Municipal bonds will cut borrowing costs says LGA Report

Municipal bonds could lower the cost of local government funding, introduce an element of competition and reduce dependency on traditional sources of finance, says a Local Government Association (LGA) commissioned report.

The LGA calls for the creation of a UK municipal bonds agency: It says the Public Loans Works Board (PWLB) accounts for 75% of long-term local authority borrowing (£63.4bn in March 2013), while banks and financial institutions make up the second largest source with 13% (£11.4bn).

However, changes in PWLB rules and increasing pressure on bank profit margins make both sources of finance increasingly expensive, and the LGA is looking for an alternative model.

Even small interest rate changes can have a considerable impact when loan repayment periods are spread out over lengthy periods. Changes of less than 1% are normally expressed in basis points (bps), or in fractions of 100. For example, a change of 0.5% is equivalent to 50bps, etc.

This is an important point, because in October 2010, PWLB began charging a 1% (100bps) margin over Gilts (UK government bonds with over one year’s maturity) on its advances to local authorities. In November 2012 this was reduced to 80bps – partly in response to reaction from the LGA and other public bodies -and is known as the Certainty Rate, and which now accounts for around 98% of all PWLB advances. A further reduction to 60bps took place in November 2013, but only for Local Enterprise Partnership nominated infrastructure projects (the Project Rate).

The LGA believes that a collective municipal bonds agency would not only narrow the Gilts-PWLB gap, but give local authorities more financial control over their own affairs:

“It is wrong that businesses and communities around the country should always have to form an orderly queue at the Treasury’s door to look for permission to finance their projects. If they have a business case they can convince investors about, they should be able to raise the capital they need without ministers or officials needing to be involved,” says LGA chairman, Sir Merrick Cockell.

The LGA business case is based on using joint and several guarantees (where councils guarantee each other’s debts) to attract AAA-sovereign like credit rating status from the main credit rating agencies in order to make their bond issues attractive to would be investors. It could lead to a reduction in borrowing costs of between 20 and 25bps below the PWLB rate: “On a £100m loan, this equates to savings of £200,000 to £250,000 per annum, or £6m to £7.5m over the life of a 30 year loan,” the report maintains.

Only the GLA and TfL have issued local authority bonds in the last few years, but this has been done on an individual, not a collective basis. However, this gives something to go on and is the next best thing to make comparisons with:

TfL (which has an Aa2/AA+/AA credit rating) raised £2bn in five successive bond issues of varying maturities in 2012 and 2013, successively driving down the costs on each stage from 98bps to 58bps over the going Gilts (G) rate. It subsequently issued (March 2014) a 50 year £370m bond issue at G+55bps.

This compares with Network Rail’s G+29bps for a £1.250bn bond with a 2035 maturity date. Now that the fiction that NR is an independent company has been dispensed with – it was recently brought within the government’s financial remit -the organisation enjoys access to cheaper (if not cheap) money and currently boasts an Aa1/AAA/AA+ credit rating.

The LGA believes a collective municipal bonds agency could raise £2bn within its first three years, and become self-sufficient during the same time; it could support loans to over 70 local authorities and account for around one quarter of annual local authority funding. Launch costs are put at around £8-£10m. The scheme would be administered by a board of directors and local authorities (and other public bodies), who would hold shareholdings in the organisation.

The report says similar schemes have been used in Sweden and Finland and have been successful.

However, the LGA also acknowledges the risks involved: the PWLB-Gilts margin may be reduced to make such an agency unnecessary; not enough LAs may back the scheme; and the bonds may not entice investors. Even if the PWLB-Gilts gap disappears altogether, there is another problem; Gilts have enjoyed nearly record low yields at around 4% over the last decade, but are expected to rise sharply during the year due to the economic upturn. That would increase borrowing costs regardless of the financial model used.

 

LGA Report

The UK Municipal Bonds Agency: Establishment of a Local Government Collective Agency for the issue of Local Authority Bonds

645/Apr 14

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