Treasury Management

Updated December 2018 View full section
The purpose of this section is to provide an understanding of treasury management for housing associations. Sound treasury management is of critical importance to housing associations because without it there is the very real risk of running out of finance to fund the organisation, which would ultimately lead to insolvency. The section outlines best practice in this area which should assist in maximising potential benefit while ensuring regulatory compliance and minimising risk.

CIPFA’s Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes 2017 Edition defines treasury management as: “the management of the organisation’s borrowing, investments and cashflows; its banking, money market and capital market transactions; the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks”. This definition is “intended to apply to all public service organisations in their use of capital and project financing, borrowings and all investments”.

For housing associations the importance of treasury management is indicated by the scale of borrowing within the sector, which was over £69.6bn at March 2017 (figures taken from the regulator’s 2017 Global Accounts of private registered providers). Effective treasury management should therefore play a significant role within a housing association’s business. 

Cash management within any organisation is crucial. It is with cash that bills and other expenditure needs are met. Some housing associations are large borrowers with extensive loan portfolios; they therefore need to manage their cash prudently in order to meet their commitments to lenders. Even those organisations with little or no outstanding loans will still need to address the problem of cash management. There may be times when housing associations have excess cash to invest and this needs to be effectively managed. Failure to manage cash flows may leave the association with insufficient cash available to meet the demands of its creditors.

In a housing association with a finance manager/director or equivalent, this post holder or one of their members of staff will undertake the role of treasury manager. In smaller housing associations the role of treasury manager may be undertaken by a board member while larger associations with more complex treasury activities may employ specialist staff. Whatever the structure, it is essential that there is clarity of responsibility and that the individuals involved have the expertise to fulfil their roles competently.

The regulator monitors treasury management activities as part of its overall regulation of housing associations. The regulator’s current requirements are laid out in Regulating the Standards (April 2018) which states, under Operational Approach at paragraph 2.7, that the regulator will seek assurance about providers’ 
  • financial strength 
  • governance and risk management 
  • vulnerability to covenant breaches 
  • liquidity 
  • approach to value for money 
  • approach to managing the risks to social housing assets arising from non-social housing activity. 

The treasury management powers of housing associations depend on what is permitted by their rules; for instance, whether they are permitted to use certain standalone derivatives or not. 

An association’s range of financial activities is also governed by the Markets in Financial Instruments Directive II (MIFID II). This piece of EU legislation aims to offer greater protection for investors. There is a distinction within it relating to professional and non-professional clients. Designation under MIFID II should be endorsed by the association’s treasury management strategy and regularly reviewed in terms of the skills and experience of the treasury team, to ensure that the designation remains appropriate so that the association is afforded the protections to which it is due under this legislation.

It can take a long time to raise new loan finance. Credit assessment by a lender and negotiating a loan agreement can take six months to a year. Then property charging, where required to provide security for the loan before release of funds, can take three months to a year to complete. It is therefore recommended that where new facilities will be required, the housing association begins to review the options well in advance of the actual requirement.

The guidance in this section is based on the regulator’s Regulating the Standards April 2018 (in particular the Governance and Financial Viability Standard) and good practice as outlined in CIPFA’s Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes 2017 Edition.

Current good practice tends to work on the basis of a ‘cascade’ model as the most suitable for defining responsibility for the treasury function. This starts with, for example, policy determined by the board, delegating strategy to the finance committee, which delegates operational matters to the executive team and so on to those involved in the daily administrative tasks of the treasury function. Reporting back up the ‘cascade’ provides control checks at each stage that agreed procedures are being followed.

CIPFA’s Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes 2017 Edition (see Section 7) addresses treasury management and proposes a policy statement recommended to be adopted by all organisations together with 12 treasury management practices that may be adopted according to the organisation’s powers and scope of its treasury management activities.

These treasury management practices encompass:

  • risk management
  • performance measurement
  • decision making and analysis
  • approved instruments, methods and techniques
  • organisation, clarity and segregation of responsibilities, and dealing arrangements
  • reporting requirements and management information arrangements
  • budgeting, accounting and audit arrangements
  • cash and cash flow management
  • money laundering
  • training and qualifications
  • use of external service providers
  • corporate governance.

