Assessing local government borrowing options

23 Jul 18

With questions being asked about the future of the Public Works Loan Board, PF takes a look at some of the other ways local authorities can raise funds.

Borrowing money

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With councils under extreme financial pressure, there is a renewed focus on commercialisation to bolster funds.

The reliable and ever-present Public Works Loan Board remains popular with local authorities that are looking to invest in capital projects. And while the government plans to dissolve the board, its lending functions will be continued by the Treasury.

This may be the end of the PWLB in name only, but begs the question: if this option were off the table, how else could local authorities fund capital projects?

The PWLB has long been the go-to option for councils looking to borrow for capital projects – as of 2015, it provided 75% of local authority borrowing, according the Treasury.

But as councils become more commercial – seeking new ways to raise funds as grants are cut and expected to become more self-financing by 2020-21 – there is a concern that PWLB loans will no longer be a suitable way of funding investments.

There has already been some suspicion that too many PWLB loans are being ploughed into the commercial property market, with a private member’s bill being laid before parliament to constrain this.

Spelthorne Borough Council raised eyebrows when it invested in a business park in Sunbury-on-Thames worth £360m by taking out 50 separate PWLB loans – a record commercial property investment by a council.

Some councils are keen to pay back loans to the PWLB to take advantage of more favourable market interest rates, but due to a rule change in 2007 they are having to pay higher early repayment fees.

The private member’s bill, sponsored by Conservative MP Sir Christopher Chope, will have its second reading on 26 October. It proposes that “no local authority in England may borrow from the PWLB for the purposes of commercial property acquisition or other purposes beyond the scope of the statutory duties of that local authority”.

The bill could turn out to be merely a talking point – but it may highlight a wider trend of changing attitudes towards local government finance.

PF takes a look the potential options for councils considering straying from the PWLB’s well-trodden path.

Rise of the council bond?

Local authorities could turn to bonds as a way of financing capital projects, especially with the UK Municipal Bonds Agency (UKMBA) due to begin issuing soon.

Don Peebles, head of policy and technical at CIPFA, tells PF that council bonds were popular about 25 to 30 years ago, fell out of favour, but might be on the verge of a comeback.

“It’s an option that has always been there, probably for about 25 to 30 years and it fell out of favour primarily because finance was plentiful through PWLB and there was an availability of other debt products, whereas the profile of bonds tended to be that they were small value,” he explains.  

Councils previously issued bonds directly without an intermediary body like the UKMBA – which has received backing from 56 local authorities since its inception in 2014.  

Christian Wall, director at PFM Advisors UK Limited and member of UKMBA’s executive team, sees potential for a renaissance in bonds.

“There ought to be a resurgence,” he says, “there’s not enough debate about the PWLB.”

Wall claims that the PWLB may not always represent the best value, especially when considering the board’s high early repayment penalties. He believes lower interest rates could be available through bonds.

“We see no reason why local authorities cannot obtain interest rates in the capital markets that are significantly below those of the PWLB’s certainty rate.

“We do not believe that the certainty rate in any way represents the ‘market rate’ for local authority debt; it is an arbitrary rate determined by the government,” he adds.

Aidan Brady, chief executive of the UKMBA, agrees and expects the organisation to overtake the PWLB when it begins issuing bonds.

“I think the PWLB will stay as the predominant lender to councils pending the UKMBA taking off, in which case I suspect the UKMBA will surpass the PWLB in due course,” he says confidently.  

“Getting a lower headline rate than the PWLB will be the main reason for councils considering bonds”.

The agency, created in 2014 by the Local Government Association to reduce councils’ capital costs over the long term, has been buoyed by an Aa3 credit rating from Moody’s and is due to get down to business soon.

Brady also points to the advantage of councils having a diverse borrowing portfolio.

“Simply by broadening out your investor base you are mitigating the risk of the PWLB changing [it’s early repayment rates]. The PWLB can change how it operates, so you are mitigating that risk.” 

Recent high-profile examples of councils issuing bonds include the “Brummie bonds” of 2017 in which Birmingham City Council borrowed £45m from the private sector to build housing in the city.

Aberdeen City Council’s successful issuing of a £415m bond allowed the council to build the Aberdeen Arena & Conference Centre and was recognised at the 2017 PF Innovation Awards.

