David Green: Top Five bond considerations
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Local authority bonds have been in the news quite a bit recently, and many councils may be considering borrowing in this format in future. What are the top five considerations for treasury managers before they issue bonds?
1. Do we need to borrow at all?
It’s an obvious question, but in the excitement of a bond issue it can easily be overlooked.
As individuals, most of us would only borrow money if we were short of cash, on the understanding that loan interest rates are higher than the rate we earn on our savings.
It hasn’t always been the case, but the same is true for local authority interest rates these days. Borrowing money you don’t need places an immediate “cost of carry” burden on the revenue account, and can also lead to increased credit risk exposure.
So, local authorities should consider their current cash and investment balances and how these are projected to change.
This involves forecasting outflows due to capital expenditure, bearing in mind that the capital programme rarely runs to budget. But is also involves forecasting the inflows resulting from capital receipts and non-cash charges to the revenue budget like minimum revenue provision and amortisation of premiums.
And while many authorities regularly predict withdrawals from reserves, history shows that reserves tend to increase each year, resulting in increased cash balances. Only a net cash outflow that takes investments below the acceptable minimum needs to be funded by new borrowing.
Government statistics show that UK local authority borrowing has increased by £21.8bn over the past 5 years. £8.1bn of that was paid to the government in 2012 for the reform of council housing finance and a further £0.6 billion has been spent on other projects. But the remaining £13.1 billion has just led to increased investments for the sector as a whole.
The consolidated figures mask individual differences, of course, but it’s clear that some authorities have borrowed a lot of cash they don’t need just yet, compounding the costs of austerity with the cost of carry.
2. Will we benefit from the stated advantages of a bond over a loan?
A wider pool of potential lenders increases the chance of paying a lower interest rate on a bond than on an equivalent loan.
The various fees payable and additional officer time will partly offset any such savings, and 
some will be payable even if there is no bond issued at the end.
There is however a good chance that a bond issued by a highly creditworthy local authority will be cheaper than a similar PWLB loan.
Just be aware that the PWLB isn’t the benchmark it used to be, and that there are several sources of cheaper loans, including other local authorities and the European Investment Bank.
Bonds can also offer features like delayed drawdown or interest free periods. These are also available in the loan market, just not from the PWLB.
One of the more useful but less advertised features of a bond is the ability for the local authority to buy back its own bonds at a later date – to genuinely invest in itself – should cash flow forecasts prove at a later date to have been over-pessimistic.
There are many who would welcome a similar cheap repayment facility on their current debt.
3. Are there any disadvantages to be aware of?
Investors tend to like bonds that are rated by a recognised credit rating agency, and the fees payable to the rating agency should be more than offset by the interest rate saving.
However, the additional external scrutiny may be an unwelcome distraction, both in terms of officer time and newspaper headlines – “local council downgraded by international rating agency” is unlikely to make pretty reading, whatever the underlying reasons.
Borrowing a loan doesn’t normally attract much publicity in itself – I don’t think there are many avid readers of the PWLB’s monthly loans reports. But a public bond issue will mean an announcement on the stock exchange that will be picked up by many media channels, maybe prompting a few journalists to enquire why you are defying George Osborne and adding to the national debt.
The daily pricing of your bonds on the stock market might also be an issue for some. Falling interest rates will increase the value of both loans and bonds – but it’s a much more public affair for bonds. Be ready to explain why the market suddenly adding £10m to your debt isn’t really a problem.
4. Should we issue an index-linked or a conventional bond? Or a floating rate note?
There is an attractive rationale to link the cost of borrowing to the inflation in the income that will pay for it. So index-linked bonds might be a good match for property projects where rent will rise with inflation.
Council tax and government grants to local authorities aren’t exactly rising with inflation just now, but in the long term it seems a reasonable assumption that they might.
Index-linked bond markets price in current expectations for long-term inflation rates. If inflation ends up averaging below current forecasts, then a properly priced index-linked bond will end up cheaper than an equivalent fixed rate product.
But if inflation is lower than expected, then interest rates will most likely be lower than expected too, in which case floating rate notes, or rolling short-term loans, would have been good value too.
A balance between all three types is probably suitable for most borrowers. For reference, central government’s debt is currently 61% long-term fixed rate, 22% index-linked and 17% short-term, including treasury bills and National Savings.
Local authorities with mainly fixed rate debt might like a more balanced portfolio in case interest and inflation rates don’t rise as fast or as far as expected.
Borrowers of index-linked debt need to understand that the principal is uplifted by inflation each year.
That can cause issues with the Prudential Code if your debt is increasing when your capital financing requirement is falling.
It also means that interest will be payable on an ever increasing balance, so debt costs could snowball.
Authorities should also be clear on the accounting requirements for index-linked bonds, especially the impact of revised expectations for future inflation rates that can cause significant volatility to the revenue account.
Finally, there’s a particular issue for borrowers of CPI-linked bonds, since the market in the UK CPI financial instruments is rather under-developed, and the pricing is therefore much less transparent.
Fixed, floating and RPI-linked markets are much more liquid, and there can be little dispute over the comparative value of those three structures.
5. Are complications worthwhile?
Investors in the sterling bond markets tend to like things simple – fixed rate, payable on maturity, no funny clauses.
Any complications, such as caps and floors on the interest rate payable, or having the principal drawn down or repaid in stages, is likely to lead to a higher interest rate.
So, stop and consider whether the benefit to you is worth the extra cost. If you are thinking of an amortising repayment profile to reduce your refinancing risk on maturity, will that repayment amount still be so significant a figure that far into the future? Or, if you are seeking to cap your exposure to inflation rates, doesn’t that go against the rationale for borrowing index-linked to start with?
Once again, there are transparent markets in interest rate and RPI inflation derivatives, even if you’re not familiar with them, and someone independent can check you’re being charged the right price for your complications.
You will also want to ensure they don’t generate any unwelcome accounting problems, such as needing to separate embedded derivatives that are not closely related to their host contracts.
In summary
Bond markets offer increased flexibility and possibly reduced costs for borrowing local authorities when compared to traditional loan markets, and especially the PWLB.
They also present some potential hazards in terms of disguised costs, increased public scrutiny, and accounting rules. A sound comparison of the risks and rewards of different options, including doing nothing, is an essential part of the treasury manager’s role.
David Green is client director at Arlingclose.
Image (cropped): Lendingmemo.com, Flickr.