These treasury management practices are written to be adopted as stated, with the details of how the organisation fulfils these declarations to be put in an accompanying schedule. However the format of the documentation is not important; what matters is that documentation addresses these issues and complies with the principles of the guidance.

Housing associations must have the skills, knowledge and experience at both board and officer levels, as well as the systems and access to independent advice necessary for identifying and managing the treasury risks to which they are exposed. Many housing associations are now finding that they need to seek specialist advice from funding advisors.

Treasury management policy should be heavily weighted towards the minimisation of risk. The maximisation of returns should be of lesser importance.

The first of the four key recommendations in the CIPFA Treasury Management in the Public Services: Code of Practice and Cross-Sectoral Guidance Notes 2017 Edition (Section 5) is that “This organisation will create and maintain, as the cornerstones for effective treasury management: 
  • a treasury management policy statement, stating the policies, objectives and approach to risk management of its treasury management activities 
  • suitable treasury management practices (TMPs), setting out the manner in which the organisation will seek to achieve those policies and objectives, and prescribing how it will manage and control those activities.” 
The first treasury management practice is risk management, (noted earlier, under “Approach”) which covers the following nine risks:
  • credit and counterparty risk
  • liquidity risk
  • interest rate risk
  • exchange rate risk
  • inflation risk
  • refinancing risk
  • legal and regulatory risks
  • fraud, error and corruption, and contingency management
  • price risks.

Credit and counterparty risk

This is the risk that an organisation with which the housing association has a contractual relationship is unable to meet its obligation to the housing association. There are two main aspects to this risk.

Firstly, there is the risk that an organisation with which the housing association has deposited surplus funds does not repay the monies. This aspect of the risk should be controlled by the approval of formal lending criteria based on the nature of the counterparty (either regulatory status (eg EU bank or building society) or credit rating), maximum amounts to be lent (in monetary value and proportion of total lending) and period of deposit.

Secondly, there is the risk that an organisation that is due to make a payment to the housing association under a contractual agreement (eg loan facility or derivative agreement) may default on its obligation, or in the case of a long-term loan agreement, may be unco-operative if the housing association needs to renegotiate the loan.

Quantifying counterparty risk in relation to derivatives is possible but significantly more complex than in relation to investment, whereas management of counterparty risk in relation to borrowing requires a more subjective approach, combining a lender’s financial status with an assessment of its commitment to social housing.

Credit rating information is freely available on the internet from Fitch (which, being UK based, may have ratings for more counterparties that housing associations may wish to lend to) and Standard & Poor’s. (The third major credit rating agency is Moody’s but its ratings are only available on a paid for basis.) Associations should not rely on credit ratings alone for their understanding of counterparties.

Associations should ensure that their counterparty lists and limits reflect a prudent attitude towards the organisations with which they invest, borrow or engage in other financing or derivative arrangements. A sound diversification policy avoids overreliance on a small number of counterparties.

Liquidity risk

This is the risk that the housing association will be unable to meet its liabilities as they fall due. This risk needs to be managed using reliable short-term (daily, weekly and/or monthly as appropriate), medium-term (rolling 24 month) and long-term (business plan period) cash flow forecasts backed up with a combination of adequate, though not excessive, cash resources, borrowing arrangements and/or overdraft facilities.

Sensitivity analyses should be run on key variables within range limits that reflect likely outcomes. Combinations of variables should be tested to see which scenarios have the greatest impact on the business.

As mentioned above, once a loan has been agreed, property generally needs to be charged to secure the loan. This process can take up to a year to complete before funds can be released. In some cases, funds can be released in tranches as security is completed, but nonetheless, plenty of time needs to be allowed for in forecasting the receipt of funds.

Interest rate risk

This is the risk that future interest rates (either paid or received) will be worse than budgeted or forecast. This risk can be managed through the maintenance of a loan portfolio with a balanced interest rate profile (a mix of different fixed periods and variable rates) and realistic and prudent budgeting and forecasting, including sensitivity analyses so that any adverse cash flows can be covered.

A housing association may mitigate future interest rate risk by using derivative products (see Debt Portfolio Management below). However, interest rates can fluctuate so as to create a ‘mark to market’ loss position (by comparison of current market value to original cost) in respect of the derivative.

