TradeRisks Q&A: Bond financing

Alex Pilato of TradeRisks explains the use of capital markets for bond financing.

 

Q: Why should local authorities consider capital markets as an alternative funding source to PWLB?

The primary debt capital market, i.e. institutional investors purchasing bonds, is a well-established and efficient source of funding. Pricing and terms are attractive, market processes are well established and streamlined, and documentation is publicly available and therefore standardised.

Capital markets can offer local authorities long-term financing that is more flexible and innovative than PWLB, and at comparable or better all-in cost. Certain financing structures (such as index-linked debt and deferred bonds) are available, which are not offered by PWLB.  This enables local authorities to make savings of around 30bps per annum on their cost of debt or gain significantly higher levels of certainty on their future cost of funding.

Furthermore, by privately placing public bonds with institutional investors local authorities can limit the execution risk that is present in the syndicated process.

Q: So how is the process of privately placing public bonds different to that followed by banks?

Local authorities can best access this market by following the approach of privately placing public bonds because the traditional syndicated sales process often produces poor results for smaller borrowers. This approach maintains price tension whilst reducing execution risks for non-frequent borrowers or even for frequent borrowers with particular issues that need time for investors to become comfortable with.

Bonds placed through private auctions benefit from the fact that investors know that the issuer is not under any pressure to close the financing, as may be the case with syndications. This in turn removes the execution risk of there being insufficient demand from the handful of investors able to absorb either all or a substantial part of the issue.

This approach was followed for the £150m of 40-year Aa2-rated CPI-linked bonds issued by Warrington Borough Council in August 2015.

Q: What can capital markets funding offer that PWLB cannot?

As mentioned above, there are various debt structures that are available in the capital markets that cannot be accessed through PWLB.

With deferred funding, the interest rate is fixed upfront based on current Gilt yields and credit spreads and drawdown is at pre-agreed future date(s) within the next 5 years. This allows the local authority to lock in attractive funding costs without incurring a high cost of carry and allows them to budget their funding programme much more accurately.

Institutional investors have high demand for CPI linked assets, meaning that local authorities can access CPI-linked funding at highly competitive rates.  The interest that would be payable by an issuer under an index-linked bond would be based on a fixed coupon on the outstanding notional of the bonds (such coupon based on a spread over index-linked Gilts, as above). The outstanding notional of the bonds would be adjusted each year by an inflation index (e.g. CPI) but where such adjustment has a cap and floor.

For example, the Warrington Borough Council bond had a cap and floor such that the minimum CPI adjustment each year was 0% and the maximum CPI adjustment is 3% (meaning a cost of debt always between 0.846% and 3.846%). Given the very low UK inflation rates, this approach would allow the issuer to benefit from a low all-in cost in the early years, while being protected from the possibility of high inflation by the cap.

The Warrington Borough Council bond was c.30bps cheaper than PWLB. It was issued at a 175bps spread over the Inflation Linked Gilt 0.5% 2050. As the mid Gilt yield was -0.904% at the pricing time, the bond coupon was set at 0.846%. Using the market RPI swap rates, the OBR estimate of 100bps for the CPI-RPI wedge and the historical 1.2% inflation volatility, the expected cost of debt is 2.988%. This corresponds to a spread of 51.1bps above the 2.477% nominal 2049 Gilt yield at the time. With PWLB’s cost of funds currently at Gilt plus 80bps, the WBC bond was 28.9bps cheaper than PWLB.

Q: But isn’t accessing capital markets an onerous and expensive process for local authorities?

The private placement of public bonds approach means that local authorities can decide whether or not to proceed with a bond issue after receiving initial feedback from potential investors, but before incurring any material costs. A financing process can quite easily be abandoned or deferred if the local authority feels that the timing is wrong or alternative funding options are more attractive.

Local authorities are well understood by investors and rating agencies, because the legislation governing local authorities is well established and most of the information that local authorities would need to provide is available publicly on their websites, therefore the management time commitment is not significant. Much of the workload associated with the bond arranging process is handled by the arranger or other external advisers.

From an accounting perspective, the costs of a bond issue may be amortised by the local authority over the life of the bond. This will increase the interest rate by approximately 2-5bps p.a. dependant on the size of the bond issue.

The execution timetable would be around two months once a local authority has made the decision to proceed.

Q: How can a local authority demonstrate value for money for a bond issue?

Local authorities naturally need to be able to demonstrate that a bond issue is advantageous in comparison to the alternatives, especially borrowing from the PWLB.

As well as the pure cost benefit of capital markets, demonstrated above using the Warrington Borough Council example, there are various other factors that need to be taken into account when considering value for money.

Deferred bonds allow a local authority to lock-in their borrowing costs for a number of years so the local authority would need to take into account the cost of carry or the risk of volatility in Gilt rates when comparing to PWLB.

The coupon on an index-linked bond issue is typically very low in the early years. This again reduces costs of carry and is very beneficial when funding projects whose cashflows are lower in the earlier years.

There is huge advantage in diversifying funding sources outside PWLB, especially in the current environment of increased devolution and continued government cuts.  When comparing the all in cost a risk adjustment should be included into the PWLB funding cost as, by accessing capital markets, local authorities are gaining certainty that they will be able to access other sources of funding if PWLB funding becomes restricted.

Q: What sort of investor is interested in investing in local authority bonds, and why?

The investor base for long-dated Sterling bonds is dominated by UK and US pension funds and insurance companies. Such entities typically have long-dated liabilities that they are looking to hedge with investments that share similar characteristics. In particular, it is difficult for such investors to obtain long-dated investments in the public markets, so appetite is strong. Index-linked investments, which are in demand as such investors’ liabilities are often linked to inflation, are in particularly short supply hence interest spreads for index-linked bonds are particularly competitive.

Alex Pilato is chairman and chief executive of TradeRisks.

This Q&A was sponsored by TradeRisks Limited.