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Bond of the Week: 11 October 2018

Heylo Housing RPI linked bond

    
Heylo Housing RPI linked bond

A new RPI-linked bond is being offered in the retail bond market. The issuer is Heylo Housing (in effect a SPV) and the bond will be secured on shared ownership property. Here are the details:

Issuer

Heylo Housing Secured Bond plc

Security

Senior secured upon all assets of the Issuer to include fixed and floating

 

charge over residential properties, cash, insurance and permitted investments

Currency

GBP

Nominal Amount

TBD

Repayment

Adjusted for the increase in inflation as measured by the RPI (upward only,

 

and at least par)

Early Redemption

None

Coupon

1.625% (income is adjusted upwards to reflect the change in the RPI)

Coupon Dates

31 March and 30 September

Announcement (Launch)

08-Oct-18

Offer Period

Until Monday 22 October at 3.30pm or earlier

Issue Date

29-Oct-18

Maturity Date

30-Sep-28

Issue price

100

Denominations

GBP100 subject to a minimum initial subscription of £2,000

ISIN Number

XS1880955007

Listing

LSE Main Market, Order Book for Fixed Income Securities

Selling Restrictions

Only to be sold into UK, Isle of Man and Channel Islands

Governing Law

English law

Settlement

Euroclear, CREST CDI, Clearstream

Lead Manager

BondCap

Security Trustee

US Bank Trustee Limited

Authorised Distributors

Retail:  A J Bell, Equiniti, iDealing, Redmayne Bentley

 

Institutions:  NCL Capital Markets, Ria Capital Markets,

 

Winterflood Securities

Covenants

asset cover test of 1.2:1.0

 

debt service cover ratio of 1.1:1.0

 

negative pledge

 

information covenant (to produce analysis of portfolio assets)

 

Before we get to the credit here is a quick overview of the retail linker market.


                                                                                 Mid Yields                          Notes

Tesco Personal Finance 1% Dec 2019                        RPI + 1.59           The bank not the grocer

Natl Grid 1.25% Oct 2021                                        RPI + 0.04

Severn Trent 1.3% July 2022                                    RPI  - 0.31

Places for People 1% Jan 2022                                 RPI + 0.69           A Housing Association

Gilt 0.125 % March 2028                                         RPI  - 1.87

 

The new issue comes at a significant wider yield than the current offerings (other than Tesco which is very short and the credit has been out of favour).

The new issue also comes with a significant structural advantage. Institutional linker bonds (including Gilts) have their principal (and hence their interest) pegged to RPI in both directions so in periods of deflation bond holders can see their principal and interest decrease. Retail linkers are floored at zero so the bond must mature at a minimum of 100. However, should inflation take the principal to a significant premium, say 120%, and an investor were then to invest, there would be nothing in theory to prevent a long period of deflation taking the redemption value of the bond all the way back to 100 (although not through 100).

The Heylo bond comes with what might be called a ratchet. RPI is floored at zero throughout the life of the bond. Therefore the principal at each 6 month recalculation period (coupon dates) can only ever be recalculated in an upwards or sideways direction. A ratchet on an RPI-linked bond is either very rare or unique. It certainly adds a degree of investor protection; but what is it worth? There is no published figure on where an RPI floor of zero could be sold. However, the CFO of Heylo told me he had been told a couple of years ago by a US investment bank that the value was around 0.4%. So only hearsay but the figure is in the region of the plausible although today the threat of deflation has retreated somewhat.

A short overview of the shared ownership market.

The Shared Ownership and Affordable Homes Programme (SOAHP) allows people who qualify (generally those earning up to £80,000 or £90,000 in London) to part buy, part rent a home on standard terms set out by the government. For developers shared ownership properties counts towards the obligatory provision of affordable homes in any large development (typically 25%).

Part ownership has been around since the 1970s and of course a private builder would be entitled to enter a similar agreement with a house buyer on commercial terms. However, the terms of SOAHP – which is what the Heylo bond is based upon - are as follows. The house/ flat buyer buys from 25% to 75% of the property (typically 30-50%). The rest is rented at a starting rent of 2.75% of open market value (OMV). The rent increases, upwards only, at RPI +0.5%. I was given a guideline that rental yields outside London average around 6% so the shared ownership buyer is getting a discount on their rent. At any time the house buyer may increase their share of ownership, or indeed buy all of the house they do not already own, at the then OMV. This is known as staircasing. In practice only about 1% of the outstanding rental portion of the properties is redeemed per year. It is unclear whether this seemingly very small number is a result of inability to afford additional purchases, the cheap level of the rent or inertia.