In such a case, collateral, or margin, calls (additional security) may be demanded under the terms of the agreement to provide security to cover the loss position. Alternatively, where security is not provided, an adjustment to the pricing of the loan may be required. The terms of the derivative need to be carefully evaluated to determine the potential for this situation to occur.

Housing associations will need to consider the risks regarding International Financial Reporting Standards (IFRS) and rules on hedging where any mark to market differential will need to be reported in the income and expenditure account, potentially causing significant fluctuations in the surplus/deficit situation and thereby risking possible covenant breaches. Currently, these detailed rules apply to a relatively small number of associations, but the application of IFRS will undoubtedly broaden.

An association should manage exposure to fluctuations in interest rates with a view to containing interest costs or securing interest revenues in accordance with the amounts provided in its budget. It should achieve this by the prudent use of its approved instruments, methods and techniques, primarily to create stability and certainty, but at the same time retaining a sufficient degree of flexibility to take advantage of unexpected, potentially advantageous changes in the level or structure of interest rates.

Exchange rate risk

Exposure to exchange rate risk will not normally arise. However, some associations have raised finance via private placements (see Capital Markets below) in foreign currencies. Wherever an exchange rate exposure arises, suitable hedging arrangements should be put in place, seeking professional advice as necessary.

Inflation risk

Inflation risk, also called purchasing power risk, is the chance that the cash flows from an investment will not be worth as much in the future because of changes in purchasing power due to inflation. 

An association should keep under review the sensitivity of its treasury assets and liabilities to inflation, and should seek to manage the risk accordingly in the context of the whole organisation’s inflation exposures.

Refinancing risk

Refinancing risk (the risk that loans falling due, which the housing association does not have cash resources to repay, cannot be replaced at an acceptable cost) can legitimately be considered as a type of liquidity risk. This (sub-) risk should be controlled by regular monitoring of loan payment profiles, a proactive approach to refinancing and avoidance of a material maturity of funding sources in any one year where this might jeopardise the ability to refinance.

Revolving credit facilities provide flexibility in that it is possible to draw and repay them during the term of the loan; nonetheless, they do have a set term after which they need to be formally renewed, so a refinancing risk also applies to this kind of loan.

These refer to the possibility that the housing association or its counterparties may be prevented from fulfilling their obligations or intentions due to legal or regulatory restrictions. Housing associations should seek legal advice on all loan and derivative contracts.

The Regulator of Social Housing requires associations to forecast cash requirements and to have a buffer to provide sufficient liquidity, allowing for the time needed to negotiate and secure facilities before they become available, for drawdown.

Fraud, error and corruption, and contingency management

This can apply within the housing association and in third parties. It can be caused by human error or system failure but the risk is not specific to treasury management. However the value of the sums involved and the specialist nature of much of treasury management mean that the risk of fraud or error is significantly greater in this area than in other areas of a housing association’s operations.

Such inherent risk should be controlled using a range of policies, procedures, reporting and training with particular focus on segregation of duties. Identified risks should appear on the risk register with plans to manage the situations in which the risks crystallise. Money laundering is a key risk within the area of corruption. The Proceeds of Crime Act 2002 established the main offences relating to this.

Price risks

Within the strict ambit of treasury management, price risks only arise if housing associations are investing in non-cash deposits with a market value such as bonds or equities. Obviously the value of such investments can fall.

However, other market risks relating to the economy generally can have a significant effect on cash flows. For instance, the buoyancy or otherwise of the property market will have an effect where property sales are a material part of a business plan. Where changing market conditions are likely to have a material effect, cash flow actuals and forecasts should be intensively monitored to evaluate what problems may arise and how they may be mitigated.

Other risks

The value of treasury management transactions and the fact that housing associations’ continued existence depends on their ability to maintain liquidity and comply with interest cover covenants mean that reputational risk is inherent throughout the treasury operation. If anything significant were to go wrong in a housing association’s treasury operation it is likely that the opinion that third parties (eg financial institutions, the regulator, the rest of the housing sector and tenants) have of the housing association would be diminished.

Reputational risk is virtually impossible to quantify but can have a significant impact on the way in which such parties do (or do not do!) business with the housing association including, for example, the cost of future borrowings. Reputational risk is controlled by managing the other risks of treasury management.

