Introduction
Over the years THFC has from time to time provided long term inflation index linked loans to housing associations sourced from the capital markets. We have long felt that an element of index linked finance plays an important part in a balanced loan portfolio because of the index linked nature of housing association rental incomes. When we have come to discuss our index linked loans, while most associations have recognised the natural hedge to low inflation that they provide, they have found some of the structural features of these loans unattractive. To date, the index linked finance provided by THFC has been sourced from the capital markets. These loans have had maturities of 30 years with the indexation applied to the nominal loan amount. This produces an ever-increasing capital liability, which, notwithstanding the amortisation of principal after year five, can result in calls for additional security. The very long term link to inflation has also not necessarily suited many associations.

Recognising that some of the features of our capital market index linked loans have been unattractive, we have been working with a new investor to design an index linked loan that provides effective hedging against low inflation within a structure which we hope will be more appealing.

Key Terms
A full summary of the main commercial terms and conditions of the new indexed linked loan structure is attached herewith. The key features of the loan are as follows:

• 25 year term
  
• 10 year initial indexed period
  
• Option to extend after initial period with new indexed period or switch to fixed rate
• Indexation of interest payment rather than principal
• Indexation compounded to provide a true hedge on rental flows
• Upfront fees significantly lower than for a capital market issue
• Indexation can be based on September RPI matching housing association rents

Hedging and vires
The indexed interest rate payable on this loan is achieved through a 10 year fixed rate swap and an RPI swap. This explains the complicated formula in the summary of the commercial terms. All the swaps are however embedded in THFC's funding agreement and so do not require potential borrowers to have specific approval to enter into separate hedging agreements. We will of course be happy to explain to associations how the formula works and how the hedging has been arranged.

Inflation Scenarios
The attached tables illustrate the cash flows for an interest indexed loan in its first 10 years under different inflation scenarios. Figure One illustrates the base case, Figure Two shows a potential "low inflation" scenario and Figure Three a "high inflation" scenario throughout the 10 year period. In reality inflation will fluctuate with periods of high inflation, periods of low inflation and potentially, periods of deflation. The examples do, however, give a reasonable indication of how the structure would work if inflation is generally below 2.4% in the one case or generally above 2.4% in the other.

The basis for the semi-annual interest payments on the loan is a fixed rate (assumed at 5.3%pa in the example) plus a credit margin (assumed at 0.5%pa), modified annually by the cumulative difference between the annual percentage rise in the RPI (say September to September) and the RPI swap rate (assumed at 2.4%). So if the RPI moves up to 2.6% after the first year the total rate is 6.0%, and if RPI is -0.1% after the first year (ie a deflationary scenario) the loan interest would be 3.3%pa.

When the inflated rental income is added to the loan interest payment the result is a stable nominal cash flow over a 10 year period, whatever the rate of inflation. The final graph shows the interest payments throughout the 10 years for each inflation scenario. The 1.5% inflation leads to a payment of interest to the borrower, not from it. If there is a period (particularly early in the life of the loan) when inflation is very low or negative, the situation can arise that for a while the borrower receives a payment under the arrangement. You will need to consider the chance of deflation happening and also whether under those circumstances you would be under pressure to reduce rents.

The consensus amongst most economists is that inflation is likely to remain subdued for some time to come. As I am sure you are aware, predicting long term inflation and interest rates is far from an exact science. However the September inflation figure on which this year's annual increase in rents will be based is already known and at 1.7% is significantly below the 2.5% used by many associations in their business plans. There is also a fairly general assumption that inflation will remain low in the near term.

At the end of the initial 10 year hedged period the borrower will be able to reassess the situation in the light of the economic conditions prevailing, the index linked and fixed rates available, and its treasury strategy at that time.

In the past, some associations have expressed a concern that in periods of high inflation, interest payments under an index linked structure would become expensive and potentially unaffordable to tenants. We think that this is a question of balance and degree. In a loan portfolio which has fixed, variable and index linked loans, the higher cost of indexed loans in a high inflationary environment will be offset by the lower real cost of the fixed rate portion of the portfolio. In the current economic environment there seems to be little prospect of a return to high inflation. Whilst there may be periods in the future when inflation is higher than the current very low levels, housing association rents should be able to follow these increases without causing particular stress to tenants. This is what the Housing Corporation would expect under the current restructuring proposals.

Inflation and the Long Term Business Plan
The compounding affect of low inflation on the cash flows of a housing association is often ignored. This can be illustrated by a simple example. The net present value of the future cash flows from a single property with a weekly rent of £75 will be £934 less over thirty years if inflation in year 1 is 1% less than that predicted in the business plan of the association. For an association with 4,000 properties that is a loss of income of £3.7 million over the life of the business plan. A series of low annual inflation figures and potentially a period of deflation would mean the effect is compounded.