Treasury puts the bind on bonds

26 Apr 12

Mark Hellowell

Councils are keen on raising extra cash from the bond markets. But the Budget has undermined local initiatives

Councils own a large part of the country’s infrastructure and many of them have top credit ratings. So, selling bonds might provide a cheap way for them to get hold of much-needed capital. But the enthusiasm for bonds in town halls across the country is not shared in Whitehall – and the mandarins are fighting back.

The Local Government Association is consulting on plans to establish an agency that would raise up to £5bn a year from the capital markets and then lend the cash to councils. The plan came as a response to two Treasury decisions last year. First, the Public Works Loan Board rate was increased from 0.2% to 1% above gilts. Second, officials handed £28bn of Housing Revenue Account debt to local authorities, a liability that many planned to finance by issuing bonds.

But decisions announced in the 2012 Budget have undermined the LGA’s initiative. The Treasury views the prospect of a lively municipal bond market and the loss of Whitehall control over public borrowing with horror. To keep councils away from the capital markets, it will provide them with cheap loans to fund HRA debt, and those that can demonstrate strong balance sheets will be offered PWLB loans at a discount.

The Budget also flagged up the ‘potential’ for a new independent agency that will ‘facilitate the provision of PWLB lending at a further reduced rate’. This looks like an attempt to pre-empt the LGA’s move.

In the post-Budget context, it’s not easy to see how bond issues can provide a financial advantage for authorities. The ostensible point of the PWLB is to enable councils to benefit from the liquid and efficient market for government debt.
At present, UK gilts with a ten-year maturity have a gross redemption yield of just 2.4% – some way below the Retail Prices Index of 3.6%. Even local authorities that fail to qualify for the discounted PWLB rate will be able to borrow for the long-term at an interest rate that is negative in real terms.

Could council bonds ever match this rate? The New Local Government Network believes they can. In a recent report, the NLGN points to the experience of Transport for London, which issued £600m of bonds to improve the capital’s infrastructure. These were popular among big institutional investors willing to accept yields just above the gilt rate. But the issue took place in 2005 and 2006 at the height of the credit boom. Councils dealing with today’s bearish markets might not get such a good deal.

The NLGN’s preference is for bonds to be sold to retail investors, rather than fund managers. The logic is that retail bonds can be more flexible and provide more local ownership of capital projects. But, as the report recognises, the fragmentation of the demand for bonds would likely increase legal and advisory costs. Such costs are almost entirely absent from the PWLB, which charges fees of just 35 pence per £1,000 and agrees loans on the basis of a telephone call. Nor is it clear there would be much demand. A competitive deposit account currently offers an interest rate of about 3.5%. The deposit is as safe as gilts because it is guaranteed by central government up to a value of £85,000.

In contrast, a 1% premium on top of the five-year gilt rate (which the LGA and the NLGN believe is at the higher end of the likely yield on municipal bonds) implies an interest rate of only about 1.5%. Why would anyone buy such a bond when they could earn twice as much with a bank?

In the US, the municipal bond markets have been a popular savings route for individual investors, but many states are now struggling with indebtedness and declining credit ratings.

Ratings agency Standard and Poor’s pointed out recently that the strong rating enjoyed by local authorities in the UK is, in large part, a product of their borrowing constraints. Allowing councils off the fiscal leash might ‘reduce the predictability of [local and regional government] finances in the long term’ – and weaken creditworthiness.

Advocates of bond finance are in step with the move towards greater localism. But no national finance ministry likes giving up fiscal control, especially in a period of rapid deficit reduction. If pension funds do get involved in local investments, it will likely involve higher capital costs than bonds, but will limit the impact of investment on departmental budgets and the national debt. That seems to be the Treasury’s enduring concern.

Mark Hellowell is the PFI adviser to the Treasury select committee and a lecturer in health systems and public policy at the University of Edinburgh

This article first appeared in the May edition of Public Finance

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