Regulatory change

This week, the Department for Communities and Local Government (CLG) published a summary of the responses to last year’s consultation on changes to the capital finance system in England, and confirmed that it intends to go ahead with all the proposals.  The two main changes relate to securitisation and corporate bonds.

Securitisation is the process by which future income streams can be sold to an investor in exchange for an upfront lump sum.  It is therefore similar to borrowing, although giving up the rights to future income is not quite the same as taking on an obligation to make future payments.  CLG is obviously worried about local authorities using their new found freedoms under the general power of competence to indulge in some financial engineering.  After all, the Greek government famously securitised its airport fees and lottery sales with Goldman Sachs in 2001, using the proceeds to hide its growing national debt and make it eligible to join the euro.  Any treasurers out there fancy selling the next five years’ council tax income to receive a lump sum now?  Probably not.  But how about selling future (variable) rents on a business park in exchange for a fixed sum upfront that can be used to finance the development in the first place?  That sounds a little more likely.  .

CLG’s solution is to classify any such lump sum as a capital receipt, which sounds reasonable, so that it can only be used for capital expenditure (such as developing the above business park) or repaying debt (like Greece, but more transparent). CLG will also legislate to treat the sum as a “credit arrangement” to bring it within the prudential framework, similar to the way that finance leases are counted as debt.  Quite how a single sum of money can be both a capital receipt (income) and a credit arrangement (debt) raises several questions.  Can the capital receipt be used to repay the debt?  Do you show it as a liability or as a reserve on the balance sheet?  I raised these questions in the consultation process, and the official response states that queries about legal and accounting issues will be dealt with in the informal commentary to be issued later.  That should be fun to read!

The other main change will allow English local authorities to invest in corporate bonds without classing them as capital expenditure, a long-standing regulation which previously made it difficult to invest without banning it outright.  Unusually, this is one area of local government legislation where England is behind Wales − authorities in the Principality have been able to buy corporate bonds without restrictions since 2004.

This will open up three broad avenues of investment, with different levels of credit risk.  Firstly there are a number of government guaranteed bonds on the market issued by companies such as Network Rail and Royal Bank of Scotland that pay a slightly higher return that gilts for next to no additional risk.  There was no reason for local authorities to ever have been restricted on buying these − they happen to be corporate bonds in name only.  Bonds issued though companies but guaranteed by local authorities, like the GLA’s recent issue, are a similar example.

Secondly there is the more traditional high grade corporate bond.  Many companies with AA credit ratings are arguably safer than many of the banks these days.  Non-financial corporates aren’t exposed to the risk that all their funding will disappear in a short period of time in a bank run, and many stockpile cash in advance to pay bonds as they mature.  A diversified pool of 10 or 20 fairly short dated high grade corporate bonds would be a decent addition to an otherwise bank-centred investment portfolio.

Going further down the risk spectrum, we come to the euphemistically named “high yield” bonds (sounds nicer than “low grade”, don’t you think?).  Authorities looking for increased returns in these difficult times may be tempted down this route, but this is where diversification really becomes key, with pooled funds being the only realistic solution.  Even then, the risk of substantial capital losses remains, so authorities with average risk appetites will be best sticking to the higher quality categories instead.

David Green is the Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice.  It should not be relied upon when making investment decisions.