Picking a path through financial market turmoil

Comment10 Oct 2022Patrick Hawkins

Patrick Hawkins, a director at Savills Financial Consultants, explores what treasurers make of the state of the financial markets and what pointers there are for housing association finance teams

Patrick Hawkins

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Patrick Hawkins, a director at Savills Financial Consultants, explores what treasurers make of the state of the financial markets and what pointers there are for housing association finance teams #UKhousing

“Nothing in gilts markets in the past 35 years – not the UK’s ejection from the Exchange Rate Mechanism, 9/11, the financial crisis, Brexit, COVID or any Bank of England move – compares with the price moves in reaction to the chancellor’s Mini Budget.”

So ran Toby Nangle’s leading article in the Financial Times on Monday 29 September, in the immediate wake of chancellor Kwasi Kwarteng’s speech.

As we all saw, the anguish in the investment community was widespread and reflected in the sharp rise in the cost of government debt (gilts), but the pension fund industry felt the pain acutely.

The spike in gilt yields undermined final salary scheme values and some pension funds were reported to have been forced to sell gilts to meet cash margin calls.

Central bank action

The Bank of England intervened to prevent what might otherwise have been a vicious downward spiral. It suspended its (anti-inflationary) programme to sell gilts, while at the same time it pledged to buy long-dated gilts at a rate of up to £5bn a day for about two-and-a-half weeks (which economists worry may fuel inflation!).

What we observed in the market was a dramatic spike in gilt yields and interest rates, and a sterling sell-off in the foreign exchange markets – especially against the US dollar.

The Bank of England’s subsequent action – and to a lesser extent the government’s reversal of its decision to remove the 45 per cent tax band – allowed gilt yields, interest rates and the currency to settle down a bit, but not recover fully.

Cost of debt

At the time of writing (4 October), the 30-year gilt yield is at 3.90 per cent – still higher than it was a decade ago.

The short sterling futures market (a proxy for the Bank of England’s bank rate) is trading at 5.35 per cent for June 2023, and secondary spreads in the housing association bond market are 15-25bps wider on the week.

None of this is helpful for housing associations which are already facing the challenge of squeezed rental income in 2023-24.

And it’s not as if they didn’t have enough on their plates already, having to grapple with rampant inflation, rising costs, fire safety and decarbonisation, not to mention providing affordable, safe and comfortable housing for their tenants.

The spike in gilt yields may prove to be a relatively short-term, but nonetheless damaging, blip in the otherwise upward trend in UK and worldwide interest rates. We don’t know if we are entering into a new paradigm for interest rates, or if the combination of rapidly falling inflation in 2023, coupled with possible recession, might bring government bond yields back down towards the levels we saw in 2021, as some economists believe.
The treasurer’s job is to manage risk, not speculate on what may or may not happen, so first principles apply.
Most housing providers will have stress-tested their business plans to ascertain how high variable rates have to rise before they breach any golden rule on interest coverage. Most registered providers have high levels of fixed-rate debt on their books, with many having boosted that ratio in 2021 (now clearly a good place to be). Housing associations with more floating-rate debt may want to consider mitigating action: a six per cent SONIA/bank rate plus a loan margin of, say, 1.5 per cent gets you to 7.5 per cent all-in cost of debt. That, coupled with rising costs and possibly capped rents, will put cashflow metrics under pressure in 2023.
When it comes to raising new finance, times such as these remind us of how important the banking community is to the housing sector. The debt capital markets are in ‘risk-off’ mode and may remain so for a while yet, meaning the prospects of raising new capital market debt at present are not attractive. Furthermore, credit rating agencies Moody’s and DBRS have expressed concerns over the Mini Budget. A downgrade of the UK’s sovereign rating would clearly have negative knock-on consequences for credit ratings in the housing sector.
Treasurers should also be alive to possible opportunities. Rising interest rates and an inverted swaps curve may open up opportunities to restructure interest rate risk profiles. For example, the 30-year SONIA swap (which can be accessed in the bank and private placement markets) is a whopping 150bps cheaper than the two-year swap.
Furthermore, shrinking mark-to-market liabilities, in some cases switching positions from liability to asset, also opens up the possibility, for example, of releasing excess collateral which might not have been feasible until now.
And finally, rising interest rates are good for savers. Our clients are actively managing their deposit accounts and money market funds, especially those still holding cash proceeds from recent bond issues. Now is a good time to focus on costs of carrying cash and explore alternative opportunities.

With the chancellor to make a further financial statement this year, where full tax and spending plans will apparently be set out, it seems likely the financial markets will continue in a state of uncertainty for the next couple of months.

In the meantime, planning well ahead of time, while having options open, is clearly the key to successful treasury strategy at present.

Patrick Hawkins, director, Savills Financial Consultants

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