Brexit: Key issues for treasurers
1. Brexit – key issues for treasurers
This brief note is to inform clients of some of the key issues Centrus sees arising from the Brexit referendum, as an early response to some of the questions clients have sought to discuss with us over the last few days. Centrus does not claim any special predictive insight into how, and indeed whether, the UK’s exit from the EU will play out. The immediate market reaction to a largely unexpected referendum result was one of the most severe since the global fi nancial crisis of 2008, but one of the positives to take away from the volatility experienced on Friday is that compared to 2008, the fi nancial system and its participants coped well with the immediate shock. Since the initial reaction, Sterling has stabilised and the FTSE- 100 share index has recovered close to prereferendum levels, for the time being at least. This note is UK-focused and, at least in the UK markets, we expect volatility to persist for a prolonged period, until there is indeed a concrete Brexit plan in place. One dimension to the uncertainty here is the big difference between an organised exit with properly-considered renegotiation of the UK’s trading and investment relationships and a disorganised and bitter “divorce” designed to discourage other countries from thinking that they can leave the EU but retain preferential access to the single market. Further, it is possible that a reasonable amount of time will pass before any real direction is known, meaning that a “wait and see” approach may not be the most useful. The following table summarises some of the key economic inter-connections. Apologies to those readers for whom this is “Economics 101”. The remainder of the note then maps out some of the key treasury implications and we offer some sector-specific points to consider in decision-making going forward.
2. General factors affecting long-term borrowers
The referendum result comes at the end of a period during which we have seen some quite radical developments in the application of economic policy in the UK and developed economies more generally, including the rest of the EU, in response to the global fi nancial crisis and the low growth environment The consequences of ultra-low rates, of quantitative easing, and of the political pressures which have both preceded and resulted from them, are not known.
Every business will have its own particular exposures based on its activities and its financing position. But within that context, the following list covers what we see as the major factors to consider for any business with long-term borrowing and derivatives arrangements:
• Falls in interest rates hold out the opportunity of low-cost debt, by historical standards; but the value in this depends on the availability of suitable investment opportunities and also on lender / investor credit margin requirements.
• Liquidity: Falls in interest rates have increased the negative mark-to-market (“MTM”) values of out-of-the-money swaps and other financial derivatives. Long-term swap rates have fallen c.50 basis points on the quarter and nearly 1% over the last six months. For borrowers who post collateral against MTM this presents increased valuation and liquidity risks.
• For fixed rates and similar which are embedded into loan products, this will change the economic dynamic between borrowers and lenders in terms of the relative values of historic below-market margins and long tenors as compared to the MTM of the fixings, with the latter increasingly expensive for banks to account for and fund. This may create opportunities for borrowers.
• Our general advice is that clients should consider their ability to collateralise MTM moves from rates falling at least 50 basis points. As rates fall, this ‘target’ moves too. If that ability is in any doubt, then the critical point is to plan well in advance. This scenario can be much better managed if foreseen prior to any “emergency”, with options including negotiations with existing counterparties, refinancing of security-hungry arrangements, or the arrangement of short-term funding on an unsecured basis, which may be available albeit at a cost.
• Counterparty risk is an area where many clients over the last year or so have revised policies or increased the frequency or detail or review. It is important to ensure that you have practical systems in place to monitor counterparty risk. In the immediate term, it is not apparent that there has been any material fall in perceptions of credit-worthiness of the main UK banks, but it is possible that issues will emerge as Brexit is thought through in more detail.
• Funding markets: falls in economic confidence and in confidence in the banking sector should encourage corporate borrowers to assume longer time-frames for putting new liquidity in place. It is possible that some international and domestic investors will be more cautious or slower to act while the current uncertainty persists but it is too early to have encountered any direct evidence of that at this stage. Borrowers accessing international investor and banking markets may find the funding environment more challenging if lenders and investors reduce their appetite for UK assets. While domestic investors and lenders are unlikely to have lower appetite for UK assets over the medium to long term, the speed of decision-making are likely to be negatively impacted while uncertainly and volatility persists.
• Exchange rates: any exporter or importer will be already well aware of the significant falls in Sterling. Hedging this on a long-term basis using just financial products has limitations so this feeds into a range of decisions including investment decisions for new capital assets.
• Credit ratings: as noted above, ratings of the UK sovereign have come under pressure. It is likely that will flow through to ratings of some corporates, particularly those corporates relying on a regulatory process involving central government or on the implicit support of central government. This could apply some downward pressure to the ratings of utilities and housing associations, amongst others, and there has already been evidence of that. In the event of a severe recession, wider downgrades across those sectors more exposed to consumer spending are likely to occur.
• Hedging: Very low interest rates present an interest-rate hedging opportunity, if rates are considered to offer good value and more importantly if they support the overall business plan given the uncertainties which apply to the latter. The key here is to understand key sensitivities in the underlying business plan, since over-hedging can prove expensive in the longer term.
• EU-related language in existing facility agreements: typically, we are not seeing any evidence yet that borrowers are being affected by material adverse change clauses or language reflecting potential changes in capital or other regulatory requirements on banks. However, it is possible that this will follow the initial analysis of bank impacts. Borrowers should present a robust position until and unless evidence is provided to support any bank position that circumstances have combined in such a way that margins should increase, under the terms of existing loan documentation. The one clause which explicitly relates to the EU is often provision for the adoption of the Euro as the UK’s currency, which it would be fair to say seems rather remote from the present position!