Forward-starting loans

Forward-starting loans have seen an increased uptake in the last year and provide certainty to local authorities on the cost of future capital spending. 

Borrowers pay a premium over the PWLB’s certainty rate, but they are guaranteed a fixed interest rate with a pre-determined drawdown rate and can agree a sum to be borrowed on a pre-determined future date.

Midlothian Council and Barnsley Metropolitan Borough Council, have led the way on these, borrowing £20m each.

Edward Simons of Deutsche Pfandbriefbank – which issued the loans to Barnsley and Midlothian – says that there is “a lack of familiarity with the product”.

However, he is optimistic about the future uptake of these deals and says: “People are attracted to the ability to forward start and lock in a rate which is still sub 3%.”

Forward-starting loans have been issued in the past by the European Investment Bank, and Simons is hopeful that these deals will provide a reference point for authorities interested in them.

“This is not a new product. The EIB, in terms of supporting infrastructure type projects, as I understand it, has been very active in both public sector and things like universities.”

As Pfandbriefbank puts it on their website “[the loans] provide certainty to local authorities on the financing cost of future capital expenditure.”

LOBOphobia?

Certainty is a rare commodity in local government finance, and this has been epitomised by the recent scrutiny of Lender Option–Borrower Option (LOBO) loans.

LOBOs’ popularity spiked in the wake of the financial crash and continued to grow as the then chancellor George Osborne raised the interest rate offered to councils by the PWLB in 2010.

According to Debt Resistance UK, which campaigns against what it calls the “debt economy” and to highlight “predatory and exploitative lending practices” some councils are facing interest rates of 7-9% on their LOBOs. In 2015, Channel 4 Dispatches found that around 240 local authorities have taken up to £15bn in these loans. 

The consensus is that at the height of their popularity in the late 2000s, these loans were not particularly risky, as their value relied heavily on interest rates – which stood at 1.5% in January 2009 – rising.

Peebles says: “If you look at the wider context at that time, you can see that actually, without knowing the detail of the products, they probably made sense.”

But in recent years, the complexities of some of the loans have come to the fore, making them less appealing.

It was recently revealed that 14 English councils were suing Barclays bank over some LOBOs it had issued, claiming that the loans were fraudulent as its traders had been rigging Libor (the interest rate at which banks offer to lend funds to one another in the international interbank market).

LOBOs mean that the rate of interest on the loan would fall if long-term interest rates rose, and vice versa.

However, since they became popular, interest rates have fallen to record lows and stayed there, leaving councils paying out millions.

The loans also allow lenders to change rates at set times in the future. Refusing to pay updated interest rates would mean councils are forced to pay back the loan in full.

Wall says that not all LOBOs are problematic, but adds: “There are some very toxic LOBOs and they are complicated in the extreme.”

In some cases, Wall says, the decision to take out LOBOs was “taken by people who do not know enough to ask the right questions.”

Joel Benjamin of Debt Resistance UK shares the view that not all LOBO commitments were well informed.

“Banks created a complicated financial product with punitive one-sided terms, which few council finance professionals (if honest) fully understand,” he alleges.

Peebles says that CIPFA is committed to gathering more data and information about LOBOs in order to become better informed about the issues with the loans.

What’s mine is yours

For councils looking to avoid the perceived risk around LOBOs, inter-authority lending may well appeal as a low-risk strategy.

This method, Wall says is “mutually beneficial” for both lending and borrowing councils.

This is because lenders should benefit from the higher credit quality that local authorities offer, while borrowers get a rate preferable to other sources like the PWLB.

Peebles agrees that this is a safe option, but adds the caveat that “we can just reflect on the last few months and on a local authority [Northamptonshire] who probably would have, with hindsight, represented a credit risk.”

He believes local authorities must try to gain a deeper understanding of the financial position of the counterparts seeking to borrow from them.

To facilitate this, CIPFA is proposing an index of local authorities to identify the extent to which they can be financially resilient.

However, while low risk, inter-authority lending has its disadvantages.

For the councils who have the funds to lend it can be time-consuming dealing with regular proposals from other authorities.

“Local government should not be a passive recipient of government austerity,” Benjamin proclaims.

Few in the sector would disagree with this statement, but finding value for money while mitigating risk is becoming increasingly difficult. Now more than ever, councils must take a broad view.

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