With Gilt yields at historical lows and institutional investors craving returns, bankers agree that there has rarely been a better time for the UK’s public sector borrowers to tap the bond markets.
“Investors need high quality bonds, so there is a welcoming market for any form of surrogate government credit that offers a bit of yield pick-up,” says Lee Cumbes, head of public sector EMEA at Barclays in London.
Issuance from the sector, however, remains lacklustre — particularly in the public market. Network Rail, previously a reliable source of regular benchmark bonds in both sterling and dollars, has been absent from the market since February 2015 following a reclassification of its debt.
The sector’s only other semi-regular borrower, Transport for London, has a funding requirement of less than £1bn a year and has also been inactive since last April. Benchmark issuance by government-related credits over the past 12 months has been limited to three universities and two housing associations.
Metropolitan Housing Trust and London & Quadrant (L&Q) sold £250m 30 year deals in September and October, respectively. The University of Liverpool went even longer for its 40 year £250m market debut last June — an example that was followed by its peers in Cardiff and Leeds, with 40 year and 35 year deals, respectively, in February .
All five deals received a warm welcome from investors, despite challenging market conditions. Bankers, however, were less enthused, noting that none of the names in question are likely to provide the regular supply currently lacking in the market.
L&Q, the largest and most active of the housing associations, has tapped the bond market just three times in the past 10 years. Francis Burkitt, a senior debt advisory managing director at Rothschild in London, says potential supply from the university sector is also limited.
“There’s a maximum of about 10 more universities that are large enough to come to the public markets,” he says. “Most of them will only issue one public bond each and the bonds are very long-dated, so they won’t have refinancing needs any time soon. We might see one or two deals a year but the sector is not going to be very active.”
The emergence of a new public sector borrower with a potentially substantial annual funding requirement has therefore attracted considerable interest from bankers and investors alike.
Modelled on Scandinavian entities such as Municipality Finance and Kommunalbanken, the Municipal Bond Agency (MBA) was set up in 2014 to provide cheap funding to UK local authorities via the public bond markets.
The agency plans to act as an aggregator for its shareholders, which will be jointly and severally liable for its debt. So far, 56 out of 326 local authorities in England have signed up to the scheme. Scottish, Welsh and Northern Irish councils are currently not eligible to join.
The consensus among market participants is that issuance by the agency would be strongly supported by investors. “There will definitely be demand for MBA paper,” says Ulrik Ross, global head of public sector and sustainable financing at HSBC in London. “Plenty of investors are
looking for safe haven paper right now and the whole SSA space has been having a very good reception in the market.”
Cumbes agrees, noting that the prospect of regular issuance would be particularly attractive for large public sector investors. “There is definitely a place in the market for the MBA,” he says. “Big investors tend to want to see a certain amount of liquidity in bonds and ideally an expectation of some frequency of issuance, in order to justify the credit work and setting up sizeable lines.”
As chief executive Aidan Brady notes, MBA has the potential to be a very regular issuer. “Local authorities in England borrowed more than £500m in February and typically borrow £3bn-£5bn annually,” he says.
There is widespread scepticism, however, about MBA’s ability to channel this borrowing through the public bond markets.
Bankers note that the agency’s inaugural bond issue has already been subject to repeated delays. It was originally scheduled for early last year but will now not emerge before the end of June, according to Brady.
Merrick Cockell, the agency’s chairman, blames the delays on the complexity of its structure. “We are not a new brand of water or detergent,” he says. “This is a very complex organisation and the stages we have had to go through have been more complicated than we originally expected.”
Reports suggest that one of the major stumbling blocks for councils has been securing approval for the joint and several liability clause. So far, only Cambridgeshire and Southampton have adopted the agency’s framework.
“From a council perspective, how do you as a politician in Hampshire explain that you’ve guaranteed the debt of the residents of Suffolk?” says a UK public sector banker. “Local authorities don’t have tax raising powers so if they have to bail out a bankrupt council they will have to cut basic services.
“If I was a councillor and could save 5bp through the MBA but had to take the risk of guaranteeing other councils to do so, I wouldn’t do it.”
Bankers also question whether the MBA will in fact be able to offer local authorities funding at lower rates than are currently available via the Public Works Loans Board (PWLB).
“It will all depend on what rating they can achieve,” says one. “We are hearing from the rating agencies that they are not as convinced by the UK model as by the Scandinavian ones, where local authorities work more closely with each other and with central government.”
The MBA has received a rating but has not made it public. Brady says it will remain private until a debut bond issue is imminent.
He insists that the agency expects to be competitive over time with other sources of financing. However, he admits that at present public bonds are more expensive than any other form of funding for local authorities.
Alex Pilato, chief executive of London-based public sector debt advisory specialist TradeRisks, argues that many local authorities will in any case be able to raise bond market funding more efficiently on an individual basis than through the MBA.
“For funding requirements of less than £30m an aggregator may be useful but for larger deals we don’t believe there is a need for legal aggregation,” he says. “As a local authority, if you can go to market on your own you can structure the deal to your and the investors’ specific requirements. If you do it through an aggregator you are much more limited in what you can achieve.”
Pilato also challenges the idea that institutional investors’ preferences are skewed towards large, liquid public bond issues. “Liquidity is a priority for fund managers but increasingly the ultimate investors have taken a greater interest in the selection of assets,” he says.
He notes that investments of £150m-£200m by a single party are now not unusual. “Many insurers won’t bother bidding for a small amount so you get better pricing when they are bidding for an entire issue or half an issue,” he adds.
A rare £200m inflation-linked bond sold by Greater London Authority (GLA) in May 2015 was bought by a sole investor, pensions insurer Rothesay Life.
Cumbes acknowledges that private placements can be cost-effective for some issuers. “For borrowers with moderate or one-off funding requirements it can be quicker and, as you are effectively tailoring a deal for the specific needs of a small investor group, they may well pay for that privilege,” he says.
Bankers note that UK public sector borrowers also benefit from strong demand from the US, as well as from domestic accounts. “US investors have traditionally been heavy buyers of private placements and at present they can be competitive in sterling deals because the cross-currency swap is working for them,” says one.
In December, a £60m 30 year bond from Guy’s and St Thomas’s Charity was bought by US life insurer MetLife.
At Rothschild, which arranged the note, Burkitt is optimistic about the outlook for further private deals from government-related borrowers. “We could see quite a lot more activity on the private placement side from other universities, charities, housing associations, etc,” he says.
Burkitt is less hopeful about the prospects for public benchmarks. “The public market is unlikely to see vast amounts of issuance in the near future from UK public sector borrowers,” he says.
He adds the situation with local authorities “will likely be binary”.
He explains: “Either they will continue to borrow through the PWLB, in which case none of them will be active in the bond markets with the possible exception of one or two of the largest and most creditworthy, or the idea of a municipal bond market will get off the ground, in which case we might see quite a few deals,” he says.
Apart from the GLA, only one other local authority in England has issued a bond in the past decade. Warrington Borough Council sold a £150m inflation linker last August.
HSBC’s Ross is sceptical of claims that such deals will continue to be cost-effective for local authorities once the MBA is up and running. “If the MBA can offer liquidity in the market with a strong rating — potentially stronger collectively than for the many individual local authorities — that should be able to be competitive with what the local authorities can achieve in the private placement market.”
He adds that he is “very optimistic” about the agency. “We expect them to be a sought-after issuer, offering high quality paper with liquidity. This is something sterling investors have been starved of recently as other SSA issuers have traditionally focused on the very short end after the halt of Network Rail government guaranteed issuance.”