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Bond of the Week: 2 October 2013
Bond of the Week : 2 October 2013
A2 Dominion is to join its fellow housing association, Places for People, on the ORB with an inaugural bond issue aimed at retail investors. The issue, rated AA-, is right at the top end of the credit spectrum for an ORB bond and with that, of course, comes an appropriate coupon (4.75%) which is right at the bottom end of coupons offered at new issue. This does not have to mean the issue is a bad investment; relative value must decide that. However, it does mean that this issue is likely to appeal to a different set of investors. Before expanding on this, here are the terms of the issue.
Building Associations are loved by all. They provide social housing but not solely social housing. As well as sheltered housing, shared ownership and affordable rent they also offer student accommodation, private rentals and they build for sale into the market. They receive large grants from the government but they trade on a commercial not a charitable basis. Housing associations are not not-for-profit but not-for-profit-distribution organisations. They perform a very important function of the modern welfare state but they are not of the state. As such they are loved both by the left and the right in politics. Don’t forget that Margaret Thatcher gave a huge boost to the movement. Subsequent to introducing “right to buy” for council tenants she then allowed tenants en masse to vote to transfer an estate from a council to a housing association (Large Scale Voluntary Transfers). Despite a slow start up, LSVTs gained momentum and a huge amount of housing stock that had been in council ownership is now in the hand of associations such as A2 Dominion. From an investment perspective, this all round political support is not an insignificant advantage. It is likely the sector as a whole, and perhaps even an individual association, would receive state support if a heavy squall interrupted the fair weather in the housing market.
With an understanding of the nature of the housing association sector and this issue’s high rating, an in-depth analysis of A2 Dominion is probably less necessary than for bonds with a lesser credit rating and where the business approach is likely to be more idiosyncratic than consistent with its sector – say one of the recent property company issues. Nevertheless, here is a brief explanation of what they do and some facts and figures.
A2 Dominion has 34,000 units and is based in London and the South East (which is considered a positive). 22% of their units has been added since 2002 and only 11% is pre-war so their stock is reasonably modern (potentially fewer repairs), although the 34% built between 1945 and 1973 was hardly an era of quality design and construction, not-withstanding the Parker Morris Standards*. A friend of mine says they are building a very handsome block near him over-looking the South Circular – and I don’t think he is just trying to talk up the area where he lives.
Of most interest to potential bond holders are their financial figures. 95% of cash flow comes from lettings (i.e. as opposed to sale of units) and 70% of that is from social letting, which is underpinned by payments from the government. It should be noted that where the government is now picking up the entire rental tab, the money is paid directly to housing associations thereby bypassing the tenant; presumably so it doesn’t get diverted to the local betting shop. This is to change and in future the government is to pay money to the tenant for onward payment to the landlord in an attempt, of which I am sympathetic, to get them involved in the process. This does of course raise the possibility of an increase in arrears although housing associations have shown themselves fairly adept at moving on deliberately non-paying tenants.
The net book value of housing (valued at cost) is £1.55 bn. Adding in fixed and current assets you get to £1.84bn. Incidentally for housing arriving via an LSVT, cost will have been derived at the point of transfer, not original purchase. Using an EUVH valuation (existing use valuation) the assets come to £2.1bn. However, even the EUVH valuation is very conservative. It equates to £60,000 per unit. Think of the virtual impossibility of buying anything at all for £60,000 in the South East and you can see the inherent conservatism. On the open market with the existing tenants the value might be in the region of £3-4bn and without the tenants, higher still. In part this under valuation comes about because repairs and improvements are not capitalised but are taken as current expenditure, unlike with property companies. Year in, year out this slowly creates a substantially gap between actual and reported market value. These assets all sit against borrowings of £1.2bn, so A2 Dominion is not over encumbered with debt. As to profit, for year-end March 2013 they had net interest rental of £42.7bn (approximately equivalent to profit) and a surplus of £28 million after donations to good works. Interestingly they avoid corporation tax by gift-aiding their profits back into the business; a very fine bit of aggressive tax avoidance. It only goes to show that in the current political atmosphere it is not what is done but who is doing it. A final point is that A2 Dominion, in common with other housing associations, is regulated by the Homes and Communities Agency.
Now let us look at value. As of today the bond will yield 2.22% over the nine year gilt. For a AA- credit this is cheap. It is difficult to find an absolute direct comparison. However, you might compare this coming issue to: GE 5 1/8 % 2023 on average the same rating, 3.82% yield; Westfield 4 ½% 2022 A2/A- worse rated, 3.6% yield; and LSE 4 ¾ % 2021 (ORB bond) much worse rated Baa2/ A- but a year shorter, 4% yield. A2 Dominion has not issued a bond before but Places for People do have two outstanding bonds with rather different maturities. They are a housing association but are two notches worse rated (A2). Their ORB bond the 5% 2016 yields 3.58%, which is gilts plus 2.84%. Undoubtedly this is a cheap bond and looks a touch cheaper versus gilts than the proposed A2 Dominion bond. However, it does trade at a premium (104.25%) and the spread is partly a function of the short maturity and the demand for absolute yield in the retail market. Places for People also have an institutional bond, the 5 7/8% 2031 yielding 4.78% or gilts plus 1.53%. This looks very expensive compared to the new issue.
On pure value terms I think this issue looks a winner. I suspect they could have got the issue away on finer terms in the institutional market notwithstanding unsecured housing association bonds are not frequent issues and that this issue has only one rating. There is of course the interest rate risk attached to this bond. As a quality borrower, the fate of this bond is more closely tied to that of the gilt market, even if there is some credit spread contraction to come (I hope), than with an issue with a higher coupon and shorter maturity. For now gilt market worries have calmed down and with short rates seemingly pinned down until 2015/ 2016 there must be a limit to how steep the yield curve can get. Nevertheless despite the quiescent gilt market, the risk to the price of the bond from a future rise in interest rates remains.
Conclusion. What I conclude depends on whom I concluding to. This issue is cheap and I would expect credit spread contraction and a healthy premium in the near term. Therefore for anybody managing money who requires a certain portion to be put into high rated issuers this issue should be a must. It also makes sense for someone who is keeping his eye on the market, whether as a professional or not, and for whom the issue can act either as a source of liquidity or just a safety portion of the portfolio. For the retail investor who has better things to do than continuously follow the market this issue does come with significant latent interest rate risk. Moreover despite being good relative value, at 4.75% it may just not cut the mustard in absolute terms. You can find higher returns elsewhere. As to making a quick turn on the issue that should be possible. However, you will need to figure in your dealing costs. And the Royal Mail will, I expect, give you a better bang for your buck.
* “The Parker Morris Standards”, abolished in the 1979, dictated minimum space standards. I was recently taken on a tour of a council estate (Highgate New Town), one of the very last to be built under these standards; and very nice it was too. Maisonettes, 50% now in private hands, fetch £1/2 million on the open market.
Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.
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