• EIB: many Centrus clients have elements of funding from the European Investment Bank. The EIB has said that “We expect that the EIB’s shareholders, the 28 EU Member States, will discuss the EIB’s engagement in the UK as part of broader discussions to define the future relationship of the UK with Europe and European bodies.” In reality the inter-connections involving the UK and EIB are quite extensive and the UK is a major shareholder in the EIB. While it perhaps appears unlikely that the EIB’s commitment to UK social infrastructure will remain as high as it is now, in relation to new loans over the medium term it may be reasonable to expect some form of replacement arrangement or scheme to be established or existing schemes to be extended within the UK.
3. Sector-specific commentary
This section considers key issues for the main sectors in which Centrus clients operate.
3.1. Real estate
For commercial real estate owners and investors we would see the key points as the following:
• General: given uncertainty over the foreseeable future, asset sale or purchase plans may be placed on hold until we see some clarity over Brexit.
• Retail: here the main feed through from the wider economic picture is in terms of dampened consumer demand. The “death of the high street” is a complex picture and only a part of the wider retail picture, but a reduced level of economic growth will harm retail investment performance.
Office: the picture here is more granular, in terms of the analysis of individual tenant exposures to the downside of Brexit or the extent to which it may or may not have an impact in some sectors. For example, we may find that bank tenants and asset managers relocate to the continent or Ireland whereas domestic industries may be less affected.
• Industrial: The devaluation of Sterling in the short-term may lead to an increase in exports which may affect demand for certain categories of occupier.
For commercial developers the speculation has of course focussed on falls in property prices, as evidenced by the sharp falls in housebuilder share prices last Friday. The immediate implications here relate to sales and cash flow projections, and to valuations including the consequences for loan covenants.
The same basic issues arise for housing associations, particularly for those with either (i) significant sale programmes or (ii) limited headroom in terms of property security and particularly where security valuations have a link to open market values, i.e. where the “Market Value Subject to Tenancy” valuation basis is used. On the other hand, the basic underlying demand for the core “output” of most associations – sub-market housing – remains strong.
3.2.1. Housing association business planning
We have discussed with a number of associations their requirements in terms of HCA regulatory submissions, and our advice has been to avoid getting bogged down in last-minute changes unless felt to be absolutely necessary.
We will be issuing shortly our regular end-of-quarter housing business planning assumptions but our thoughts in terms of elements to consider for downside plan sensitivities are as follows. Clearly it is a matter of judgement in terms of what to put in a base case vs. what to model as sensitivities but our focus is on downside risks and sensitivities:
• A downside scenario might incorporate significant movements and volatility in borrowing rates.
• Ongoing low rental inflation is more likely, perhaps with a greater likelihood of extended “rental austerity” for sub-market rents (“austerity 2” – recession / deterioration in public finances / further savings on the housing benefit bill), and perhaps also in the context of higher cost inflation and particularly on imported materials and hence maintenance and construction costs. It may be simplest to think in terms of a short-term one-off shock (e.g. 5-10%) to some costs.
• Further cuts to welfare payments and potentially higher void rates and bad debts are possible. In some areas any material change to immigration patterns perhaps would affect demand for accommodation but any underlying lack of demand for social housing seems some way off in most parts of the country.
• The likelihood of significant house price falls is unknown – it is too early to tell and ongoing low interest rates will continue to affect asset prices generally. But it may be helpful to consider the liquidity impact of significantly slower sales rates or conversions to rental tenure, as well as lower projected sales values. In the longer term the picture for development scale is more complex in terms of the interplay between house prices, land prices, and rental yields.
Some utilities businesses have significant levels of index-linked borrowing. The falls in rates will impact on existing inflation swap positions and more generally any economic shock has the potential to introduce a mismatch between net revenues and financing costs, in terms of the actual inflation indices which apply.
On a more positive note, nominal and real rates have moved significantly lower presenting opportunities for fixing very low nominal and real rates to fund ongoing capex requirements. Despite a pause in debt capital markets issuance, we would expect good ongoing access for funding utilities.
The consequences should be considered carefully for any more complex positions within the liability portfolio, such as mandatory lender breaks, where there is a combination of market-observable data and lender behaviour factors to consider in terms of the cash flow implications.
For many infrastructure investors an important issue is the future investment pipeline. It appears that already key national infrastructure decisions, such as Heathrow expansion, are likely to be delayed further and the willingness of the government to fund investments such as green energy generation is likely to be reduced further to the extent that Brexit does lead to depressed economic growth and confidence. However, there may be financing opportunities presented for owners of existing assets, depending on the robustness of the underlying asset cash flow and the nature of any hedging already in place, whether that is refinancing or extending the amount of leverage within a portfolio, given very low underlying rates. One other point of note is that given the change in value of Sterling, secondary market opportunities for investing in UK infrastructure may look more attractive to international investors.
3.5. Further Education
For universities, one issue of particular salience is greater uncertainty on future foreign student numbers in terms of any changes to the immigration regime. This could affect both revenues from providing courses but also demand for student accommodation and in some cases the finances of the latter are closely entwined with the finances of universities themselves. Government funding could also be reduced if the public finances come under further pressure.
There are positive factors also, such as low underlying interest rates as noted above (i.e. in the context of new borrowing to support investment in new facilities, albeit the underlying rate is only one factor in the overall cost) and also a weak Sterling will make UK education cheaper for foreign students at the same time that the trend for UK students studying elsewhere in the EU could also reduce.