October 2017

October 2017

Plenty of news to cover this month so we’ll just dive straight in to talk about ratings, a topic close to the heart of many a housing association treasurer and also of interest to a wider audience. One initial comment – credit ratings are a communication tool first and foremost and there are no special brownie points or rewards in the next life for a higher rating (well, ok, maybe just a couple of days fewer in purgatory for the small number still clinging on to double-A ratings). Strategy around ratings and more generally should be cast in that context.

Moody’s downgrade

Firstly, readers will be aware that Moody’s downgraded the UK government rating from Aa1 to Aa2 on 22nd September. This brings their sovereign rating into line with S&P and Fitch but of course threw into doubt the extent to which they have been lifting ratings up based on their view of potential government support. The associations at Aa3, for example, were looking a bit close to the Aa2 sovereign for comfort.

To recap: this methodology is common to all three main agencies. However, the majority of S&P social housing ratings are A+ on the basis of an underlying rating (“Stand Alone Credit Profile” in S&P-speak) also of a+. i.e. no actual uplift. A number of S&P ratings do have an uplift of one notch, but the majority are a+ SACP with no uplift and it’s only the weaker ones that are uplifted. For Fitch there is a one-notch uplift – there are two A+ and one A rating and all are one notch up from the underlying rating. But for Moody’s until last week associations were benefitting from an uplift of 2 or 3 notches from their “Baseline Credit Assessment” to actual rating.

In the event, Moody’s downgraded all of their rated associations, by one notch, effectively reducing the uplift to “1 or 2”. Moody’s also changed the outlook from negative to stable for all housing associations. The charts show the resulting Moody’s and S&P ratings mixes:

One technical observation to make is that for investors which are insurance companies required to hold stress capital against their assets, dropping down from single-A to triple-B is a driver of increased capital requirements (more so than movement between double to single A). There isn’t any particular impact within the categories, but the proximity to that A/BBB threshold is relevant to such investors given the risk of future downgrade. There are now six BBB-category associations with Moody’s.

There isn’t any particular impact within the categories, but the proximity to that A/BBB threshold is relevant to such investors given the risk of future downgrade. There are now six BBB-category associations with Moody’s.

It is worth reflecting for a moment where we are now in terms of the differences between the Moody’s and S&P ratings. S&P ratings cluster around A+, on an SACP of a+. Moody’s now cluster around A2/A3, reflecting BCAs across the triple-B range of Baa1-Baa3 (with Baa3 and Baa2 both coming out now at A3 – for some years now there has been this feature of two BCAs mapping on to one final rating, as weaker BCAs are seen as benefitting more from potential government support).

So S&P see most associations as strong single-A regardless of government support; Moody’s as triple-B and indeed some as double-B and even with their more generous credit uplift only (in the main) get to mid-single-A level. The downgrade underlines how different these analyses really are.

Given the scale of change in the sector and the fact that the shift into more commercial activity has not yet really been tested in a downturn, we’re not going to make an issue out of “who is right”. Although having said that, amongst our clients the majority are managing their finances and liquidity in a way which supports the risk profile. It is also worth asking whether any investor seriously agrees with the logical conclusion of the Moody’s rating actions, namely that the likelihood of timely payment for these housing associations is lower than it was a couple of weeks ago simply because the UK has been downgraded.

The received wisdom has always been that investors “look through” the ratings methodologies – is that consensus starting to crack? Surely that smaller investors use public ratings even if pricing gets dictated by the big guys, and even big investors who might have their own view are constrained by client mandate and regulatory / internal policy requirements to reflect public ratings levels – what is the net effect of this?

The following chart shows trends in secondary-market pricing (by bank trading desks, effectively) across a selection of RP credits:

It is noteworthy that the Moody’s A3s price very closely to the A2s. The only A1 with an own-name bond, Riverside, is pricing at c.120 which is wider than the A2 bonds. One can strip out the two large names of Clarion and L&Q and then the A3s show wider pricing, as one might expect, but playing with the dataset is a slightly dangerous game – fundamentally it is a small dataset.

For S&P the A+ pricing is at least stronger than the A-flat. Overall, S&P A+ looks like a good place to be but there is quite a small number of associations behind this data so statistically-significant conclusions are hard to draw in our view.

There are quite significant ranges within the main ratings bands, as the following table shows. The range is the difference between the smallest and largest spreads against the relevant gilt benchmarks (and of these the S&P A selection is the smallest, with only a few securities):

Interestingly, if we compare to the utilities sector, we can see some somewhat different trends as the following graph shows:

Firstly, for utilities the ratings are more the “right way around” in terms of relative standing by same-agency rating, at least in the last few months. Secondly, the equivalent ratings price very closely: A3 and A- are about the same; Baa1 and BBB+ are about the same. Thirdly, all the pricing is tighter with the central pricing band around 80-90 bps rather than 100-115 for the RPs.