There are potentially a further six mainstream risks (lenders’ covenants, management, inflation, systems, banking and political) but even this list is not exhaustive and each housing association may also have unique risks. It can be argued that each of these is a variation or subset of one or more of the above.

Banking risks are particularly to the fore at present due to the state of banks’ balance sheets with many of them actively looking to reprice older loans, lend at shorter maturities and indeed reduce lending overall, making the sourcing of new funding more difficult than it has been in the past.

Political risk is a variation on legal and regulatory risk, but not one that can be controlled by taking legal advice. A change of housing policy could radically change the environment in which housing associations operate. As far as is possible, adverse scenarios need to be modelled to determine the effect on cash flow.

Systems risk is ‘operational risk’ which arises through the failure to employ sufficient system and control procedures to prevent losses arising out of fraud, error, wilful override of controls or other eventualities. Political risk is a variation on legal and regulatory risk, but not one that can be controlled by taking legal advice. A change of housing policy could radically change the environment in which housing associations operate.

The inability to satisfy lenders’ covenants is worth identifying separately due to the possibility that this could cause the risk of cross default. This, in turn, arises from the clauses in most loan agreements which mean that a breach of covenants for one loan could lead to a requirement to repay them all.

It has to be accepted that the diversity and the extent of potential risks is such that it is not possible for all eventualities to be covered. There can be no absolute protection. However, these risks can be substantially mitigated by having a balanced portfolio of debt (ie a mix of fixed and floating rate, different terms and different lenders) backed up by sound controls.

Defining a treasury risk management framework and policy is the essential first step in ensuring that treasury risk is under control and properly managed. Generally, risks cannot be completely eliminated, therefore a policy determining the level of acceptable risk in various circumstances needs to be agreed, subject to the principle that minimisation of risk is of primary importance, maximisation of returns being secondary.

Within the housing association’s treasury management policy and practices there should be a requirement for an annual treasury strategy to be approved by the board before the start of the financial year. This should encompass:

  • a review of the policy and practices
  • economic and interest rate forecasts, to include inflation rates and the likely effect that they may have on interest rates
  • identification of borrowing requirements and proposed sources of finance
  • a review of the loan portfolio and identification of debt management opportunities
  • an investment plan
  • a model of the housing association’s activities that can be stress tested to assess the outcomes of possible variations in the forecast assumptions.

All of which should be set in the context of the current long term cash flow forecast.

The regulator requires all housing associations to evidence value for money. It is essential, therefore, that the reporting and measurement of the treasury function demonstrates that value for money is being obtained.

During the year there should be regular reports to the finance committee or equivalent on treasury activity since the last report and current investments, borrowings, derivatives and cash flow forecasts, including compliance with the housing association’s policies and loan covenants. At an officer level there should be suitable reports to enable the director of finance or senior management team to exercise executive oversight of treasury operations, including compliance with policies.

At the end of the year there should be a summary report to the board on activity during the year compared with the strategy.

It is difficult to measure the effectiveness of a housing association’s treasury operations. However, the following factors can be used to this end:

  • performance against strategy and policy
  • investment returns compared with market rates
  • benchmarking cost of funds/treasury operation costs with a peer group.

These approaches can be used in a formal best value review of the treasury operation. It is essential that a clear audit trail is kept of decisions made. Markets can be volatile and a decision made on one day can appear less favourable just a few days later. Evidence needs to be kept that due process in decision making was followed.

Housing associations are expected to ensure that their viability is maintained and are expected, by way of the Governance and Financial Viability Standard (2015) contained within the regulatory framework, to demonstrate this within their annual report. The routine reporting process noted above will form part of the evidence to permit the board to make the relevant certification.

Finally, treasury management should be covered as part of the housing association’s internal audit plan and audits carried out at a frequency agreed by the board or audit committee. The board should ensure that the auditor(s) and it or the audit committee have sufficient expertise to review rigorously the operation and reports. Where a housing association does not have an internal audit function, the board is nevertheless responsible for the probity of the treasury management function.

A housing association’s borrowing requirements will be based on its acquisition and development and stock reinvestment plans, plus its refinancing requirements. Lenders, of whatever type, need to be assured that the borrower will be able to pay the interest and repay the loan. To this end, lenders usually require some form of security (over either property or income streams) and require covenants restricting the activities of the borrower.