Other relevant details to know about SOAHP are: 1) The house-buyer’s equity is subordinated to the landlord as the freehold is owned by the landlord and the house buyer has a 125 year lease on the portion he has bought (until he has bought the whole house). 2) The landlord ranks as a senior creditor to any bank that has given a mortgage. 3) The house buyer has full responsibility for property maintenance.

A short history

Heylo originally started as a joint enterprise with Lancashire County Council. Two bonds were issued (Heylo RPI+1.57% 2051 and Heylo RPI+2.5% 2082) to the tune of £750 million. These bonds are entirely owned by Lancashire and do not trade. Heylo’s management owned 60% of the company and Lancashire 40%. As I understand it, owing to a desire of Heylo’s management to broaden their reach there was a re-organisation and Lancashire now owns 99% of the equity but Heylo continues to manage the properties for a fee. I am not privy to the precise terms of the re-organisation or the full story. To be precise I did ask and Heylo wouldn’t tell me because it was confidential.

 

Cash flows within Heylo Housing Secured Bond PLC

At this stage it might be normal to discuss the financials of Heylo but I can’t because there aren’t any. Heylo should be seen as an SPV with a series of cash flows coming in and a series of cash flow leaving (the interest on the bond). The proceeds of the bond will be used to purchase the assets and the assets are lined up waiting to be bought from the builders. I am told the first purchases should go through within a week or two and within three months the entire proceeds of the bond will have been invested. The order pipeline from builders is in the region of £230 million. It is because the company does not have three years of financials that the bond is being quoted on the LSE’s OFIS and not the usual ORB, although this is a technical issue. There is the same set of market makers.

The bond issuer has no employees. Heylo has a separate management company that manages the portfolio and this company charges a percentage of the rent.

Heylo purchases the properties at a fixed percentage of 60% of OMV. They only buy the properties once they have been built and sold/ rented so there is no execution risk. There is a queue of housebuilders keen to sell in order to release capital and move onto the next development. Generally housebuilders build affordable homes because they have to not because they want to and the profit comes from the houses they can sell on the open market. In addition the government now offers subsidies (in some cases) to the tune of 15% of the total value of the property. Heylo will pass this on so the housebuilder will in effect be selling the house for an average of 95% of OMV (using the example of a £200,000 house owned on a ratio of 50:50 that would be £100,000+£60,000+£30,000 subsidy = £190,000 or 95% of OMV).

It is best to illustrate the cash flows by way of example. To continue with a £200,000 house owned 50:50 the figures would be.
 

Outgoing cash
Heylo buys their 50% of the house for £60,000 (60% of OMV)
The interest on the bond is RPI+1.625%  so on day one the interest is 1.625% X 60,000 = £975.

 

Incoming cash

The tenant pays an initial 2.75% of £100,000 (OMV) adjusted by RPI+0.5% = £2,750.
23% of the rent is deducted as a management charge (£632.50) leaving net cash of £2,117.50

Net cash flow is £2,117.50 - £975 = £1,141.50. [For the first year there will be additional costs – stamp tax, legal fees etc which amount to c5%. Presumably these will be capitalised.]

 

Thereafter tenants rent increases by RPI+0.5% while the bond interest increases by RPI+1.625% - but on a smaller capital sum. Even after 30 years there is positive cash flow and that does not include the build-up of cash which can be re-invested. I am told there is no intention to dividend up the cash surplus (although there is no covenant on this) and investors are protected because Heylo is unable to dividend up the cash since for accounting reasons there are no distributable reserves. This is best illustrated by using the same inputs above.
 

