Apart from the Gilt market, there are precious few opportunities in the capital markets to buy UK public sector risk. Prayers for a spate of local authority issuance in the UK bond markets have yet to be answered, but investors may be about to be gifted with other opportunities to buy quasi-UK government debt at a spread to Gilts.
The next potential source of quasi-government bond issuance in the UK could be housing association debt with a UK sovereign guarantee.
The UK government is offering a guarantee on up to £10bn of debt raised to fund housing. The policy went live in June and works through one of two schemes.
One is the Affordable Housing Guarantee Scheme, which will be run by Affordable Housing Finance — part of The Housing Finance Corporation (THFC). Through it, the government will guarantee up to £3.5bn of debt to lend to housing associations to rent properties to families in need.
The second is the £3.5bn Private Rented Sector Guarantee Scheme. This enables the likes of property investors and developers who want to manage homes specifically for private rental, to obtain cheaper financing rates. The government is looking to attract greater institutional investment in this sector.
The government could boost the schemes by a further £3bn which it has kept in reserve.
“The Affordable Housing Guarantee Scheme is very exciting,” says James Solomon, sterling syndicate at RBC Capital Markets in London. “The THFC group, which is running the scheme through a subsidiary, has a strong and successful record in the capital markets. We expect issuance under it to be longer dated — 10 years and out.”
Any deals are expected to price back of Network Rail but inside where the best housing association debt trades — which is roughly between about Gilts plus 30bp and Gilts plus 90bp, according to one syndicate official.
The potential arrival of further debt issuers with government guarantees is unlikely to take demand away from the UK’s only agency with an explicit sovereign guarantee, Network Rail, even though it will pay a healthy spread over the rail provider.
“This is such a rare kind of product that even with the new scheme out it won’t cannibalise demand for other UK government guaranteed debt,” says Solomon at RBC CM.
Still hope for local authorities?
UK public sector bankers were set all of a flutter two years ago when the UK government whacked up the borrowing rate at the Public Works Loan Board to 100bp over Gilts (from around 20bp). The move promised a rush of local authority issuance as capital markets finally began to look a competitive funding option.
But in autumn 2012 the government offered local authorities a 20bp discount for providing more information on their borrowing and spending plans, making PWLB loans as cheap as 80bp over. Suddenly capital markets looked expensive again and bond issuance plans were put on hold.
The local authority market may not be dead, however.
“It’s a shame local authorities don’t look at issuing, whilst the market has been volatile over the last two years, at times it has offered opportunities to beat the PWLB,” says James Marshall at Lloyds Bank commercial banking in London. “When the Greater London Authority got their deal away [in July 2011] at 80bp over Gilts, the iTraxx was just over 100bp, in the interim spreads did widen significantly but now credit markets are trading tighter. TfL have traded at 60bp over Gilts and the GLA could achieve similar levels.”
A shortage of supply of triple-A or double-A rated debt in sterling aside from the sovereign, plus diminishing yields, means that demand for highly rated issuers, such as local authorities, that pay a decent premium over Gilts should be highly prized by investors.
All together now?
One way in which local authorities could make themselves more attractive is by clubbing together and forming an aggregated issuance vehicle.
“We’ve looked at aggregated issuance in the past,” says Marshall. “We didn’t get it away in the end but it’s definitely a viable way for smaller issuers to come to the market. That said, it will depend on the names. Issuers would need to be very similar to avoid cross-subsidisation of credit quality. County councils and city councils would work better for investors as they are more visible and have large diversified revenue streams.”
Even ratings aren’t too much of a bother for issuers, says Marshall, as many investors are willing to do the analysis themselves. “These are quasi-public sector issuers and investors are happy with the risk,” he says.
The PWLB, however, provides another slight sticking point to investors. They know that even if a local authority decides to come, if the market gaps out they can resort to the PWLB, so they will only ever likely be a fair weather borrower.
