Credit where credit’s due

In the first article in this series, I described the use of ancient bond market techniques to provide permanent capital for housing associations. The second explored the need for more affordable rental housing to help the million or so families stuck waiting for council housing – often young people living with their parents or sofa surfing with friends or relatives. As our governments (central, regional, and local) are currently strapped for cash, I have suggested that housing associations step in to help address these challenges without resorting to grant funding. Ms Rayner and Ms Reeves, you can rest easy.

An incremental million homes is a large number in a nation that struggles to build more than a quarter of a million new homes a year – just enough to cover net new household formation, including net immigration. However, events in the last few days underscore the need to provide affordable housing – and other services – for all, as one way to ameliorate concerns about inward migration. For the moment, let’s leave it to Ms Cooper to deal with immigration concerns, and let's have Ms Rayner address the very real challenge of finding locations with appropriate planning permission. This piece focuses on Ms Reeves's bailiwick, the financing challenge.

Housing associations must tap a very deep pool of capital to fund these new homes making it all the more important that the private sector leap in to tackle these endemic problems at scale. As luck would have it, institutional investors have lots of spare cash lolling around looking for opportunities; so much cash that investing at scale ought to be more attractive than piecemeal projects; particularly if those investments – like social housing – come without excessive risk and tick sundry other social and environmental boxes.

In short, the time is ripe for a new bond asset class

This piece provides a pencil sketch for such an asset class. I hope others will help me colour it in. Today, I will take a rather plodding approach to the subject as the single largest barrier to this proposal might be the unwillingness of the housing associations themselves to do something new and untested. As charities, housing associations can’t issue shares. The deepest pools of capital available to them are in the bond markets. I say pools because the bond markets are vast and far from monolithic.

The niche I will address is the market for investment grade, long-dated inflation-linked bonds, and nothing could be longer-dated than a bond that pays cashflow forever. Despite a smidge over half a trillion of debt outstanding, the market for rated indexed bonds in sterling can be described as a niche because there is only one regular issuer, His (and formerly Her) Majesty's Treasury. Indeed, the Treasury's Debt Management Office rather enjoys telling investors that they save the taxpayer money by issuing bonds at low (and sometimes negative) real interest rates. Inflation-indexed bonds are so popular in part because inflation crosses borders. We live in a globalised connected world. For example, Canadian institutions buy indexed bonds in sterling because they issue so few of their own, and non-correlated assets are attractive in their own right. Ergo, the demand for these bonds is arbitrarily large on a global basis, making the funding of a trifling million new homes, not quite child's play but achievable if investors were presented with a cogent investment thesis.

If the cost of funding is low for the government, housing associations are well placed to barge in and play. And they ought to issue perpetual bonds as almost all their revenue arrives in the form of inflation-linked rent and – barring a miracle – there will always be demand for the accommodation they provide. In fact, if your principal source of revenue is linked to inflation and your principal source of funding is not, you have a mismatch that creates risks you might be ignoring.

For this proposal to work, the associations must find new ways to tout their credit to bond investors

Such touting may seem unseemly as it is new and unfamiliar.? Conservative housing associations must confront the cognitive biases that attract all of us to tired and tested ideas rather than new ones [sic]. Take loss aversion, for example. Issuing bonds at scale in a new format sounds risky. The obvious benefits may be outweighed by potential losses that are hard to define but likely to be small or de minimis on every objective measure. Please don't use the expression cognitive bias when explaining this concept to your board of directors!

Pointing to someone else's experience seems prudent, even if failing to act for lack of precedent creates the very real risk of ignoring one's core (and far from de minimis) desire to deliver new homes – lots of them, yesterday if possible.

My goal, in this article, is to tick through those objective measures to get the conversation started. Few things are more objective than numbers. How many hundreds of millions of pounds should a responsible institution forego to avoid a de minimis loss? Putting hard numbers on it requires one to descend into an unfamiliar realm called mathematics.?For those familiar with Leo DiCaprio’s role as Dr Randall Mindy in the movie Don’t Look Up, it’s hard to be confident about risks without resorting to the hoary mathematics of probability. Sorry.