 

Profit and Loss                                                  Year 1

Rent                                                                 2,750

Operating Expenses                                           - 688

Gain in value of property                                  40,000

Operating Profit/Loss                                       42,063

               

Bond Coupon                                                     - 975     

Bond Indexation                                              - 1,650   (i.e. RPI effect on principal)

Total Interest Cost                                           - 2,575

               

Profit Before Tax                                              39,438

               

Gain in value of property is not distributable or taxable until sold             

So Distributable Profit is actually                        - 562

 

The risks

 

For those who seek inflation protection, an RPI-linked bond that pays 1.625% with a ratchet and is also secured on property is seemingly very attractively priced. However, given Heylo is not operating yet and there are no financials it is important to be aware of the main risks. I see them as follows:

The Company is not yet operating. There is an element of project finance about this bond because the assets are not yet owned. It would be wrong to over emphasise this because the management does have experience and does have a pipeline of assets ready to be bought. Heylo is about setting up cash flows that work rather than operating a business as such. However, logically it would be difficult not to argue that Heylo will be a better risk 6 months to a year down the road when they will have a track record. The counter argument is that once they have a track record and the credit is proven the yield should tighten. So by that logic if you get in now you should get some capital uplift when the pudding has been proved, so to speak.

Contribution of equity. Heylo will have positive equity because they will buy housing assets at 60% of OMV and using the complicated Housing Association valuation model (EUV_SH) they will be valued on the balance sheet at around 100% of OMV. However, Heylo‘s shareholders will not have actually contributed any equity/ cash. In addition Heylo is a self-contained unit and is not guaranteed by its parent Heylo Housing Group. Ideally I would have preferred either the parent to have put in cash or for them to have guaranteed the bond issuer. I note Lendinvest, another secured property bond, has a parental guarantee although their bonds are secured on a 1:1 asset covered basis whereas Heylo has an Asset Cover covenant of 1.2:1 (because they are buying the houses substantially below OMV).

How realisable are the assets? Heylo will have good asset coverage. However, in practice it is open to question whether this is more theoretical than real. If they needed to sell then presumably any prospective buyer would want the same sort of deal that Heylo had (40% discount). If the landlord forecloses on the occupier then the house has to be on-sold on a shared ownership basis but if a bank forecloses on a mortgage than the house can be sold in the open market. Some Housing Associations, in order to move things along and release capital, do occasionally offer to sell the proportion of the property they own at a discount to NAV (maybe 10%)  so that is a possible out. In short the full OMV is only really likely to be realised when the house ceases to be a shared ownership property.

 

Credit risk with the tenants. This seems pretty remote. If the tenant walks away he loses the entire proportion of the house he has bought; the landlord stands in a senior position. The tenant can only relinquish his contract by selling on his shared ownership (I am told there is a secondary market for this). For any tenant getting into difficulties, as you would expect, there are all sorts of best practice procedures to help them before it gets to the point of selling the house. Once set up the income side of Heylo looks pretty secure.

 

Substantial fall in the property market. Property prices would have to fall by 40% (adjusted by RPI) before the bond was not fully backed by its assets. Given the pent-up demand for affordable property this seems only a remote possibility. Also given the householder is tied in there is every reason to expect them (short of a change in personal circumstance) to keep paying the rent even if the house suffers from negative equity. But don’t forget the tenant has the right to buy the house at OMV at any time. If house prices fell 50% he could then buy creating a loss for Heylo (although for a 50% house price fall there would be more pressing things to worry about).

 

The idea of shared ownership falls out of fashion. Shared ownership is heavily promoted by the government and others and there is a waiting list. However, it is part of the ever more complicated and labyrinthine social housing market. At the moment it suits all concerned but the wind might change. It is possible that buyers find they have not acquired such a bargain after all. Maybe there could be a prolonged period of falling market rents such that the upward only RPI +0.5% rent contract becomes relatively onerous. Or maybe it becomes difficult to resell shared ownership properties and owners are trapped unable to move (as has happened with some who took out equity release mortgages). Legally Heylo is well protected and shared ownership is government policy. However, when something starts to go wrong in today’s world first we hear words like unacceptable or unfair and then the screaming starts. This is not a risk for the near term, it is not a significant risk and I do not suggest the scale of screaming will reach that which recently seems to have overcome a portion of the gentler sex. However, it is something to keep in the back of one’s mind.
 

A final point. Like all RPI-linked bonds it is best bought within a SIPP or ISA, not as an individual, for tax reasons. Capital gain (the RPI element) is treated as income and the bond is not a QCB. For institutions and companies this is irrelevant.

ODRB

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