SSA market struggles to put a price tag on Kilts
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SSA market struggles to put a price tag on Kilts

Humza Yousaf Scotland_19Oct23_alamy

Scottish government declares bond plans but SSA experts puzzle over rationale and spread to Gilts

The SSA bond market was divided this week over whether the Scottish government’s bond issuance plans were genius or insane, but one thing was clear — pricing the so-called 'Kilts' will be far from straightforward and the issuer would have to pay a fat spread over UK Gilts.

Scotland's first minister Humza Yousaf said this week that Scotland will issue bonds for the first time to fund infrastructure projects, aimed at “delivering high quality public services, boosting a green and thriving economy and ensuring equality of opportunity for everyone”.

The government has given itself more than 2.5 years to work on the inaugural issuance, saying the aim was to offer the bonds to the market by the end of this parliament, in May 2026.

It was not the first time the idea of a Scottish government bond has been floated. Scotland gained the right to issue bonds for capital investments in the Scotland Act 2016. Its borrowing limit is currently at £450m a year, up to £3bn in total, and will increase with inflation.

“It’s super interesting on a number of levels,” said a public sector bond banker. “They’ve obviously looked at this in the past and I think that was more of a vie for money. Investor interest then was really positive and it was a combination of those looking at it as a novelty museum piece and those looking at where it might come versus the UK and versus Gilts.”

Market participants, however, agreed it was too early to dive too deep into Scotland’s proposed bond issuance. “It does feel more definitive and real versus a few years ago, but let’s see what really happens,” said a senior banker in London. “There can be some political posturing still but at least we’re seeing some real numbers being mentioned. But for now it remains high-level talk.”

Another banker was similarly sceptical whether any bonds would be issued. “I have a fear that it could be a similar situation to the UK Municipal Bond Agency where it just never really got off the ground," he said. “But even if it does, what are you going to do with a funding programme of £450m a year? With that amount it feels more politically than financially motivated. It’ll also be interesting to see who would be buying it other than some specialist funds.”

Investors were cautious too. “We will have to wait to see what the details are,” said a fund manager. “As I’m sure we have discussed Kilts before with the plan going nowhere.”

“Lots of questions, no answers,” said Nick Chatters, investment manager at Aegon Asset Management. “How should this price? Will it be against the Scottish government as a legal entity? Will it be denominated in [sterling]? There is also no mention of whether the borrowing will be ring-fenced or secured against the infrastructure, or if it will just go into the government's pot; if the latter, then the market would add a premium for this.

“Given that Scotland is a member of the UK, would there be an explicit or even implicit guarantee over the debt from the UK government? This is the case with many [supranationals] where the national government guarantee gives investors confidence that in the event of default, they are taken under the wing of the grown-up.”

In response to a request for comment from GlobalCapital about investor concerns, a Scottish government spokesperson said: “Given the recent changes agreed as part of the fiscal framework review now is the right time for the Scottish government to reassess its policies and sources of borrowing to fund future infrastructure.

“That’s why the first minister has commissioned due diligence work with a view to issuing bonds by the end of the Scottish parliamentary term. The precise terms of any bond issuance will be notified after the completion of all necessary due diligence and standard credit rating processes.” 

A price to pay

Without a more detailed plan from the Scottish government on how to move the plans forward, bankers agreed there was little point getting too technical about pricing just yet. But one thing was clear — Scotland would have to pay a premium over Gilts.

A similar discussion took place almost a decade ago, in the run-up to Scotland's independence referendum in 2014, including questions over whether it would gain a credit rating at the same level as the UK, which would then guide the market about an appropriate spread to Gilts.

One suggestion at the time was that Scotland could be rated two notches below the UK, although the UK has since been downgraded and is now rated Aa3/AA/AA-.

Mehdi Fadli, senior vice-president, public finance ratings at DBRS Morningstar, which rates the UK at AA, said Scotland would likely be rated as a sub-sovereign government, and its total budget size of nearly £60bn for 2023/2024 would put it among the largest sub-sovereigns in Europe, in the same league as some German states, the Flemish Community of in Belgium, and the Autonomous Communities of Andalusia, Catalonia and Madrid in Spain.

But Scotland may still have to offer a spread over Gilts regardless of its rating, said Felix Ejgel, senior director, sector lead, sovereign and international public finance ratings, at S&P. “While it is not necessarily that Scotland would be rated lower than the UK, even if it is rated the same, there will likely still be a spread," he said. "Just look at Bavaria or Saxony in Germany or prominent French regions. The liquidity, at least at the beginning, will not be there; not to mention that it is a new issuer, so there are tons of technical reasons why investors may ask for a higher spread.

“But liquidity is likely the biggest problem — even the total announced £3bn size is a very small amount, less than 10% of government revenues. In comparison, UK local authorities as a whole have a debt stock of 80% of revenues, which is still quite moderate in our view.”

'God only knows'

With five and 10 year Gilts currently yielding around 4.7%, two year paper just under 5% and 30 year notes over 5%, that would mean a hefty borrowing cost for Scotland.

Spreads versus Gilts would be “wide”, “but God knows” what it should be, especially with the structure of the deal or a UK government guarantee uncertain, said a senior debt banker.

Others said they were surprised Scotland had not issued when funding conditions were much more conducive, with this reinforcing their point that the bond proposal was more of a political distraction rather than a project that made economic sense.

“I see no cost advantage of them doing it,” said a rates analyst. “Being funded by the sovereign would have a better cost, so you couldn’t help but think of the political motivation driving it. If you look at Spain or Germany, the direction has been trying to bundle things up — like the joint Länder issuance in Germany — to get a cost benefit and this is just going the opposite direction.

“And with the small issuance amount — it’s not how you set up a bond market. Even the smallest Belgian region and German Länder would have a larger programme than this.”

Nevertheless, sub-sovereign bonds from Canada and Europe may provide a clue as to pricing — though some said there was little clarity at this stage whether Scotland’s spread over UK would be even wider given its poorer liquidity and arguably higher political risk.

From the eurozone, French and Belgian regional issuers paid around 30bp-45bp on top of their sovereigns this year and the Spanish regions 20bp-30bp, according to GlobalCapital data. German Länder in recent months have come 60bp-70bp wider than Bunds. In dollars, five year Quebec bonds 25bp over the Canadian government.

Two self-governing British crown dependencies, the States of Jersey and the Isle of Man, were also highlighted, with both of their 30 year bonds trading around 70bp over Gilts. Jersey paid Gilts plus 100bpto print last year and Isle of Man offered Gilts plus 60bp in 2021.

Some also referred to issuers such as Network Rail and Catalonia, though others argued these would offer limited reference points given even their newest bonds and were almost a decade old.

“The question will be around comps," said one public sector bond banker. "There’ll undoubtedly be a diverse range of views on pricing, but it’s still very early days.”

Additional reporting by Georgie Lee.

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