Bond ambition

The loan is set up by one or more investment banks; they agree to underwrite it by buying all of the bond notes issued. They then sell them on to investors, such as pension funds or insurance companies, and the bond notes are traded on the capital markets.

Who uses bonds?
The social housing sector has not made much use of bonds: of the £23.2bn of private finance the sector has raised since 1988, only £3.535bn of this was from bonds.

To date, only a very small number of housing associations have issued their own bonds. Sunderland Housing Group funded its purchase of Sunderland council's stock by issuing £239.5m worth of bonds in June 2001 and, in 1999, Flagship Housing Group issued a £81.4m, 38-year bond through intermediary RSL Finance to keep a chunk of its available bank credit for its later funding needs. Flagship has since extended its £221m bank loan facility, and tapped the original bond issue for a further £54.9m in September 2002. A very different type of bond was piloted in Sheffield in 1999, when the Places for People Group and North British Homes borrowed £800,000 from local people and businesses on an interest-free basis for five years. But deals like this remain unusual.

Why are bonds so rarely used?
Bonds carry very large amounts of money – the minimum issue is currently around £100m – and that amount has traditionally been far beyond the requirements of individual housing associations. For this reason, most of the housing association bonds trading on the capital markets today were set up by not-for-profit intermediaries, such as THFC and Haven, which issued bonds on behalf of a number of associations and then lent them the money. The Housing Finance Corporation estimates that fewer than 150 associations have borrowed money in this way.

Price-wise, bonds have been unattractive in comparison with competitive, low-interest loans from banks and building societies. THFC treasurer Fenella Edge points out that many associations are put off bonds by higher payments on earlier issues. "In the late 1980s, interest rates were much higher and you could be paying 11.5 % or 9.6%. Now it's more likely to be under 5.5%," she says.

Many RSLs perceive bonds as inflexible and complex to set up. Timing is also an issue, because there is no guarantee of the price on a given day or that the market will want to buy them. Where bonds have been used to finance stock transfers, the funding required on the day of transfer is often warehoused in a bank loan facility and bonds issued later. Sunderland Housing Group used this method: in a deal arranged and underwritten by Royal Bank of Canada and ABN AMRO, its bond issue meant it could repay the loans used to buy the council's homes.

Why might RSLs consider bonds now?
As reported in Housing Today (7 March, page 14), an Office of the Deputy Prime Minister working group is looking at bonds among other ways of raising the private finance for stock transfers. It met for the first time last week and will report its findings in April. RSLs are increasingly dependent on a shrinking, competitive number of high-street lenders, but their finance needs are increasing. The NHF predicts that £11.1bn will be required for the mixed funding programme and stock transfers in the years 2002/03-2004/05. By 2005, the total amount in the sector will rise to more than £34bn.

While there is no immediate danger to RSLs' available credit, there is clearly a need for variety. "Housing associations should have an alternative investment base," says Clive Barnett, head of housing finance at Royal Bank of Scotland.

"As funding needs increase, it's becoming worthwhile for bigger associations to get their own bonds arranged," says Andrew Joyce, partner at lawyer Allen & Overy, which advised RBC on Sunderland's bond issue.

A large, well-established RSL could use the much larger capital markets to access new sources of funding and reduce its reliance on individual lenders.

What are the advantages of bonds?
Although at current pricing rates, bonds do not offer significant pricing advantages over bank loans (see table), other factors make them appealing to housing associations.

Bonds can be used as an alternative to a bank loan fixed with a derivative product, such as a hedge or a swap, to repay debt over a very long period. Bonds can run for 40 or even 50 years, whereas bank loans are unlikely to extend beyond 30.

While a lending bank will take an active interest in an RSL's business plan, bond holders don't interfere as long as it operates above minimum levels laid out in the covenant – typically much lower than for bank loans. This was part of the attraction for Andrew Taylor, group finance director at Sunderland Housing Group. Another advantage of the 40-year bond term was that the group could pay back only interest for the first 20 years. "The typical business plan curve for a transfer is that you struggle in the first few years, and then things get better," says Taylor. "The shape of the bond payments recognises this."

In terms of security, bond covenants place more emphasis on cashflow than assets, which may free up more of an association's stock at an earlier stage to allow for further borrowing. "The stronger the cashflow generated from rents, the less security bond holders require to feel comfortable," explains Nick Swiss, an associate at Allen & Overy.

"It's almost like rewarding housing associations with strong cashflow."

What are the drawbacks?
The flipside of freedom from lender scrutiny is that bond holders are much less likely to help an association work through difficulties than a bank or building society would be.

The possibility of bankruptcy may not trouble RSLs because the Housing Corporation will step in, but having such little scope for renegotiation might. Once bonds are traded on the capital markets, it can be hard even to work out who the holders are and the costs of early repayment are prohibitive. As Royal Bank of Scotland's Barnett says: "A bond is for life, a bank debt is more flexible."

Setting up a bond requires a far more intensive period of due diligence to obtain the necessary credit rating than a bank loan. David Mairs, operations director at funding adviser HACAS Exchequer Services, warns that the "hidden costs" of employing lawyers, auditors, financial advisers, valuers and consultants can run into six figures.

Depending on the mood of investors – currently very jittery, as the briefest of glances at the financial pages will show – the need for a good credit rating can add costs to the deal in the form of the debt service reserve, which is held in a trust to cover repayments should cashflow dry up, particularly if it is the structure of the bond that is rated rather than the organisation itself. In Sunderland Housing Group's case, 15 months' worth of debt service reserve was held aside in a trust to make repayments should cashflow fail, amounting to £19.7m over the stock purchase price of £219.8m.

Credit ratings are reassessed every year, and the relationship with the investigating agency or insurer will take the place of the meddlesome bank manager.

The future
There have been suggestions that the Office of the Deputy Prime Minister's interest in bonds stems from a desire to be seen to have examined all the funding options in advance of a report by the government's internal watchdog, the National Audit Office, that will be published at the end of March. Whatever the conclusions of this study, and whatever the working group reports in April, the case, the bond choice remains open to RSLs.

The problems of using bonds for transfers are not all insurmountable: one answer to the problem of size, for instance, could be to run a number of transfers to the same timescale to allow one bond issue to cover the lot. Bonds may not be right for all RSLs and all transfers, but, should they wish to use it, this extension of RSLs' borrowing options cannot be a bad thing.