Putting security in place can be a lengthy process often taking three to six months, and in some cases longer, so it is important to allow sufficient time for this to take place as funds will not be released to the association without security for a loan being in place.

There are two main sources of loan funding available to the social housing sector: banks/building societies and capital markets.

Banks and building societies

The significant factor about borrowing from banks and building societies is that the housing association will have a relationship with one or, if the loan is syndicated, a few known lenders, meaning that there is, in theory at least, greater scope for (re)negotiating terms.

Different banks or building societies are prepared to offer loans on a variety of terms, from repayable and redrawable working capital loans, through project specific funding to non-specific medium term facilities on a variety of repayment terms. Generally banks are unable to lend for terms in excess of 15 years.

Housing associations are increasingly using revolving facilities and overdraft facilities to build up a level of debt which is then repaid and replaced with longer term funding.

Capital markets

Capital markets loans are provided by the proceeds of investments made mainly by insurance companies and pension funds. A bank or finance company will sell bonds into the market on behalf of the issuer (a housing association or group of housing associations) and will generally underwrite the issue to guarantee that all the funds are available, even if all the bonds are not purchased. Out of around £67bn of private finance raised in the sector, just under 30% has come from the capital markets.

There are various capital market structures: 
  • Conventional property secured debentures – similar to ordinary loans with a requirement to provide both income and asset security cover.
  • Cash flow structured secured bonds – These do not need asset cover but instead take into account a charge over the projected gross or net income streams from the charged properties. These cash flows are subjected to the lender’s internal credit assessment and often external verification by a valuer or rating agency, which determine the levels of finance that can be raised and the margins charged.
  • Unsecured bonds – A credit rating is generally necessary for this kind of lending and although specific assets are not charged as security, normally a pool of assets must remain uncharged to other lenders, effectively providing a level of security for the ’unsecured’ lender.
Note purchase agreements – These are generally used in private placement loans (see below).

The capital markets can be accessed in one of three ways:

  • Own name issue – this is where a housing association issues a bond in its own name which is a publicly listed instrument. Generally £150m would be a minimum economic level and a credit rating would be essential. An amount in excess of £250m will get better pricing as the issue is immediately large enough to go into a benchmarking index used by institutional investors.
  • Private placement – this is where a housing association approaches a restricted number of investors. A credit rating may be needed. A credit rating may be needed. Generally £50m to £100m would be an economic level, but amounts lower than that can be economic depending on the terms of the loan.
  • Aggregating vehicle – oorganisations such as the Housing Finance Corporation (THFC) and GB Social Housing and the newly formed MORhomes, aggregate the requirements 
    of housing associations to get to an economic volume to undertake a market issue. Individual requirements from £1m to £100m or more can be considered. No credit rating is necessary.

Sale and leaseback

To date sale and leaseback has not been widely used by housing associations although it is becoming more prevalent. It lends itself more to situations where a relatively large project or portfolio of properties can be sold to an investor such as a pension fund. This provides the association with a capital sum to reinvest in its work. The properties are then leased back from the investor.

The main problem with this is that social housing rents are relatively low and sometimes the yield from them is insufficient to be able to pay a sufficiently attractive return to the investor. Generally, investors look for an index linked return. A danger exists that, if the indexation that an association gets on its rental income does not keep up with the indexation required by the investor, then the association could incur heavy losses unless it defers some of its expenditure.

Real Estate Investment Trusts (REITs) use a similar model to ‘sale and leaseback’ whereby they purchase properties from associations, particularly those involved in care provision where returns are higher than for general needs properties.

Financial costs

Whatever the source and type of borrowing, a number of common factors apply. These can be grouped into financial costs and other factors.

The main financial cost is the interest payable. This is likely to be comprised of three elements:

  • the underlying rate (eg the London Inter-Bank Offered Rate (LIBOR), a swap rate, or a gilt rate)
  • a margin over this rate
  • in the case of banks, a mandatory cost which is a requirement of banking regulation.

Housing associations should endeavour to ensure that the underlying rate in their loan agreements is a market rate, not a rate determined by the lender (a potential weakness of private placements is the lack of price competition). This way the housing association can ensure that it is not paying more than it needs to.

