Fixed income: the next generation of funding

Over the past five years, property companies across Europe have increasingly turned to the debt capital markets, but nowhere is this trend more pronounced than in the Nordics. The numbers say it all. Real estate firms were behind some 43% of the region’s Swedish krona-denominated corporate bond sales in 2017, according to Swedbank, and now account for more than 40% of outstanding Swedish corporate paper.

Issuance from Swedish firms alone soared from some SKr10bn ($1.17bn) in 2010 to nearly SKr70bn in 2017, while their Norwegian peers nearly doubled their bond sales between 2015 and 2017. “Real estate companies are starting to issue to a larger degree in the bond market, rather than only relying on loans as their primary source of financing,” says Tomas Lundquist, Citi’s head of European corporate debt capital markets. “It’s a trend that has taken off and I have a feeling is likely to be the case for years to come.”

As issuance is dominated by the large, listed Swedish property managers, most real estate bonds are investment grade. Indeed, it is these players that have driven the historically small Swedish krona bond market’s transformation into a self-sustaining market. Only about 20% of the sector’s outstanding bonds are high yield, having been sold by property developers and sub-investment-grade managers.

Perfect business sense

The primary reason why Nordic property managers are tapping the capital markets is to diversify funding, reduce their historical reliance on secured loans, and spread counterparty exposure. Bonds and commercial paper now account for about 40% of some of the bigger firms’ debt stack. According to the Riksbank, the Swedish central bank, as of May 2017, Swedish commercial real estate companies had SKr456bn in bank debt and SKr344bn in bonds and certificates.

It is undeniable, however, that robust market conditions are a major drawcard. Since regional interest rates hit record lows and the European Central Bank started its corporate bond-buying programme, firms have been able to sell bonds with extremely low coupons. Furthermore, while Nordic banks now require interest rate floors in their loans, investors are happy to live without them.

“Currently it is cheaper for us to borrow via an unsecured bond than a bilateral loan for which we must put up collateral,” says Arvid Liepe, chief financial officer at Swedish property company Wihlborgs Fastigheter. “Also, an unsecured medium-term note [MTN] programme is a practical instrument to work with – the flexibility is reasonably high and the administrative cost relatively low.”

While most European investment-grade notes are fixed rate, Swedish property managers issue a large portion of their bonds as floating rate. Tenors are about five-years – which is similar to what the banks offer – and in Sweden the vast majority of bonds are unsecured. Compared with secured bank loans, this makes it easier for firms to sell properties to improve rental yields. It is notable that in Norway, however, most of the sector’s investment-grade issuance is secured.

Buy-side universe

Unconventional monetary policy, having sparked the buy-side to seek out new investment opportunities, such as Nordic real estate, is one reason why the sector’s bonds are regularly oversubscribed. But it is the not the only reason. There are fundamental shifts happening within the investor base that indicate the buoyant market will continue after rates rise and central bank bond-buying comes to an end.

First, the buy-side is moving some resources away from industries that dominated bond volumes in the early 2000s – such as utilities and telecoms – and into those driving today’s market. “We sometimes meet investors who used to cover utilities, or other sectors, but now cover real estate,” says Mr Lundquist. “It seems the investor base is repositioning some of its team to reflect market volumes and opportunities.”

As a result, the buy-side is expected to develop a more nuanced appreciation of the characteristics of each sub-sector, be it retail, commercial, residential or logistics. “Today, many investors talk about real-estate as if it is one sector. But they will, and it’s important that they do, start to get a more granular understanding of which segment the company operates in,” says Mr Lundquist.

Second, debut deals have been snapped up, with the number of property issuers in the Swedish krona market increasing by more than 30% over the past two years. “Investors’ willingness to accept new names has also contributed to the very strong market,” says Mathias Leijon, Nordea’s head of corporate and investment banking. It shows investors will support a growing issuer base.

Finally, Sweden’s strong economic growth and financial stability has prompted investors to up their exposure to the country. “Liquidity in the Swedish market has been incredible,” says Michael Johansson, a credit analyst at Swedbank. “It has seen very positive fund flows since a few months into 2016, and the larger buyer base has obviously helped them to issue at tight levels.”

Furthermore, while Swedish investors do venture beyond the Nordics, they tend to gravitate to familiar names from their home market. “You have a Swedish investor base, particularly the Swedish krona portfolios, that really take a lot of comfort in primarily Swedish names, and also Nordic names more broadly,” says Derry Hubbard, Danske Bank’s global co-head of debt capital markets.

Sector risks

Investors are, however, being advised to watch some sector-specific risks. After a decade-long surge in Sweden’s and Norway’s house prices – which had sparked warnings from multilaterals, rating agencies and analysts as potential bubbles – both markets experienced corrections in late 2017 and early this year. This has hit the price of tenant-owned apartments and some of the smaller developers building them, but market participants agree there has been no direct and immediate impact on residential property managers. 

