The UK Treasury’s decision to raise the cost of borrowing for local authorities has caused quite a stir in private placement markets, as players realise institutional investors are prepared to offer debt at more attractive rates than the Public Works Loan Board (PWLB). But the more adventurous local authorities may find capital markets a tougher pitch to play on, writes Silas Brown.
Capital markets have long been unattractive funding arenas for UK local authorities as the PWLB — a government body that provides loans from the National Loans Fund to public bodies — has offered lending levels that capital markets could not compete with.
But this obstacle was at least temporarily removed when the Treasury announced on October 9 that the PWLB would immediately increase its lending margins to local authorities from 80bp over Gilts to 180bp — a level as much as 80bp more expensive than where sources say they could raise private debt.
The rate hike was met with a cocktail of shock and excitement from those in the US private placement market, many of whom have had a keen eye on the UK’s local councils for some time.
“We had several inbound enquiries from intermediaries for local authorities to use our market after the announcement,” said a US institutional investor in London. “In a very obvious sense the private placement market is a good fit for local authorities, as they more often than not want long-term debt that’s sub-benchmark [size, which bond markets might struggle to accommodate].”
Institutional investors have flirted with the prospect of funding local authorities before, but could never be tempted to the level of 80bp over Gilts offered by the PWLB. Last year Birmingham City Council, for example, alongside an arranging bank, approached US PP investors, according to a senior USPP investor from a UK institution.
“Everything made sense — credit quality, risk and maturity — until it came to the price,” said the investor. “They wanted pricing comparable to the PWLB, which we just could not do.”
Agents thought a way to tempt local authorities to stray from the tight levels of the PWLB could be the delayed draw function in the USPP market, where a borrower can lock in pricing levels but not draw the money for a certain period — typically six months to a year.
“We could bring USPP investors to around 100bp for high quality UK local authorities,” said a USPP agent. “Then it was trying to convince the councils that six month or one year delayed funding was worth the premium.”
But this touchy negotiation has turned to dust following the Treasury announcement.
On the news that PWLB is increasing its margin, the agent added: “I got an email from a local authority I met two months ago this week, which said it had raised £250m from the PWLB this year but was looking for funding for future capital expenditure. I wouldn’t have got that before the rules changed. This is clearly exciting, but there’s still a great deal of uncertainty and lack of understanding about the sector — and I’m not sure the local authorities are ready to be scrutinised by private investors.”
The Treasury indicated the margin increase was because “some local authorities have substantially increased their use of the PWLB in recent months, as the cost of borrowing has fallen to record lows.”
In August and September local authorities borrowed £2bn and £1.6bn respectively — the first and second highest months of debt raising on record.
Years of austerity and budget cuts from successive Conservative governments have forced councils to look further afield for new sources of income.
Councils have been acquiring land and buildings at a quickening rate, for example. According to data from the Ministry of Housing, Communities and Local Government, councils invested £4.43bn in the financial year to March 2019, which is up 8% from £4.1bn the year before that. That in turn was up from £2.92bn the year before.
There are some local councils with particularly ambitious programmes. Spelthorne has raised roughly £1bn from the PWLB in the past three years to buy commercial real estate among other things. In its accounts for last year, the chief financial officer wrote that the council’s funding programme is financed in part by the acquisition of commercial income generating assets, which was financed by borrowing from the PWLB in the form of low fixed rate loans.
Spelthorne’s income from rental properties for 2018/19 was £39.6m, compared with the £18.8m interest it is paying on its borrowing. Spelthorne in its accounts states that its strategy to acquire real estate and rent it is to generate “investment income to offset loss of government grant funding”.
Spelthorne is by no means alone in employing this strategy. As another example, Warrington has lent money to housing associations from £800m of debt it borrowed from the PWLB.
Moody’s said on October 15 that the rate hike will be “credit negative” for UK local authorities, simply because borrowing will become more expensive, but it also said it may dissuade councils from buying commercial real estate, which the rating agency considers risky for local authorities.
It’s grim up north
Indeed, there are examples of local authorities’ funding strategies going seriously awry, which may serve as useful guidance for institutional investors on not only governance in local councils but also UK government responses to mismanagement.
The Conservative-led Northamptonshire County Council took this cost cutting exercise as an opportunity to lead the way in rebranding when it had to make roughly £376m of savings between 2010 and 2018.
Hailed by many in the Conservative central government as illustrative of the next generation of local authorities, Northamptonshire outsourced many of the essential services a council would usually carry out — even elderly care and child protection — to mutual companies and social enterprises, as well as private companies.
But according to The Guardian, Northamptonshire spent more than £50m on management consultants and branding specialists to spearhead a new look for local councils, becoming a body that displays the characteristics of a company rather than those of a traditional council. In February last year, the council issued a section 114 notice — an official admission that it did not have the resources to meet its financial obligations, becoming the first council in several decades to become effectively bankrupt.
By November 2018, the government permitted Northamptonshire CC to use roughly £60m it gained from selling its headquarters to fund day-to-day services. This is typically against accounting rules for local authorities that prevent them from using capital receipts on daily services, but meant the government could avoid bailing out the authority directly.
“The Northamptonshire problems were serious in two respects: one, it showed that councils can get into trouble. But two, it showed the government was only half there to help. Councils that have a chance in institutional debt markets will need to be much stronger than that,” said another agent.
That episode will have knock-on effects for how investors view the UK’s local governments as credits. One investor from a US institution said: “The big judgement for us is whether to see local authorities as quasi-governmental or not. And, crucially, whether councils are well managed enough to work through proper funding strategies.
“Institutional investors are not just going to rubber-stamp borrowing, and allow councils to invest in ludicrous commercial real estate schemes. Local authorities will have to go through a rigorous process with much more disclosure and explanation to get money from us. Some are capable of this, clearly, and others are not.”
Of the eight private placement participants interviewed for this story, every single one thought that the PWLB rate hike will generate serious talks between investors and appropriate councils, ready for the market.
Starters for 10
Councils that have been floated by market participants are Birmingham, Camden, Royal Borough of Kensington and Chelsea, Manchester and Westminster, among others, but in some respects, the market has already seen its first widely marketed UK local authority.
The City of London via the Corporation’s endowment fund sold £450m US private placement notes in July via Lloyds and Santander. According to one source close to the deal, the transaction was sold below 100bp over Gilts, mostly to UK institutions.
“City of London is obviously a special case but it put local authorities on the map for sure,” said one agent from a UK bank. “It also maybe showed that UK institutions will be first to commit to this new UK asset class.”
Four institutional investors interviewed said pricing for appropriate local authorities — depending on credit quality and tenor in particular — would range roughly from 100bp to 150bp over Gilts. But two of them, from US institutions, said it would be harder for them to understand the credit quality.
“We have municipal bonds in the US so as institutions we understand local authority debt — but it’s quite different here,” one said. “If it has a strong recognition, like Westminster or Kensington and Chelsea, and it has high quality assets, I think it’s certain to get funds. With regional councils it’s a bit more work — but we’re prepared to do it over time.”
But most accept there’s a way to go for the market to get used to the councils, and vice versa.
One agent from a UK bank said: “Make whole clauses — who is going to educate local authorities on that? We are a while away on documentation and disclosure... they have been able to borrow on an easy basis, but our market’s different.”