BoE buying is a timely boost for the corporate market

Those with a good memory will recall that the Bank of England’s last significant attempt to buy corporate bonds was in the aftermath of the 2016 EU referendum. It took them several months to build up a £10bn portfolio, finally finishing in April 2017. From an investor’s point of view it was a somewhat drawn-out, convoluted and opaque process. The Bank drew up an eligible list of bonds it would buy, then held reverse auctions three times a week in which it invited investors (via the large investment banks) to show them offers in those bonds. The eligible list itself was somewhat debatable, they refused to buy bonds that the issuer could redeem at no cost within 3-months of final maturity (a “3-month call option” and a pretty standard feature in corporate bonds), and they limited themselves to only buying a relatively small amount (10m) of an individual bond on any one day. For many investors it felt far too cumbersome and after an initial period of enthusiasm it quickly became something of a sideshow. The Bank briefly restarted its Corporate Bond Purchase Scheme (CPBS) back in August last year to re-invest some of the interest and principal they had harvested from the portfolio they bought in 2016/17.

So when the Bank announced it would restart the CBPS as part of its recently announced QE programme there was a hope, if not an expectation, that the process would have evolved to make it more user friendly. The Bank finally announced the details of its CPBS late on the 2nd of April. So what, if anything, has changed? Let’s start with the positives, at least as I see them. (1) The amount they are buying is meaningful – “at least” £10bn, with potential to grow. This becomes more important when you couple it with (2) They aren’t going to take nearly as long to go about it. They start buying on the 7th of April, and to quote the Bank themselves “It expects to make these purchases at a significantly faster pace than in the 2016 scheme”. To do this they will increase the amount they will buy of individual bonds (from 10m to 20m) at each auction. (3) They will potentially buy bonds with 3-month call options, although they are not as yet on the current list of eligible securities.

Which takes me to some of the lingering flaws in the scheme (1) The list of eligible securities hasn’t been updated since August 2019! During that time there have been a significant number of bonds issued that would have otherwise qualified for inclusion. They have promised to revise the list mid-April, but would it really have taken that much work to bring it up-to-date? I’m sure a friendly investment bank would have helped them out. (2) They still won’t buy “new issues”. Bonds must have existed for a month before the Bank will buy them. This is in contrast to how the ECB conducts its corporate bond QE purchases. They will happily buy bonds on the day they are issued. Relaxing this rule could have really helped to boost new £ corporate bond issuance. I still think we’ll see a meaningful uptick in issuance (see comments below), but this would have been a game-changer.

The pace of the buying is the most important change here. It seems the Bank has got the message that if they want to make a real impact – and not descend into an afterthought – they need to move at a much quicker pace than the last time. The other issues become somewhat secondary. The “clunkiness” of the system will no doubt frustrate £ credit market participants, but I’m sure that is well down the Bank’s list of considerations.

So will the CPBS meet its objectives? Well if the primary objective is to improve overall liquidity in the £ corporate bond market (which the Bank says it is), then I think it will, although its impact will vary widely. Since the acceleration in the Covid-19 pandemic, liquidity in the £ credit market has deteriorated rapidly, especially in certain areas such as short-dated (<5 years to maturity) bonds. This has the potential to kick some life in to that part of the market. For other parts, especially longer dated, relatively high quality bonds, it may well have the opposite effect, making them increasingly difficult to source for investors. Finally, I expect the restart of the CBPS to result in a significant increase in issuance of £ corporate bonds. This was certainly the case back in 2016 when companies rushed to issue debt in the aftermath of the Bank’s announcement. It could be bigger this time around. We have seen very little issuance in the £ market in the last few weeks, certainly relative to the $ and € markets where there has been a glut of issuance from companies looking to bolster their liquidity in these uncertain times.  Despite the quirk that the Bank refuses to buy bonds at issue, I fully expect lots of Treasurers and Finance Directors at large UK companies are eyeing up the CBPS as a means of doing the same thing.

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Bank of England QE – the resurrection?

Flying under the radar of the recent “Super Thursday” Bank of England announcements was the news that the Bank is about to start buying corporate bonds again.