The margin will depend on the market for housing association loans at the time, the length of the loan (longer term loans are usually more expensive) and the lender’s credit assessment of the housing association. The housing association needs to ensure that the margin charged is competitive, by either arranging a tender, taking expert advice and/or comparing with other similar housing associations.

It is normal for bank and building society loans to be at a variable rate with options, at a cost, for the housing association to choose a fixed rate for a range of periods. Capital market borrowing will normally be at a single all-in fixed rate for the full term of the loan, which will be quoted as a credit spread over the equivalent government bond (gilt) at issue.

Housing associations may also require or be offered interest rate management options within the loan facility. Banks may offer loans where the lender has the option to fix the interest rate over an extended period. Housing associations should be careful to evaluate the benefit of granting such an option.

In addition to the interest cost, other financial costs are payable to the lender, namely:

  • arrangement fees
  • initial legal and valuation costs
  • non-utilisation fees
  • monitoring/agency fees
  • subsequent costs such as revaluation fees and legal fees to release security
  • early repayment charges – financial flexibility for early repayment at an acceptable cost should be sought.

Quotes should be obtained from competing lenders and for alternative sources of finance, and a discounted cash flow/net present value calculation should be done to evaluate the total cost of each proposal on a comparable basis.

Accounting standard FRS 102 has introduced more onerous requirements in respect of accounting for financial instruments which have to be classified between basic and non-basic. Basic instruments are relatively straightforward and occur where there is no exposure to interest rate fluctuations and no optionality – for instance, a loan that is taken out at a fixed rate for the full term of its life. Non-basic instruments do have exposure to interest rate fluctuations and optionality, so mark to market assessments of these are required which can lead to volatility in the statement of comprehensive income.

Terms of loan agreements

Loan agreements are legal documents that place significant obligations on the borrower. Therefore, although heads of terms are usually agreed without taking legal advice, it is always advisable to take such advice on the detailed terms of the loan agreement.

This is obviously a further cost to the housing association but is usually well worth it, particularly if a solicitor with recent expertise of similar deals is used. This will avoid wasting time and cost in trying to negotiate terms that there is no chance of the lender agreeing to, and may also strengthen the housing association’s hand based on knowledge of what has been conceded in other deals. Quotes should be sought from suitable firms to ensure value for money for this service.

The housing association’s solicitor will advise on the negotiation of detailed legal points but before this stage, the housing association needs to pay attention to the non-monetary loan terms such as security cover, financial covenants, restrictions on corporate restructuring and restrictions on intra-group support.

Many conditions proposed by lenders (eg the requirement to remain registered with the regulator) are not negotiable, except perhaps by the most financially robust housing associations. However other conditions are negotiable; for example, where consent is needed from lenders, if possible this should be ‘not to be unreasonably withheld’. The housing association should therefore ensure that it has sufficient negotiating expertise, either in-house or in the form of an external adviser or consultant.

Housing associations should ensure that financial covenants (eg interest cover and gearing) can be complied with during the life of the loan (based on the housing association’s financial forecasts, base and flexed cases) and, as far as possible, that they are consistent with the covenants in the housing association’s existing loan facilities (to facilitate monitoring of covenants). Often, the definitions of measures such as interest cover and gearing will vary between lenders, so it is important to understand the precise wording in the housing association’s loan agreements.

Housing associations should evaluate how important security cover requirements are to them. This depends on how much free security they have. As well as the loan to value ratio, the valuation basis may be important, depending on the relationship between the income and capital values of the housing association’s properties. Housing associations should also consider pressing for provision for release of security in future if values increase.

A further issue requiring attention is that of premature repayment (prepayment) fees. It is normal for lenders to require payment of breakage costs in the event of prepayment of fixed rate loans. It is possible that a prepayment may result in a profit to the lender, so ‘two-way’ breakage costs should be negotiated whereby the association can share in any gain on prepayment.

Once a loan facility is signed, security needs to be put in place before funds can be drawn down. It is advisable to start this process before the funds are required (assuming that the security is available). This avoids the possibility of encountering problems when funds are needed urgently. The process of getting security for loans is now more complex and time consuming.

Where property prices are falling, it is essential to complete the charging process quickly otherwise a portfolio of property sized to secure a loan, say, six months ago, may no longer be adequate if a revaluation is required immediately prior to drawdown.

