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Bond of the Week: 11 October 2018
Bond of the Week : 11 October 2018
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:
Before we get to the credit here is a quick overview of the retail linker market.
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.
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
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.
The tenant pays an initial 2.75% of £100,000 (OMV) adjusted by RPI+0.5% = £2,750.
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
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
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:
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.
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