Licensed to pay the bills

This is a story about the importance of timing, so the way it begins is fitting. In September 2008, after months of rumours that major housing associations were preparing to return to the capital markets after a five-year absence, Affinity Sutton broke the silence with a £250 million bond issue.

The deal was noteworthy from the moment it was priced as the largest issue in history by a single association at that time, the first in five years, and as a hefty wedge for anyone to borrow in the credit crunch. But it was cast in a greatly improved light when it was followed, literally a few hours later, by the catastrophic failure of investment bank Lehman Brothers.

The bank’s implosion sent a second paroxysm through the diseased financial system, lenders ran for cover, and borrowing costs - already at ugly levels - rocketed to new highs. Affinity’s finance team had walked out of a mine with their arms full as the tunnel collapsed behind them.

When Circle Anglia completed a £275 million bond issue the following month, it found that where Affinity had secured its cost of borrowing at 5.98 per cent it would have to borrow at 7.25 per cent - the difference between the two interest rates was more than 20 per cent. If life was tough in the capital markets, though, it was a golden age compared with what was happening to the sector’s traditional bank lenders. And so the exodus continued.

Growing trend

Since the Affinity deal, seven housing associations have issued bonds in their own names, and borrowing costs have fallen successively on almost every deal since their post-Lehman peak. What’s more, The Housing Finance Corporation, which raises capital markets funding to on-lend to clusters of associations, last July completed the largest issue in its 22-year history. In total, more than £1.8 billion of social housing debt has hit the bond markets in the past 18 months, and the trend shows little sign of abating soon.

THFC aims to go back to investors for another £60 million to £70 million any day now. Hyde Group is publicly planning an issue of at least £200 million, and, according to one reliable market insider, there are at least six associations considering issues in the next 12 months. All this has unfolded at a time when nearly all the news coming from the sector’s bank lenders has been bad. After years in which a handful of banks enjoyed unchallenged hegemony in social housing finance, bonds are once again the biggest game in town.

To understand the sector’s rekindled love affair with the capital markets, you need to understand why the two fell out of love in the first place.

When housing associations first began raising private finance, following the 1988 Housing Act, the capital markets were one of their main sources of funds. The banks joined in later, and, according to Piers Williamson, chief executive of THFC, by around 1996 there were eight to 10 banks competing for the sector’s business. These lenders, he says, were attracted by the huge amounts of government subsidy which cushioned their investments in housing associations, the regulated nature of the sector, and the fact that they could treat the loans to housing associations as analogous to residential mortgage lending. The latter point allowed them to offer housing associations untypically long loan terms of 30 years or more.

At the same time, long-term interest rates started to fall. Housing associations that were stuck with 30-year bonds issued in the high-interest rate environment of the early 1990s found that they could borrow much more cheaply on a floating rate basis from the banks. What’s more, explains Mr Williamson, associations ‘found that as banks competed more and more they [the landlords] could use that, and could rip up old deals and get them refinanced.’ Bond finance developed a reputation for being expensive and inflexible.

Around 2003 this process entered warp speed, when it combined with what Phil Jenkins, social housing bond guru and a managing director of investment advisors Traderisks, calls ‘the era of cheap liquidity’.

‘There was too much money chasing too few deals around the system,’ says Mr Jenkins. ‘In affordable housing, that simply expressed itself in the banks falling over themselves to lend money at 20 to 25 basis points over Libor [theLondon inter-bank offered rate, the rate at which banks lend to each other] in as much supply as borrowers would take it on.’

To put this period in context, Mr Williamson is fond of saying that associations ended up being able to borrow on tighter terms than the republic of Portugal. The capital markets simply couldn’t compete on price, and banks dominated the market.

Banks retreat

The credit crunch turned all this on its head. Starved of funds, banks ratcheted up prices to the point where the capital markets looked competitive or cheap. At the same time, bankers reined in the quantities of cash they were willing to lend to individual associations. Asked why Sanctuary Group went to the bond markets a year ago, Craig Moule, director of finance and resources at Sanctuary, says: ‘The banking market had pretty much fallen away… I think the bond market’s always been there but had been unable to compete with the pricing and terms offered by the banking market, and clearly that’s no longer the case.’

As an illustration, Adrian Carter, head of banking and finance at law firm Trowers & Hamlins, points to London & Quadrant’s recent issue of £300 million of 30-year bonds at an interest rate of 5.55 per cent. ‘You just couldn’t get that [rate] in the bank finance market at the moment,’ he says. ‘And you probably couldn’t get £150 million or £200 million either.’

Martin Watts, head of treasury at L&Q, believes that for L&Q it would still have been possible to raise that quantity of cash from the banks, at a price. But he adds: ‘If you want funding from the banks, it comes with caveats. And those caveats are along the lines of it must be embedded, it must be hedged with us, you must provide us ancillary business… For us, the debt capital markets allow us to be independent.’