As investors ponder whether the European Central Bank will restart its CSPP (Corporate Sector Purchase Programme), the Bank was releasing some details of its upcoming purchases. Some of you may remember that the Bank bought £10bn of corporate bonds through the second half of 2016, and the first part of 2017. It was part of the quantitative easing (QE) policy they put in place after the EU referendum in the summer of 2016. Well, since then they have been collecting coupon payments and redemption proceeds from the bonds they hold, and they believe that it’s time to start investing some of that money.

They have yet to quantify the exact amount, but it’s likely to be around £500m. In the grand scheme of things this doesn’t sound particularly market moving, but it does throw out some interesting questions.

Back in 2016 the Bank drew some criticism on how it drew up the list of companies whose debt it would buy. The definition was “companies (including their finance subsidiaries) that make a material contribution to economic activity in the UK”. That sounds admirable, but the inclusion on the list of companies like American telecom giant AT&T left many scratching their heads.

Moreover, back in 2016 the Bank was happy to “hoover-up” bonds from companies whose main exposure was to the UK retail sector… but a lot has changed in three years. The sector is now facing significant structural headwinds. Will the Bank still be comfortable buying bonds from the likes of Hammerson, the owner of a number of large UK shopping centres? They will update the list of eligible bonds later this month – I have no doubt it will certainly make for interesting reading.

Finally, will the Bank treat this foray back in to the corporate bond market as something of a dry-run for a much larger programme later in the year? A number of market participants have speculated that should the UK have a disorderly Brexit, the Bank will look to stimulate the economy through another round of QE, which will presumably include a much bigger portion of corporate bond buying.

The way the current Brexit process is developing, perhaps UK credit investors need to prepare themselves for the Bank being an active participant in their market for the foreseeable future.

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Safe as houses?

Last year, I wrote about the risks for investors in housing association (HA) debt of the significant increase in housing development for outright sale that many HAs are undertaking.

This risk has recently come in to focus following the latest trading update from London & Quadrant (L&Q), one of the largest HAs in the UK with one of the most ambitious development plans. They are also one of the most prolific issuers of corporate bonds, with £2.3bn of public bonds outstanding, and maturities out to 2057. In what amounted to a profit warning, L&Q announced at the end of January that their expected surplus for the year ending March 2019 would be £150m lower than they had originally budgeted for (£190m vs £340m).

The majority of the blame was placed on weakness in the London housing market: “…the ongoing political and economic uncertainty continues to weigh on consumer sentiment, particularly in the London sales market where confidence remains a constraint and is contributing to downward pressure on pricing.” In simple terms, they are making less money from selling homes (both outright and via shared ownership schemes) than they thought they would. Indeed, L&Q’s net margin on all sales fell to 7% in the 3rd quarter, down from 16% in the same quarter of 2017.

It may well be that this is a short-lived phenomenon, and that post-Brexit consumer confidence returns with a bounce in sales and operating surplus. However, for us, these results re-affirm our view that the outlook for much of the sector is more uncertain than is reflected in current bond pricing. In general, we will continue to avoid those HA bond issuers with development plans that expose them to excessive outright sale risk.

That’s not to say that funding social housing isn’t a key focus for our Ethical range of funds. Indeed, we recently purchased a newly issued bond from Futures Housing Group, a smaller sized association (<10,000 homes) based in the East Midlands. Although it is increasing its development pipeline, the proportion earmarked for outright sale is very limited, with most of the development still focused on affordable housing. At a spread of close to 170bps over similar maturity gilts, the 2044 dated bond (rated A+ by S&P) offered a much more attractive risk/reward profile than many of the alternatives in the sector.

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Student housing accommodates sustainable solutions

Recent figures from the Office of National Statistics showed demand for UK goods and services continues to grow, with exports rising to £637bn in the year to August. A rise of 5.5% compared to the same time last year. One industry leading that charge is the Higher Education sector. The UK is the 2nd most popular location, behind the United States, for international students. We have some world class Higher Education institutions in the UK, which offer highly desirable courses to international students.  Of the over 1.8 million full time student population in this country, 23% are from outside the UK. It is a key export sector for the UK economy. That’s not to say there isn’t strong demand from within the UK as well. Overall demand for applications continues to outstrip available course places. On average, over the last 6 years, demand for course places has outstripped available supply by over 35%. We expect demand for places to remain strong over the longer term with demographic trends implying a significant growth in the student age population from 2022 onwards.