Property prices falling may not have a direct impact as valuations are usually based on existing use value social housing but it depends on the valuation basis that is required by the funder.

Fixed and variable rates

In order to manage interest rates in the context of inflation risks, housing associations should ensure that their loan portfolios have a balance of fixed and variable interest rates. Best practice is to set a maximum target for variable rates (including fixed rates with less than one year left), fixed rates over two years and fixed rates over seven years.

This can be achieved either through the initial interest rate basis established when the loan was agreed, or through interest rate options in the loan facility or, if the housing association’s rules permit, through standalone derivative transactions.

Whether the arrangement is embedded in the loan facility or standalone, a change in interest rate basis (eg variable to fixed) can be achieved through an interest rate swap entered into either by the bank with another party (if embedded) or by the association. It is possible to swap a fixed rate for a variable rate and vice versa.

For instance, a bank will agree to receive a variable rate (LIBOR) in exchange for paying a fixed rate (determined by the market) thus cancelling out the fixed rate received from the housing association and leaving the bank in the position of lending on a variable basis. If the housing association is entering into the swap itself, it will receive a variable rate (to cancel out that payable under the loan) and pay a fixed rate.

In addition to a definite agreement to change the interest basis using a swap, it is possible to have an option to do so.

Using derivatives

There are various other types of derivatives which can be used to change the interest payable on a loan, either embedded within the loan or standalone. These include inflation linked payments and limits on the maximum rate (a cap) or minimum rate (a floor) payable.

In order to cap the variable rate payable, a premium will be payable. Conversely a floor can be sold (although housing associations are not permitted to do this on a standalone basis).

Combining these two creates a collar, ie a range to which the interest rate is limited. Levels of the cap and floor can be set to create a zero cost collar, ie the value to the other party of the cap bought equals the value of the floor sold.

Another type of derivative is the forward rate agreement (FRA) which is useful if a housing association has arranged a loan in advance of a major drawdown on a known date in the near future (eg to fund a major acquisition). Without the benefit of an FRA the housing association is at the mercy of the markets to the extent that interest rates (either variable or fixed) may deteriorate between agreeing the loan and drawing it.

Inflation can be hedged against by using index-linked debt instruments. An element of the principal of the loan and its related interest can be linked to the rate of inflation. As associations’ rents are also index linked, it means that there is a natural match between the two bases, ensuring that a reasonable parity is maintained.

However, it should be noted that even the wider model rules (standard rules governing the constitution of housing associations, issued by the National Housing Federation) which can be adopted by the housing association only permit standalone derivatives intended to reduce risk, for example the purchase of interest rate options/caps (not the sale of options/floors).

Two financial instruments that have become more prevalent in the sector are callable swaps and lender option borrower options (LOBOs).

A callable swap is a swap agreement in which the fixed-rate receiver can terminate the swap on one or more specified dates before the stated maturity date. The potential early termination offers a chance to protect against large, adverse changes in interest rates; in the case of a fixed-rate receiver, against a large rise in rates which would cut the present value of cash flow from the swap.

A LOBO is a floating-rate instrument that permits the lender to nominate a revised rate at periodic reset dates, and lets the borrower decide whether to pay the rate or redeem the loan. It is essential to take professional advice on these instruments if it is not available in-house.

Where a housing association is using a derivative, the association must be exposed to a risk against which the derivative instrument can be matched. An association would not be able to enter into derivatives with nominal amounts in excess of its total outstanding and committed debt, other than those associations with a wider rule which wish to close out an existing position.

The normal terms for a derivative are based on a constant notional principal amount (equivalent to the amount of the loan). This is fine for interest-only loans but if the loan principal amount varies during the life of the loan (eg through repayment by instalments) the terms of the derivative will need to reflect this to match.

The market will offer a price for almost anything but the more specialist the requirement, the less competition there will be and the more expensive the transaction is likely to be.

Length of loans

Housing associations are likely to have arranged a series of loans, one at a time. Historically, apart from perhaps short term development/working capital facilities, housing associations have tended to arrange long term facilities (25 years or more) for their borrowing needs. Latterly, a wider range of maturities have been used so that a concentration of repayments around one date (refinance risk) does not occur.