The ‘flexibility’ of bank loans has also proven a double-edged sword. Many of the cheap loans bankers made to associations in the boom times are now unprofitable; as a result, the banks have allegedly been unwilling to lend new money unless the associations agree to re-price their existing loans. ‘As a borrower facing banks with this motivation,’ says Mr Jenkins, ‘your natural response will be not to ask them for anything… This has led many of the larger borrowers to seek new lenders in the institutional market.’

But some associations, such as Affinity Sutton and Circle Anglia, were planning their move back to the capital markets when bank finance was still booming. According to Nathan Dunton, group treasurer at Circle Anglia, the motive was ‘diversifying our funding so we weren’t so reliant on just a few smaller banks that were funding the whole sector. It was a model that wasn’t going to be sustainable into the future, regardless of whether the credit crunch happened or not.’ As some of the largest borrowers in the sector, they were at risk of hitting the limits that these banks were willing to lend to individual organisations. Mark Washer, group finance director at Affinity Sutton, says ‘at least one’ of Affinity’s banks had made it clear that it was not able, under its prudential limits, to lend more money to the association.

So how much appetite is there in the capital markets for housing association debt? It’s hard to be certain, but pressed for a figure, Andy Sweeney, director of bond syndication at RBC Capital Markets, suggests that the market has capacity for total bond issues in the region of £2 billion a year. L&Q’s £300 million issue was three-and-a-half times oversubscribed.

Why the demand? According to Mr Jenkins of Traderisks: ‘Aside from the stable cashflows, regulated nature and “essential service” characteristics of the sector, it occupies a handy niche as one of the few industries that borrows very long-dated fixed-rate debt, out to 30 years or longer.’ In other words, unlike banks, institutional investors like pension funds are keen to lend long-term, because ‘they tend to have very long-term liabilities to which they need to match assets’.

Preparing the way

What does an association seeking to get its hands on some of this cash need to consider?

First, size. According to Mr Carter of Trowers & Hamlins, the ‘accepted wisdom is that in order to go to the markets on your own you have to be looking to raise at least £100 million, preferably £200 million plus’. Associations seeking smaller sums have two options. They can borrow through an ‘aggregator’ organisation such as THFC. Cutwater Asset Management launched a rival structure called GB Social Housing last Tuesday. One market source suggests that it may not be the only would-be competitor out there.

Or, in theory, they can go directly to one or more investors to borrow money, instead of issuing a bond publicly. ‘That would be either a direct loan from the [institutional investor] to the [association], or it would be what’s termed a private placement, which is exactly the same as a capital markets issue but without the public document,’ explains Mr Carter. ‘I suspect that the only thing that’s stopping people doing that is not having the contacts and the network to do it.’ Traderisks has made clear its interest in brokering private placements for associations (Inside Housing, 10 April 2008).

Second, preparation. Preparing a bond launch is a more labour-intensive process than preparing a bank deal, with greater upfront costs. You will need to get a credit rating, and will need to put ‘considerable’ effort into giving the rating agency the information it needs, says Mr Carter. You should also be ready to put up all the security needed for the bond on day one. ‘[If you were] borrowing from a bank you could get on with your day job. Borrowing on the capital markets, that’s probably what you’ll be doing for the next two to three months,’ he concludes.

Third, the bookrunner. ‘The investor world has key relationships with key banks,’ says L&Q’s Mr Watts. So, when picking the bank to act as bookrunner for the deal, ‘you’ve got to get it right’. When L&Q was selecting banks for its bond issue, he says, it sent out a detailed request for information to a host of banks, covering everything from the investor base and pricing that L&Q wanted from the deal, to the banks’ positions in the marketplace. From the responses it selected a handful to present their proposals, and made its choices from that group.

Fourth, marketing strategy. ‘Getting your roadshow right is completely key,’ says Mr Watts. For L&Q this was about making sure that investors went away with ‘key messages about the sector and about us as an individual organisation’. Also, make sure you put your top brass in front of the investors. ‘They want to see those people who know the business, that is, top-tier management, chief executives, group finance directors. They know this sector, they’re very sharp, so you need to be transparent and adaptable.’

Finally, of course, timing. Bond markets can be volatile, and prices can vary day by day, but once a bond is priced, the terms are fixed. Hit the markets on a bad day and you’ll be stuck with high interest payments for 30 years. ‘We advise clients… to get everything ready, put all the paperwork on the desk ready to sign and go, all negotiated, and then just sit and wait until the bond markets are at the right point,’ says Mr Carter. ‘If you haven’t got the luxury of being able to do that then the bond markets become less attractive.’

Following this logic, Affinity’s Mr Washer doesn’t see anything particularly lucky about the timing of its bond issue. ‘If we had been due to go the next day [after Lehman’s collapse] and the pricing was 150 basis points higher we wouldn’t have done it. We were not in a position where we needed the money, unlike, I think, one or two who went up since us… We would potentially have pulled the deal, and that would have been fine.’

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