Housing bond finance is essentially a loan agreement used to provide financing for a borrower and income for a lender. Called a "security" because they have a fixed yield, bonds compel the borrower to pay interest on the amount of the loan. This is called the principal or par value.

The capital is normally paid in full by the borrower at maturity although some bonds do provide for repayment over the period of the loan agreement. Until maturity, the borrower makes interest payments to the lender. The rate at which interest is paid on the bond is essentially the cost of obtaining the loan.

The bond will have a fixed date for maturity set at the time the bond is first issued. In housing loans that period has often been 30 years but may be shorter or longer. Most bonds are issued by governments or corporations. However a number of significant housing associations have issued their own bonds and The Housing Finance Corporation also has a significant presence.

Usually an underwriter provides the borrower with the full amount of the financing being sought, buying all the bonds issued and then reselling them to investors at a profit on the open market.

Bonds can have other features depending on the terms of the financing:

• Callable bonds allow the borrower to pay the principal and therefore retire the bond before the maturity date, limiting the interest income to the bond holder.
• A putable bond is the reverse, where a bond holder can demand early payment of the principal, eschewing future interest payments.

For the bond holder, a bond is an investment, and therefore the terms of the bond will depend on the creditworthiness of the borrower: a higher risk entity will be required to pay a higher interest rate to the bond holder.

The recent downgrading of the UK and the corresponding downgrading of housing associations is likely to mean that bonds, where the borrowers are housing associations:-

• will be regarded as riskier
• interest will correspondingly be more expensive as the investor will demand a higher rate of return

The perceived default risk of the borrower will determine how much interest the underwriter and subsequent bond holders will demand. Debt issued by the lowest-rated organisations, with the highest default risk carries the highest yield for the lender over the corresponding government stock, but also the highest default risk.

For more information on housing bond finance please contact our team.