Treasury Options To Mitigate Housing Sector Rent Cuts
Centrus’ previous analysis of the impact of the rent cuts for England, announced in the post-election budget in July, indicated that many RPs could be looking at a reduction in interest cover ratios of around 60 percentage points (e.g. a reduction from 200% to 140%) by 2019, absent any mitigating actions. The severity of this effect has caused most RPs to consider how they can generate cost efficiencies to offset impact of the rent cuts. RPs have invested considerable time since July developing and refining their response to this pressure, including the submission at the end of October of revised business plans to HCA.
In addition, many of our housing clients will also find themselves in the position of not wishing to show large I&E surpluses in the current financial year given the currently “unfriendly” political environment. So there are potentially competing objectives to be balanced, alongside which RPs may wish to give consideration to the impact on short term interest cover in terms of credit ratings and lender/investor perception which could in turn have an impact on their funding costs. These are complex issues albeit part and parcel of RP treasury activity.
It is worth restating that of course this applies in the first instance only to England in terms of the rent cuts. However, the broader strategic position is perhaps relevant elsewhere across the UK.
There are various treasury strategies which can be implemented during the final quarter of 2015/16 to achieve these objectives – i.e. effectively to generate interest savings in the short-to-medium term in return for either taking an up-front accounting hit, or back-loading interest payments. We have set some of these out below:
1) Buy back high coupon debt: some old group borrower bond issues can be purchased in the market and surrendered back to the issuer for cancellation. The impact on the RP is a “break cost” hit in the current financial year (equal to the difference between purchase price and book value) in return for interest savings in future years. The effectiveness of the strategy depends on the structure of the bond as well as the profile of the new funding strategy (duration, floating or fixed, nominal vs inflation etc.).
2) Break short dated standalone swaps: clients could choose to pay off the negative MTM of short to medium dates (5-10 years say) swaps, or break the early years of longer dated swaps. It is important to note that under FRS102, standalone swap fair values are already on balance sheet so there is not the same I&E “break cost” effect as was the case under old UK GAAP. Under FRS102, the cash paid to the counterparty instead goes to reducing the balance sheet derivatives liability. However, if the RP is applying hedge accounting then the impact of recycling of any accumulated cash flow hedge reserve balance to I&E needs to be carefully considered. The broad economic impact of this strategy is a cash hit in the current financial year in return for substantial interest savings over the remaining life of the broken swap (and some transaction costs will likely be incurred). From an execution standpoint this may prove to be a cost efficient strategy as there is an argument for bank counterparties to release certain credit and funding charges.
3) Break short dated embedded swaps: the situation is qualitatively different to standalone swaps under FRS102 because embedded hedging is most probably not on balance sheet at fair value (it is most likely booked with the loan at amortised cost). An I&E break cost may therefore result from paying off embedded hedging, and also the impact on EIR/Amortised cost and exchange accounting would also need to be fully considered (in this instance, clients would not want to achieve exchange accounting!).
4) Receive fixed in long terms swaps: clients could enter into a swap where they receive fixed at a higher long term swap rate in exchange for paying LIBOR, earning them a significant “carry” benefit in the early years. Key considerations are the cost of entering into such a transaction (likely to be significant) in the context of the carry benefit, and the impact on the interest rate risk profile. Shorter term interest rate risk can be mitigated by simultaneously entering into forward start pay fixed swap strategies.
5) Inflation strategies: although never wildly popular in the housing sector, some of our utility clients (which currently face similar interest cover pressure due to challenging price controls) have very effectively used inflation swaps to convert high coupon fixed rate debt into “back loaded” inflation linked cashflow streams, generating very large early years interest savings. Such hedging in CPI format may be priced attractively due to high demand from the ultimate investors.
We would caution that clients considering these strategies must be clear on the following three key aspects before proceeding with any transaction:
1) What is the economic cost of the transaction? Treasury transactions almost always come at a cost, and sometimes this can be a very large hidden cost. Boards must be provided with transparency on the economic cost of any transaction so that they can make an informed assessment of any short to medium term cashflow and accounting benefit versus the overall economic cost.
2) What is the treasury risk impact of the transaction? Any significant treasury transaction is likely to involve a related impact on covenant risk over different timeframes and/or liquidity risk and/or counterparty risk and/or interest rate risk and/or treasury operational risk. We would recommend that a full treasury risk assessment is carried out before proceeding with any transaction.
3) What is the FRS102 accounting impact of the transaction? FRS102 financial instruments accounting is much more of a minefield than old UK GAAP and clients must ensure that the accounting treatment reflects the desired outcome, and ideally seek confirmation from their auditors before proceeding.