First, let’s step back a moment. What does the word “credit” mean? Its many dictionary definitions include trust or belief in someone's ability to repay a debt. Credit is about the future, not the past. The future is unknowable, but it is not chaotic. The strength of someone’s credit can be measured. When people pay their debts their behaviour may be reflected in a credit score assessed and made public by a credit reference agency like Experian.* When companies issue bonds in the public markets, investors take comfort from credit ratings assessed and made public by reputable rating agencies, like Moody’s or Standard & Poor’s.**

For the uninitiated, a triple A-rated bond issuer is considered more creditworthy than a junk-rated bond issuer. Go back and watch the movie Wall Street for a refresher course on junk bonds. In the meantime, to oversimplify, imagine two issuers side by side; one triple A-rated, the other triple B-rated, on the cusp of investment grade. Both issue a bond that will (barring default) pay the same amount of cash over time. Bond investors can be expected to pay more for the triple A-rated bond. If such bonds are fully amortising annuities (not bullets), the proceeds will be received once and for all in exchange for delivering to the bondholder identical strips of future cashflow. In every relevant sense, both issuers will have "sold" a piece of their future but one will be paid more than the other because they persuaded the rating agencies that their risk of default was low.

As time passes a borrower’s credit rating might change

Periodically, the agencies may notify investors about a potential upgrade or downgrade from the original rating. The issuer can also guide investors by publishing their financial results, characterising those results in words, numbers, and ratios, and – more straightforwardly – by making the management team available to talk to bond investors and bond research analysts just as publicly traded companies talk to their shareholders and develop relationships with influential equity research analysts.

Such touting involves conducting these investor conversations, expressing confidence in one's own credit, and doing so energetically. This persuasion rests on two things: keeping the risks low (which is hard work) and telling people why the risks are low – which is easy if said risks are, in truth, low. You have to do this persuasion thing loudly and at regular intervals. Sadly, it is not a good idea to auction off part of your future in secret. Issuing bonds is a market-driven price discovery process. It's about selling your story – even if the bond structure is new – to raise money for your mission and the sums involved can be prodigious.

But are perpetual bonds really so new? In 1751 Henry Pelham – then Chancellor of the Exchequer – introduced perpetual bonds to "consolidate" government debt and finance Britain’s wars. Investors bought these bonds cheerfully more than one hundred years before American banker and philanthropist, George Peabody, funded the first British housing association in 1862. From the perspective of the perpetual bond markets, housing associations were the big new idea back in the day.

There are other reasons to see perpetual bonds as safe for the issuer. Normally, bonds are issued in bullet form, meaning they will be redeemed at par on a specific date. For companies that remain viable going concerns at that date, the debt will typically be refinanced. This refinancing cycle can continue ad infinitum. Thus, in practice, issuing a common or garden bullet bond is the same as issuing a perpetual bond.

Except that it’s not. Having a specific redemption date introduces an artificial point of fragility. If, for whatever reason, the debt cannot be refinanced on that specific date, the issuer might tip into financial difficulty, even if their operations are otherwise sound. For example, the markets as a whole may be disrupted, think 9/11, Lehman Brothers, Brexit, Covid 19. If such an event coincides with a redemption date, the issuer might face a problem unconnected to its own financial performance.

There is no such artificial break point for companies with access to the equity markets as shares are considered perpetual. Shares can be bought and sold or held by investors in perpetuity. When a shareholder takes a dim view of the issuer’s future, they might choose to sell the shares to a willing buyer at a loss, if necessary, but they have no right to demand the issuer buy back those shares and the issuer is rarely compelled to issue new shares in the teeth of a storm.

Bonds are not shares so let's talk about the time value of money. Usually, it is inconvenient to give someone money knowing they won’t return it for a few years. Even if the borrower will repay you with triple A certainty an investor might still demand a fee (an interest rate) to compensate for the time value of money. It would be normal to add a credit spread (an additional percentage point or two) to reflect the potential that a bond issuer might not redeem the bond with absolute certainty. The sum of these two interest rates (the all-in cost) can be used to discount future cashflows, to arrive at a present value. This number will not be infinite, even if the bond in question is perpetual. The best way to arrive at a number is to auction off the bonds to investors who take the rosiest view of your credit.