Full time student applications continue to outstrip available places
Sources: UCAS, HESA, Unite estimates

Place of study for 4.5 million international students

Source: HESA,UNESCO, QS World University Rankings, NUS, Education at a Glance 2016, OECD

Providing good quality, affordable accommodation to students is vital to the ongoing success of the Higher Education sector. UK universities frequently cite their guarantee of accommodation to first year and international students as a key competitive point of differentiation. Moreover, students are increasingly opting for purpose built accommodation, which offers dedicated facilities like study rooms, high speed Wi-Fi, and 24/7 customer care. This has the benefit of freeing up the existing stock of housing for more general needs. However, financial constraints on many universities mean that they are building very little new accommodation themselves, preferring to spend their money on upgrading campus facilities like lecture halls, libraries, and laboratories.  The gap has been filled by the independent providers of student housing such as Unite, who are the biggest in the UK with just under 50,000 beds. They let out accommodation both directly to individual students, but increasingly through “nomination” agreements with various universities. These agreements see the universities guarantee Unite, to a greater or lesser extent, that they will fill the rooms in their properties. For the universities this allows them to continue to attract students, and for Unite it provides a highly visible and recurring income stream, usually linked to the level of inflation.

Unite is a core holding for a number of funds in our Ethical range of products, across both their equity and bond instruments. Indeed, our Ethical Corporate Bond Fund recently participated in a new bond transaction from them, which offered an attractive coupon of 3.5%. We also have exposure to bonds issued by Liberty Living, a privately held provider of student accommodation in UK, with over 20,000 beds.  For us, these are prime examples of the type of investments we are looking to make in these funds. Ones which help provide long-term, sustainable solutions in an important industry, whilst offering attractive returns for investors.

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New steps in social housing

The UK needs more affordable housing. In 2017 there were 1,155,285 households on local authorities’ housing waiting lists in England alone. Development of new council housing has fallen off a cliff over the last half century and councils no longer have the resources to be significant developers of social housing. The burden has been left to the private house builders and, particularly for social housing, the Housing Association (HA) sector. HA’s have been somewhat reluctant participants in the development game, being happy to cautiously grow their housing stock, but not picking up the slack from the dearth of council housing.

New homes built by private and social sectors in England

Source – Ministry of Housing, Communities and Local Government

It has to be said that government policy has, at times, not exactly been favourable towards the sector. Under the Cameron government the onus was on advancing home ownership, rather than promoting social housing. HA’s pared back their development in the face of a series of cuts by George Osborne to the level of rent they were being paid. The Theresa May regime seems to be more predisposed to the social housing sector. Rent levels will return to being linked to inflation in the coming years, and there has even been a return of government grants, albeit relatively small, to fund new social housing development. The quid-pro-quo for this friendlier relationship is that housing associations have to get out and build new affordable homes. Many in the sector, especially the larger associations, have heard the call. They have responded with a spate of mergers designed to pool resources and flex balance sheets to launch ambitious development programmes. Some of this will be funded by government grant, but much of will come from debt raised by HA’s in the corporate bond market. Indeed, they have become some of the most prolific issuers of corporate bonds in the UK market in recent months. It is rare that a week goes by that my colleagues and I don’t have a meeting with one HA or another looking to raise fresh bond market finance to fund new housing.

These development programmes often consists of a mix of “tenures”. Some new homes will be for traditional social housing, some will be for shared ownership schemes, and some will be for outright sale on the open market. The profit from the open market sales is used to subsidise the new social housing. All very sensible and commendable. However, from a creditor’s point of view it introduces more risk. Developing homes for outright sale exposes them to potentially adverse movements in house prices, especially in volatile markets such as London. This increase in risk has been reflected in a drift downwards in the credit ratings of some of the larger issuers of corporate bonds in the sector. When I first started analysing the sector over a decade ago, the small number of issuers generally had very strong credit ratings – usually in the broad AA range. That has all changed. There are still a few who can boast of a AA rating, but they are the exception rather than the rule as the table below shows:

Housing Association  Initial Moody’s Rating Current Moody’s Rating
London & Quadrant Aa2 (Jan 2010) A3
Affinity Sutton* Aa2 (Oct 2012) A3
Notting Hill Aa3 (Jun 2010) Baa1
Sanctuary Aa2 (Mar 2009) A2

*Now part of Clarion Housing

Part of these moves reflect the downgrade of the UK’s sovereign rating (to which HA ratings are linked) in recent years, but the increase in development risk has taken its toll on the credit rating of many an association.

