First rate

1 October 2012 Recent changes to the Public Works Loan Board rate have made bond financing less attractive for local authorities. But there’s still an interest in council credit ratings, reports Colin Leopold
It must be have been frustrating for the finance director at Wandsworth London Borough Council this year. Having got all the council’s documents in order ahead of getting its first credit rating last November, subsequent changes at the Treasury have meant that the Public Works Loan Board (PWLB) would lend at close to the base rate, making it a cheaper option than any bond issue.

A statement from Wandsworth at the time said its triple-A rating would make it “easier and cheaper” to raise funds from the money markets to finance big capital projects. But nearly a year later, there has been little bond financing activity from any of the six councils in the country with a rating.

“It is not necessarily the cheapest way to fund the public sector if all city mayors go out and do their own funding, compared to a scenario where the Treasury raises funds centrally and passes them on through the PWLB,” says Georg Grodzki, head of credit research at Legal & General Investment Management.

So was the cost and time to secure a higher rating than the likes of Spain or Italy a waste of time?

“Wandsworth are very ahead of the game,” says Luke Reeve, partner at Ernst & Young. “The finance director was very educated in the bond market. The interesting question is – is it cheaper to raise money from the PWLB? The public bond market moves. Had we been speaking a year ago it would have been cheaper in the public bond market.”

One analyst insists the move was more of a “diversification [strategy] and made deep financial sense”.

Local authorities have been increasingly incentivised to take control of their own sources of funding. Also, institutional investors have restrictions on how much unrated bond finance they can hold. It may make sense in the long run for councils to have a rating, but how will they actually use them?

“Overall, you’re going to see a lot more bond financing full stop because banks are still trying to reduce balance sheets,” says Reeve. “Basel III requirements are hammering banks also.” The key issue in the short-term is the PWLB rate. There have been around six changes to it over the last three years.

Chancellor George Osborne announced in this year’s Budget that he would reduce the rate this year by 20 basis points to 0.8% above gilts. This chopping and changing has made things “very awkward” for councils, said Mark Luntley, the Local Government Association’s (LGA) programme director for finance, earlier this year.

Councils typically borrow £5bn annually over a 20-year average duration. So the 2010 rise in the PWLB rate to 1% above government gilts increased total borrowing costs by £1bn. No wonder bond financing seemed attractive.

“There were many years when people knew the name of the game with the PWLB and it was a stable and reliable source of funding. But that’s been brought into question over the last few years by the frequent rule changes,” says Martin Easton, senior finance manager at Birmingham City Council, which achieved a triple-A rating just before Wandsworth.

Further reductions in the PWLB rate, based on an authority’s capital performance, have also been proposed but there has been little progress on that, according to Easton. Should central government change its pricing on the PWLB there may be a number of authorities coming back to the ratings agencies or issuing on their own on the bond market. Are more PWLB changes likely?

“Our baseline scenario sees a relatively low probability of rapid change in the rate of the PWLB,” says Nicolas Fintzel, an analyst at Moody’s. “However, last September, to support the Housing Revenue Account reform, the UK central government did lower the PWLB rate for local authorities quite quickly [so] we can’t exclude that happening again.”

If the PWLB rate remains competitive, there may still be merit in having a rating. The LGA is currently looking at setting up a collective vehicle that would issue rated bonds to benefit smaller authorities. As it’s not economical for someone to issue a bond for less than £100m it can make sense to set up a special purpose vehicle to issue larger bonds and then make a number of smaller loans from the proceeds.

“If a council wanted to borrow, say, £250,000 then they could do that,” said Luntley earlier in the year. “Where we would probably differentiate in the early days is that we’re likely to look more at funding for the longer-term rather than short-term money. So we’d be looking at 15, 20 or even 30 year money, say.”

“The most interesting game in town is the LGA collective vehicle,” says Easton. “It’s possible that similar types of authority may club together to have vehicles. There is a real advantage in pooling everything together and there are precedents in other countries which have been working well for years and with housing associations.”

The Greater London Assembly and Transport for London (TFL) have also shown over the past year that accessing the bond markets for infrastructure financing may still yield results. They went out to the markets in July last year seeking £600m for the Crossrail project, and this has given confidence to Birmingham and others.

“It’s not just the cheapness, it’s diversifying the sources of borrowing,” says Easton. “If we don’t know what the PWLB rules are going to be like next year then it makes sense to have other sources of funding and that was our main objective in getting the credit rating – to use a bond issue or, in the short-term, commercial paper.”

The question now is do councils want that diverse source of funds, or are they happy in having a near monopoly of supply in the shape of the PWLB?

“It is very positive for the sector when you’ve got places like Birmingham getting a triple-A rating that shows how local authorities have been able to manage their finances and the potential of their plans going forward,” says Joe Manning, senior researcher at the New Local Government Network.

There may also be a benefit on a project-by- project basis. Manning believes a strong rating may help councils negotiate preferential terms on a project and bring in some private money in a way other than bonds.

“A number of clients find ratings useful for internal purposes to provide an independent view of the creditworthiness of an organisation, and to give a different perspective on benchmarking international peers,” says Fintzel.

“[Our] two top quality ratings can be significant reassurance to our partners,” agrees Easton. “The broader advantages of ratings are quite significant in encouraging partners’ participation and getting the best value out of deals. It’s good PR as well, promoting Birmingham internationally.”

While many smaller authorities may not need or be able to afford the international exposure that a rating can give, the LGA’s model and the trend towards a collective vehicle may prove useful.

Until then the demand for the bond market will remain “a function of the relative pricing of the PWLB as well as managers’ appetite to diversify their lending base”, says Hugo Foxwood, associate director at Standard & Poor’s.

“We’ve had many local authorities reach out to us but the bottom line is they’re only going to look at ratings and bonds if it becomes cheaper than other forms of funding,” says another analyst. “The more progressive ones [may] like to have the option”.

This page was last updated on:
3 December 2012.

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