Notting Hill are the latest association to issue, in an interesting context given the merger under way with Genesis and with the ratings of the two associations at A3 and Baa2 respectively from Moody’s and A+/A- with S&P. The issue was printed at a spread of 135 bps for £400m, which given the context probably doesn’t tell us a great deal more than the above about investors’ slight nervousness about ratings trajectories.

Overall our conclusions on all of this are that:

  • Some investors claim to look through ratings and some are less emphatic. If we take that at face value: they don’t all look through ratings methodology differences.
  • The correlation between rating and pricing is weak.
  • The Moody’s A2 and A3, and the S&P A+, are all very close with at best a very small improvement for the S&P A+ bonds. (This does if nothing else support the ‘look-through’ concept.)
  • The ranges within ratings bands are large.
  • Several investors – including insurance companies – have expressed genuine concern about actual or potential drops below single-A (for those lucky associations who aren’t already there). This is not really relevant to an S&P rating at the present time.
  • Perhaps looked at in the round, A+ is a safe place to be if it’s an option?
  • For associations looking for a rating for the first time, it is as well to take time to consider the potential outturns; advisors and bookrunners will have views on shadow ratings and potential outcomes and these should be sought and reflected on.
  • Associations at the lower echelons of the Moody’s ratings who expect to be accessing the capital markets in the near term might want to consider a rating from S&P, to complement rather than replace (replacement would probably be viewed as “ratings shopping”). For some investors it will make no difference as we know that at least one major fund manager is obliged to use the lower public rating where there are two, but it may be a sensible piece of risk mitigation.
  • The cost of a rating is of the order of £1m over the life of an issue, i.e. another £1m for a second rating. Clearly a significant sum to consider from a value-for-money perspective, but potentially ‘earned back’ given that the increment is only a basis point or two on a public issue.

Rent settlement news

Hidden amongst the outpouring of emotion and general back biting of the Conservative Party conference there was another £2bn committed towards the social good of social rent housing, of which presumably a substantial amount will find its way to housing associations.

But of more interest to our clients (particularly those responsible for business planning!), the rent settlement for the period from 2020 has been clarified as a return to CPI+1. This is welcome and the fact that it is only for five years is a sensible recognition of political reality. Centrus has consistently advised clients to use CPI+1 in base case business plans along with stress testing. For those who have preferred to take a more cautious baseline approach, arguably we now have enough comfort over the CPI+1 for those five years (notwithstanding the usual caveats around the whims of politicians in a period of political instability). Boards and management teams who were more comfortable with CPI flat could apply the new settlement but still return to CPI flat from 2025 if they remain unpersuaded by our view on the long-term relation between rents and other costs. Associations will also of course need to continue to be mindful of the future funding of the welfare system and whether there are potential pinch points in their area or for the type of housing they provide.

Financial Markets and Economics Overview

With the Brexit discussions rumbling on, uncertainty around the future of the UK within the European Community has been having some knock on effects. House prices fell in London by 0.6% YoY, being the weakest performing region for the first time since 2005. a combination of Brexit and higher rates of stamp duty for high-value homes being the initial driving factors. The impact of the BoE’s rates decision will also weigh in on the housing market. The historically low interest rates environment, allowing for low rate mortgages, coupled with high employment and a shortage of supply of property has been driving up prices in recent periods.

A combination of inflation data results above expectations at 2.90% YoY (0.1% above consensus) and the publication of the BoE’s MPC minutes showing an increasingly hawkish stance on rates, were factors leading to a significant widening of rates by 20-30bps across the curve. The current 30y swap rate at 1.64% is up 21bps on the previous month. Gilts mirror a similar trend, currently at 1.92% at the 30y point, up 22bps since August. Consensus appears to be that absent of any sharp shifts in data or external geopolitical factors, a BoE rates hike is imminent, potentially as soon as November. Breakeven inflation rates remain relatively stable over the period, resulting in less negative real rates across the curve.

Sterling has shown strengthening performance over the month in relation to the Dollar, largely fuelled by a weakening Dollar. The exchange rate moved from 1.289 to 1.339 between August and September. Against the Euro, there was also a overall improvement, with movement from 0.921 to 0.882 across the period. However, UK GDP data released on the 29th showed a slowing to 1.5% YoY in Q2, with the current account deficit increasing more than expected.

Jeremy Corbyn this month re-introduced the idea of rent controls at the Labour Party Conference. This is not a new idea, with Ed Milliband including a similar concept in Labours 2017 manifesto. This would involve devolving powers to cities rather than the government holding the power to set rent levels. The impact on markets is still uncertain until further details are known.

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