Following the financial crisis of 2008/09, the banks’ cost of funding themselves has risen dramatically and new capital adequacy limits mean that the longer the term lent, the greater the capital to be held by the bank. The result of this has been twofold. Firstly banks are reluctant to lend much beyond ten years. Notionally, 25-year facilities may be offered, but only with five year break clauses at the banks’ option.

Secondly, many existing facilities will be loss making from the banks’ point of view and so great care needs to be taken not to breach any terms of the loan agreements, otherwise a repricing of the entire loan may be required. Any changes requiring the banks’ consent may also trigger a repricing or a fee, but there will probably come a point where an association needs to strike a balance by accepting some level of repricing/cost to enable it to continue with its business strategy.

The capital markets, however, have been and still are a consistent source of long-term (25–40 year) finance with no repricing risk.

Facilities negotiated some years ago may well be costing housing associations significantly more than a new facility would (even taking account of set up fees). Such situations need to be identified (with any prepayment penalties) and the options for renegotiating or refinancing the loan identified and pursued.

There is no universal optimal loan portfolio in terms of the mix of product, lender, maturity and interest rate. It is prudent to strive for a balance that spreads the potential business risk and matches the funding needs of the housing association.

At any time, a housing association is likely to be both borrowing and lending, albeit as a significant net borrower. The extent to which it is desirable to avoid borrowing or repaying loans will depend on the forecast cash requirements and the relative costs of borrowing and investment, taking account of any non-utilisation fees and the availability of repayable or redrawable facilities.

Where a housing association has surplus funds to invest, a variety of investment instruments are available, with a range of deposit periods and rates of return. Investments can be entered into either directly through banks and building societies or through a broker. Because of the numerous instruments available, if a housing association has significant sums available to invest it is prudent to consult investment experts before entering into any transactions.

The increase in bond finance (whereby all funds have to be drawn down on day one) led several associations to be significant investors of surplus cash. Generally, the longer a deposit is placed, the greater the rate of interest earned. However this has to be balanced against cash flow requirements so splitting an investment into different maturities can be an effective way to maximise interest earnings while retaining the ability to source funds when necessary.

A housing association should have a list of investment counterparties approved by its board or relevant committee, specifying the maximum amount that can be invested with each counterparty. The approval should be reviewed each year as part of the annual treasury strategy (see Policy, Strategy and Reporting above).

Often, deposit counterparties are selected on the basis of a credit rating which aims to indicate the relative financial stability of those counterparties. Recently, due to the economic crisis, banks and other financial institutions have had credit rating downgrades applied to them. The housing association will need to be aware of these changes as downgrades could mean that counterparties are no longer approved under the criteria set down.

In some cases it will be necessary to confirm the deposit counterparty as being acceptable, because so many banks have been downgraded. The pool of highly rated counterparties has reduced considerably.

Money market funds can give a better rate of return than bank deposit accounts, but the funds will need to be acceptable within the approved investment parameters of the association. That may relate to the credit rating of the deposit counterparties or some other criteria.

For investments longer than a year, UK government gilts could be an option, again depending on investment parameters. The balance to strike is that the real value of cash funds will erode due to inflation (unless the deposit rate is greater than inflation), whereas gilts or other financial instruments, as exchange traded investments, have the potential to increase in capital value, but due to their fluctuating market price, the capital value could also decrease leading to a loss for the association.

The time period is critical. If the investment is to be held over a fairly long period where a forced sale would not be necessary then there is a reasonable chance of selling the investment at a surplus, but this cannot be guaranteed so the decision has to be predicated on the association’s appetite for risk and its overarching policy of minimising risk rather than trying to maximise returns.

Some investments may be made for non-treasury management purposes. Such activity includes investments in subsidiaries, joint ventures (including guarantees to such entities) and property portfolios. All such decisions should be subject to the relevant capital or investment strategy, which may be subject to a risk appetite quite different from treasury activities. A schedule of all such material investments should be kept including the association’s risk exposure.

The following publications are sources of further information regarding treasury management for the social housing sector:

For further information regarding accounting standards refer to the Statement of Recommended Practice (SORP): Accounting by Registered Social Housing Providers 2014 (National Housing Federation).

The Association of Corporate Treasurers (www.treasurers.org) has a number of courses and qualifications suitable for treasury managers of housing associations. It can also advise on further reading and best practice guidelines.