HA’s have a tricky path to navigate – developing new housing stock to keep policymakers happy, but also maintain good relations with bondholders on whom they rely to finance this development. The two aren’t mutually exclusive, but will provide a difficult challenge for management teams in the coming years.

At Kames, we have long been providers of finance to the housing association sector, often through our range of Ethical funds. It will continue to be an area of focus for those funds. However, now, more than ever, we are being increasingly selective about where we invest in this sector. We will concentrate on those HA’s with a proven track record of development through different property cycles, and on those whose focus is on developing primarily social housing, without taking outright sale risk.

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Back in the summer of… 2011

As fund managers interacting with our clients, the team often gets asked, “What’s the holding period for a trade”? And, given our strong belief in active management, we typically respond by explaining how we rotate our portfolios’ credit and rates exposure across issuer / sector / quality / currency to find the best value in the market. It’s not often we say “six years” and leave it as that.

But for those of you that have followed our strategic bond funds over the years, you will have noticed that we recently closed our long-held position in US Non-Agency Residential Mortgage Backed Securities (RMBS).

The aftermath of the great financial crisis created many opportunities for us as active managers. One of these transpired back in the summer of 2011, when we started to establish a position in US RMBS. These were bonds secured on pools of US mortgages that had been originated in the years 2006 and 2007 and were trading at very distressed prices (on average in the low 60 cents in the dollar). This reflected a US housing market still in a state of flux following the financial crisis, and an expectation that these bonds would experience losses as home owners defaulted on their mortgages.

At the time we believed that the pricing of the bonds reflected too pessimistic an outlook for the US housing market, pricing in significant further declines in average home prices. In our opinion, we were nearing the bottom of the housing cycle, and these bonds would perform well as the US housing market recovered. With the benefit of hindsight, we were six months too early in our entry point as US house prices didn’t trough until late 2011/early 2012. But as long-term investors and given the scale of the subsequent recovery, it is harsh to quibble about the exact timing.

Source: Bloomberg

We recently took the decision to exit this position. With average US prices now above the level they were before the financial crisis, we believe we have seen the bulk of the performance from the trade. That is not to say we believe there will be a downturn in US house prices, rather the bonds now more accurately reflect the outlook.

One of the skills we must have as active managers is the discipline to take profits on a successful trade. These bonds have been an excellent investment for our clients, with some positions generating an average return of close to 8% each year since our initial entry. They have also provided excellent diversification benefits for the funds, exhibiting very little correlation with other parts of the global fixed income market. In this case, it was well worth an extension to our typical holding period of a trade.

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A timely reminder – the importance of strong covenants

In certain sections of the investment grade market the credit cycle could best be described as “mature”. By that I mean companies are looking for ways to reward their equity holders, rather than bolster their credit rating.

There have been numerous examples in recent months where companies have taken advantage of historically low cost of debt to either finance acquisitions or return money to shareholders. More often than not this has meant a downgrade in the credit quality, and poor relative performance from their existing bonds.

It’s at times like these that credit investors seek out bonds with protection from a strong set of covenants. These are the rules and regulations laid out in the bond documentation that dictate what the issuer of the bond can and cannot do. These can include rules around distributions to shareholders, maintaining a credit rating, and importantly the amount of leverage that the business can run. In an environment where companies are generally adding more financial leverage to their business, these covenants are a valuable safeguard for bondholders.

In the UK credit market, the strongest covenants tend to be found in the fixed rate securitised sector, where companies pledge assets against their debt. We have been investors in this sector for a long time, valuing the protection these covenants afford.

A further benefit from a strong set of covenants is that when companies outgrow their existing debt structure and want to refinance they often have to pay their bondholders a premium to redeem their bonds early. These “make-whole” payments can be significant depending on the maturity of the bonds.

A very recent example of this is Annington Finance; a complex and highly covenanted bond structure secured on a portfolio of Ministry of Defence housing in the UK. We have been invested in its bonds for many years. The company has announced its desire to redeem its entire debt structure, and refinance in a more vanilla manner. Should it proceed, bondholders look set to benefit from material “make-whole” payments. It’s a timely reminder, in a world where credit quality is being sacrificed, of the worth in a well-covenanted bond structure.