With this rather dull foundation established, there are large differences in the proportion of the all-in cost that can be attributed to the time value of money (as opposed to the credit spread) when the underlying benchmark is a nominal interest rate versus a real interest rate; real being the expression we economists use when we strip out inflation.

At present, the forty-year forward nominal gilt yield is about 320 basis points and the comparable inflation-indexed equivalent is about 50 basis points. Don't look at me. Look it up . The numbers hide in plain sight in the public domain.

However, the probability of default (measured in basis points) for an entity that issues two bonds side by side (one nominal, one real) will be the same. Thus, the impact on the proceeds from issuing a bond with a wide credit spread will be far greater for that issuer when issuing against a real, inflation-adjusted, benchmark. Since, to my knowledge, no housing association has issued ultra-long dated, investment grade, inflation-indexed bonds, it's worth reading these paragraphs slowly to see if they make sense. That the description of these bonds is unfamiliar is what is meant by the expression: new asset class. And, to repeat, new does not translate as bad when you consult a dictionary.

In today's ever more frenetic environment, reading things slowly seems anathema but now and again it's worthwhile. There's a lot of money at stake and plenty of investment banks available to double check my maths.

Now, here's the really new part of this proposal. Strap in. Imagine a “club” of four identical single A-rated issuers combined forces and issued bonds through a collective vehicle in which each issuer takes on the responsibility of paying the entire amount in the event one or more club members default. The probability that bond investors will lose everything from this club must be lower than the default risks attached to any one club member.

Yes, it's just maths, but the real world consequences are important. This lower probability will increase the amount that bond buyers will pay to receive the less risky income stream. When selling part of your future, you have one shot at it and the differences will be prodigious.

As at the time of writing, the risk-free forward rate for long-dated indexed gilts is about 50 basis points, and single A-rated housing associations issue bonds with credit spreads in the range of 100 to 150 basis points. Hunting as a pack, there is every reason to believe a collective vehicle (when rated) would be able to tap the market on very fine terms. At a guess, the credit spread could be cut by fifty basis points. That doesn't sound like much, right? Wrong.

When the gilt yield itself is so low (or even negative) the amount bond investors will pay is extremely sensitive to the all-in cost, which will be increasingly determined by credit spread. This spread is a judgment call about the future. Hence the credit spread can be influenced by what the club members say about their own credit, individually and collectively. Go tell it on a mountain.

This chart shows the potential proceeds for an issuer that offers investors a perpetual inflation-linked annuity of twenty five million pounds under a range of assumptions about the all-in cost. Think of this as around two million pounds a month, or rent from four thousand tenants paying five hundred a month each.

That bendy yellow line tells an interesting story. With bullet bonds, the benefits of lower issuance costs are received slowly over time. With an annuity the differences are reflected in one cheque received upfront. The rather less exciting pink line is the same concept except this time the bond offers the investor ￡25 million per annum, forever, with no inflation adjustment, rather like the perpetual bonds issued by Sir Henry Pelham back in the day.

To repeat, the yellow line is a new asset class. The pink is the old familiar class. Just eye-balling the difference, you can see that a fifty basis point reduction in the credit spread is a big deal; particularly when rates are low to start with. This depiction does more than hint at the potential answers to the question posed above. Say it with me.

How many hundreds of millions of pounds should a responsible institution forego to avoid doing something new?

The idea that housing associations should club together and accept joint and several liability for a collective issuance vehicle is new and new (on its face) is challenging. However, there is no shortage of demand for rated indexed bonds. There is a dearth of issuers. The supply-demand imbalance ain't going anywhere any time soon. The social good that can be done with the proceeds is obvious, and it would take a few weeks – a few months tops – to implement this structure and use it as a repeat issuance vehicle.

What are we waiting for? Fortune favours the brave.

People affected by these issues should feel free to reach out.

#socialinclusion begins at home

Ike Udechuku | Cofounder | CEO | The Pathway Club

* Other credit reference agencies are available. ??

** Other credit rating agencies are available too. ??