Deferred Funding Structures – An Objective Analysis
Clients often ask us for our views as to whether deferred funding structures are an appropriate fit within their treasury strategies. Like many things in life, the answer in most instances is that “it depends”…
At its most basic level, deferred funding should be thought of as a way to avoid paying a borrowing spread during the deferral period. Let’s imagine a simplified world where the gilt curve is flat at 5.0% and borrowing spreads are 1.0%. A borrower could raise 30 year fixed rate debt at a fixed coupon of 6.0% and invest it in short term gilts yielding 5.0%. As this borrower does not expect to use the cash for at least 12 months, its “cost of carry” in year 1 will be 1.0%.
Alternatively (assuming that the borrower didn’t actually need to commit the funding in question until year 2), in this world the borrower could choose to lock in 1 year forward starting 29 year funding at the forward rate of 6.0% (the same as the current level due to the flat yield curve). In doing so, the borrower has locked in its cost of funds from year 2 to 30 at 6.0% and has saved a 1.0% cost of carry in year 1. From this simplified analysis it is clear to see that the economic benefit of deferral is 1.0%: the borrowing spread.
Although evaluating the economics of deferred funding in the real world is significantly more complex than this, the same basic principles apply. In the current environment, cost of carry is largely a function of the steeply upward sloping yield curve. Deferred deals will be priced over a forward starting gilt yield which is adjusted upwards versus today’s yields to reflect rising interest rate expectations. Economically (when viewed on a PV basis), this gilt yield “forward premium” broadly offsets any apparent economic benefit arising from avoiding the gilt curve-related component of cost of carry. However, from an economic perspective the borrower still saves the borrowing spread during the deferral period, all things being equal.
This said, we would also observe that depending upon the length of the deferral period it will not always be correct to compare this borrowing spread saving to the cost of raising the full amount of finance on day 1. For example, in practical terms few borrowers would actually raise funding now which is not required until 4-5 years hence and would do so at the prevailing market terms at a much later date. As such, any presentation of savings driven by borrowing spread during long deferral periods may not be comparing apples with apples.
In the real world, deferred funding deals will also typically be priced at a “spread premium” to a comparable conventional bond or private placements, which is reasonably explained by factors such as lower liquidity, greater complexity, and lower structural demand for deferred issuance (due to the small investor base for such bonds). While is it often difficult to cleanly extract a deferred spread premium from any particular deal, it is worth noting that social housing issuers Knightstone, Southern, and Radian have priced deferred deals as follows:
A deferred spread premium of 7bps is apparent from the Radian and Southern deals. In the case of Knightstone, although both the day one and deferred elements priced at G+140bps, this was notably wide of where comparable secondary market spreads were at the time, suggesting that some deferred spread premium was built into G+140bps. The deferred spread premium can be seen to an extent to offset the borrowing spread-related economic savings during the deferral period in the same way as a higher forward gilt yield offsets the benefit of the gilt curve-related cost of carry savings.
These various dynamics make deferred pricing relatively complex to evaluate and it is generally not obvious whether there is value in a particular proposal. Pricing needs to be assessed on a case by case basis taking into account both the economic benefits of deferral for the particular borrower and spreads relative to what might be achievable through more conventional funding routes which will undoubtedly attract a wider number of interested investors. In addition, when evaluating any financial product proposal, it is always essential to consider the risks, and with deferred funding there are a number of key risks to consider:
Firstly, the borrower is taking counterparty credit risk on the (usually one single) investor in the sense that the investor may not turn up with the cash on the day(s) of the contractually agreed future drawdowns. Notably, the economic incentive for the investor to “default” on its commitment might be greatly increased if rates rose substantially following issuance of a deferred deal. This is because the investor might find itself having to put up say £100m in cash for an asset now worth only £90m in the higher rate environment. Although there are legal protections which can be employed to ensure the investor is kept “on the hook”, the credit risk cannot be ignored and rating agencies may be concerned about this commitment where the party is unrated. Where borrowers take counterparty credit risk in relation to deposit taking institutions or swap counterparties, there is usually credit rating information (with the usual health warnings) available in order to guide risk appetite limits based upon treasury policies. However, the small number of investors which have appetite for deferred transactions are usually unrated and so the borrower has no ability to appraise their credit in the same way.
Secondly, borrowers need to consider the risk that, for whatever reason, the locked in funding commitment is not actually required on the drawdown date. This risk can be mitigated to an extent by 1) allocating deferred funding against highly probable cash outflows only (e.g. a debt refinancing or contractually committed expenditure), and 2) not deferring beyond a reasonably visible planning horizon. For example, the economic, operating and regulatory environment could change significantly over say a 4-5 year time horizon and the borrower could find itself contractually obliged to draw down funding which it no longer requires if this has not been allocated as suggested above.
Finally, the very thin nature of this segment of the investor market means that borrowers are more prone to the appetite and credit view of the small number (with one bulk annuity provider particularly well known for having appetite for these structures) of investors at any given point in time. To this extent, execution risk is arguably higher than for more standard transactions aimed at a much wider investor pool.
Providing these risks are understood and can be managed, there may be a number of other attractive features associated with deferred funding arrangements. Firstly, a borrower might view the redistribution of cashflows arising from drawdown deferral as highly advantageous (particularly where a financial plan is put under pressure by cost of carry in the early years). Secondly, there is clearly value in having certainty over one’s future funding costs, even if locking into forward funding rates means paying both a yield curve and spread premium which are likely to neutralise any cost of carry savings achieved by the borrower. Where there is significant concern around exposure to financial risk but funding is not required immediately, deferred funding could provide an attractive mechanism whereby both rate and credit spread risk can be hedged by a borrower (notably, hedging the latter is not possible to achieve using conventional capital markets instruments).
So in summary, in evaluating deferred funding proposals, we would suggest that clients at a minimum address the following key considerations:
- What is the spread for deferred funding versus the (estimated) spread for comparable conventional funding?
- How is the forward gilt yield being calculated and is this calculation reasonable?
- Are there really any economic savings arising from the deal or are we just rearranging cashflows?
- From a planning perspective, are we happy locking into funding at a more expensive forward level?
- Are we comfortable with the the credit worthiness of the investor(s)?
- Do we have sufficient legal protection against an investor default on the commitment?
- How sure are we that we will actually need the funding on the drawdown date?
- How much do we value being able to hedge both rates and credit spread risk?
- Is the associated redistribution of cashflows advantageous to us?
- Are we comfortable with the extent of execution risk and what is the Plan B if appetite for deferred structures or the borrower’s credit isn’t there?