yield and the underlying drivers are recognisable to the RP market, including:

  • Accepting that the prepayments will reduce reported net asset value in the short term (because of the break costs), but in the context of property value growth
  • A payback of lower future interest costs and an opportunity to manage refinancing risk
  • Reported financial performance: stronger earnings per share going forward and potentially higher dividends

In any transaction of this nature, if the priorities of counterparties (in the case of a bond tender, of investors) are understood correctly then the economic costs may represent good value for money.

These examples focus on public debt markets, but the equivalent for hedge restructures is that where lenders are willing to transact at discounts to mid-market hedge break costs, driven by their own accounting and capital requirements, then again, the transaction may be mutually beneficial. As with the institutional deals, a clear strategy and confident approach to the market is key, including a willingness to walk away from unattractive terms.

So, to conclude this line of thought – for RP treasurers considering the merits of restructuring their existing portfolios and asking whether it is worth looking at inflexible long-dated hedging arrangements or security-hungry / expensive bond liabilities, our assessment is always to avoid undertaking transactions for the sake of being seen to do something. But one also should take seriously the potential benefits of more robust interest cover projections or improved security arrangements and other terms.

To add one further observation, banks are now reaching conclusions on the impact of “ring fencing” for them and their clients. This is planned for 1 January 2019 and where clients fall within the ring-fenced bank there will be limits on the nature of the services provided. This appears now to be filtering through to specific transactions proposed by lenders to specific clients, for example on terms within derivatives contracts. There may be commercial benefits or opportunities for RPs resulting from this and we will be communicating our views when we have a clearer sense of where the banks are landing on implications for their clients; but in the meantime, a number of clients have received approaches from lenders and please do not hesitate to ask for advice on this topic.

Financial Markets and Economics Overview

The FT’s annual predictions indicated that the majority of economists who took part believe that the UK’s economy will slow further in 2018 as business investment remains on hold, interest rates creep up 0.5%, indebted consumers curb their spending and inflation starts to recede. Just over half of the 111 economists who responded to the survey expect growth to be no more than 1.5% in 2018 will be pulled in two separate directions next year as uncertainty over the outcome of the Brexit negotiations reduces growth at the same time as an upswing in global activity boosts exports.

Chancellor Philip Hammond earmarked a £31bn fund to try to boost the country’s weak productivity growth and raise UK economic growth over the six years from 2017-18 to 2022-23. The Treasury has included within the fund’s remit building more homes in high demand areas. £11.5bn of the fund has been allocated to housing, with potentially more after allocations of the £7bn out of the £31bn yet to be allocated. Almost £2bn will pay for projects to unlock land for housing and related infrastructure.

CPI inflation rose to 3.1% in November, surpassing analysts’ expectations for to remain steady at the 3% rate from in October. The main drivers were a fall in sterling, rising electricity prices and rising global oil prices.

UK manufacturing PMI slipped to 56.3 in December, from a 51-month high of 58.2 in November. Producers of intermediate and investment goods reported an acceleration of growth in activity in December. But this was offset by a slowdown in growth among producers of consumer goods.

Annual house price growth rose modestly to 2.6% in December, as indicated by the Nationwide House Price Index. This resembles a stable level of house price growth, despite current tougher market conditions, lower consumer confidence and the seasonality effect. Low mortgage rates and healthy employment growth continued to support demand in 2017, while supply constraints provided support for house prices. However, this was offset by mounting pressure on household incomes.

1-month and 3-month Libor have both remained steady at 0.50% and 0.52% respectively. Gilt yields and swap rates fell in December as investors took a more cautious view on the progress of Brexit negotiations.

On the Brexit front, the UK reached a historic deal on its EU exit terms, enshrining special rights for 4m citizens and paying €40bn to €60bn in a Brexit divorce settlement that clears the way for trade talks this year.

Interest Rates

Inflation

Capital Markets

Bank Credit