“Sweden’s rental market is regulated, the vacancy risk is close to zero and it takes some time for any price development to fully flow through the cashflow-based valuation models,” says Mr Johansson. “So for the managers, certainly at the outset, the direct effect should be quite limited.”

Another issue is the sector’s relatively short debt maturity profiles. Many firms are regularly refinancing, which creates liquidity risks plus other potential problems. “Many property companies are rolling over secured bank debt annually or with two- to three-year maturities, while they reduce their reliance on loans by looking more to the bond market,” says Fredric Liljestrand, a director in Fitch’s industrials and real-estate team. “If the bank debt matures before the bonds, the bonds become temporally subordinated.”

According to the principle of temporal subordination, any debt that is payable before the bonds – irrespective of their respective rankings – becomes more senior.

Eurobonds: broadening horizons

Naturally, real estate issuers have initially focused on the local Nordic markets, but there is a nascent trend of firms looking to foreign currencies. A handful of Swedish names, including Akelius, have issued Eurobonds and bankers expect the trend to continue. To date, firms with purely domestic portfolios have steered clear of international issuance as it would create foreign exchange (FX) risk. But for those managing assets in other countries, international bonds are a way to currency match; by borrowing in the same currency in which they hold assets, they reduce their FX risk.

Another advantage of Eurobonds is the ability to raise larger tickets than in the Nordic markets, and for tenors of up to 12 years. It is a way to significantly lengthen debt maturity profiles – particularly useful for real estate companies as it allows them to match their long-term portfolios with long-term financing.

Due to managers’ historical reliance on secured bank loans, local markets have become a vital stepping stone to issuing a Eurobond, not only as a form of financial education, but also as a way to unencumber portfolios. This is important for two reasons.

First, international investors generally are not willing to hold the only unsecured slice of an issuer’s debt stack, as it means they rank subordinate to every other creditor. Local investors are less concerned about this, which makes selling domestic unsecured bonds – and using the proceeds to repay secured bank loans – an ideal way to get balance sheets in shape for a Eurobond.

Second, reducing the proportion of secured financing is necessary to convince rating agencies that they are investment grade. “Once they have a more balanced portfolio of secured and unsecured debt, it has become possible for them to get a rating that doesn’t penalise them for the secured debt,” says Mr Lundquist. “This makes it easier for them to issue bonds internationally.”

Ratings enter a new era

Kungsleden is a case in point. Last September, Moody’s rated the Swedish company Ba1, and affirmed that at least 30% of its properties must be unencumbered for it to be lifted one notch to investment grade. It has since worked towards that goal by reducing its portion of bank loans, and launching and issuing from a SKr5bn MTN programme. As at the end of March, 26% of its portfolio was not pledged as collateral. Its CEO, Biljana Pehrsson, says the company will consider issuing a Eurobond after it receives an investment-grade rating.

The Moody’s assessment was Kungsleden’s first official credit rating, and it has already paid off. “The rating has enabled us to reduce the cost of our bond financing by roughly 30 basis points [bps] to 40bps,” says Ms Pehrsson. She expects to see a similar reduction again after it has reached investment grade.

The reason why Kungsleden and many other large Nordic corporates have only just received their first official rating is because they have historically relied on so-called shadow ratings. These are free assessments made by Nordic banks using the rating agencies’ criteria, which was accepted market practice until late 2016 when the European Securities and Markets Authority warned it would clamp down on the process. Today, the only major Nordic bank to still offer shadow ratings is SEB.

Hedging and green shoots

Managers hedge their interest rate risk via local swaps, however Mr Johansson’s research shows that the sector’s average maturity for these hedges has not been extended in recent years. “This is understandable given they’ve paid to fix their interest rates, but haven’t got a lot out of it as rates haven’t risen as some experts forecast,” he says. “If rates look like they will go higher, they might start thinking about pushing out their maturities again.”

Another reason Swedish firms have stepped back from interest rate swaps is because negative interest rates have created a mismatch with the loan market. “Bank loans are floored at zero – so we don’t benefit from the negative Stockholm Interbank Offered Rate [Stibor] – while swap agreements aren’t. It means we are actually paying more on our swap agreements than if Stibor was zero,” says Ms Pehrsson.

In a separate development, Nordic real estate firms have implemented world-class sustainability frameworks and have been very active in the green bond market. “Sweden is still the region’s biggest market but interest is increasing rapidly in Finland and Norway, and Denmark is starting to pick up, too,” says Einar Erici, a director in Nordea’s debt advisory division. “It means tapping into another pool of capital, and the price they pay is 2bps to 4bps lower than a conventional bond.” Indeed, the sector is a leading example of how issuers can lower their borrowing costs by selling green bonds.