Investor work pays off
On the surface, life looks set to get more difficult for Network Rail, the authority responsible for the UK’s railway network. It faces an increased borrowing requirement for its next financial year (starting April 2014) of £6.5bn up from £5bn, and has lost its triple-A rating from two rating agencies.
However, its position as the only issuer with a direct UK guarantee and its sheltered position outside the eurozone during the currency bloc’s sovereign debt crisis, plus a lot of investor work, has enabled it to expand its investor base, insulating the impact of those downgrades and leaving it in a strong position for its increased borrowing.
“This issuer treats markets with the utmost care,” says Stuart McGregor, head of European SSA DCM at RBC Capital Markets in London. “It’s done a lot of work on expanding its investor base. Wearing the shoe leather out is the only way to do that.”
Samantha Pitt, Network Rail’s group treasurer in London, has plans to expand the investor base further: “There are still a few central banks that won’t buy our name but we’re working on it and we’ll keep working. We want to continue to expand and diversify our investor base.”
And, although Network Rail funds mainly in sterling and dollars, other currencies are an option.
“EIB did a Canadian dollar issue recently which we found very interesting,” says Pitt. “While Australian dollars has been another popular currency for issuers this year indicative pricing has not been consistent for us since the downgrade. Because with the downgrade we are no longer Reserve Bank of Australia repo eligible, the pricing went all over the place. Some banks are putting us as much as 20bp-25bp wide of KfW. Until we have more consistency in Australian dollar pricing then we will hold off from looking at that market.”
Since the rail company became repo eligible with the Bank of England 12 months ago, bank treasuries — a growing pool of liquidity for SSA issuers as regulation means banks must have a certain percentage of highly rated paper that they hold in order to bolster their liquidity reserves — have begun to buy. Bank treasuries bought 26% of Network Rail’s most recent benchmark, a $1.75bn 0.875% May 2018.
“Network Rail consistently is attracting new investor to its offerings, but there are still a handful of accounts that categorise Network Rail as a corporate” says Dan Shane, Morgan Stanley’s head of SSA syndicate.
“It does differ in that respect from some other SSA names, but that means that there is still scope for some upside spread performance for current holders, as there are a few central banks and bank treasuries yet to approve it.”
Network Rail has increased its presence in the US since it set up a 144A programme three years ago. In its latest dollar benchmark, 29% was placed in the Americas.
“Our dollar spreads have performed over the past two years, and we now trade in line with KfW, which is not bad for a double-A rated credit,” says Pitt. “Even when the UK was downgraded we managed to keep our dollar levels in line with KfW.
However, if Standard & Poor’s decides to make it a full house and downgrade the UK to double-A — the agency still has the sovereign on negative outlook — that could hit Network Rail’s spreads, she says.
But the rarity value of the credit — even a £6.5bn funding target puts it at about one tenth of what a KfW needs to raise each year — and being virtually the only way to get UK sovereign risk exposure outside sterling (aside from the Bank of England’s single annual dollar benchmark) means its paper should continue to be a popular buy.
“Network Rail has benefited from having a UK guarantee, and from the UK having a much stronger credit story over the past few years than many eurozone countries,” says Morgan Stanley’s Shane.
“As Europe starts to recover, the question has been will investors look elsewhere? That’s not been the case, investors have absolutely stuck with Network Rail. In dollars it has continued to outperform relative to its peers. That’s partly due to the size of the funding programme ------— it has rarity value, but it’s also due to the extremely high quality of its guarantee structure.”
Transport for London, is another issuer that straddles the corporate/public sector divide, although it is closer to the corporate side than Network Rail as it lacks a government guarantee.
TfL, which resumed capital markets bond issuance in 2012, having taken a break from bond issuance since 2006, has carved out a niche for itself as a quasi-corporate, quasi-sovereign issuer.
“TfL trades wider than Network Rail, but is clearly in a different league to corporates,” says Solomon at RBC Capital Markets in London. “They stand on their own at the moment. They’ve done a lot to expand their investor base.