The capital markets have traditionally been sources of finance limited to large corporates and central government. Local government now needs to think more broadly about their financing options to enable them to invest and fuel economic growth.
Local authorities are taking on new roles. Devolution is giving them the power to move beyond providing core services to help shape their communities’ future through large capital projects. These projects can regenerate areas and create economic growth while producing income, representing an exciting shift in focus.
New projects require new capital. Up until now local authorities have generally turned to the public works loan board (PWLB) for long-term financing. There’s no doubt that PWLB will continue to play a significant role in providing capital sums. But we believe that local authorities that want to raise sums for large projects should consider alternative sources. On their list should be listed bonds.
Bonds have a couple of advantages over PWLB finance: a basic, vanilla product in which authorities borrow at a given rate and repay over a given profile. A bond can be designed to more closely meet the issuing authority’s financing needs. This means there would be no need to over borrow simply to have the cash to service finance payments until the projects start generating income – something which often happens with PWLB financing.
Second, a bond’s repayment profile can better fit the capital project’s income profile. Initial repayments – those made during the construction period, before any income is generated – can be low, rising as the income needed to pay them off starts flowing in. If the bond is linked to inflation, an index-linked rise in financing costs should be offset by a similar index-linked rise in the income stream, providing a natural hedge.
Further, the current economic environment makes borrowing index linked financing to finance future growth attractive. Local authorities can expect to borrow at negative real interest rates, meaning they will pay a cost of capital less than future inflation over the life of the debt. It is unlikely these conditions will persist for long, presenting a window of opportunity.
A bond’s flexibility can come at a slight additional cost. But this cost needs to be assessed in the overall context of the project’s economic life, with any increase in finance charge weighed up against the benefits of using the bond. Government value-for-money tests are useful here in working out which is the better between different financing choices.
Local authorities need to look at speed and ease of raising finance too. Listing a bond is not as simple as accessing PWLB finance. A bond issuance needs time, money and effort. The process normally takes about four months, as opposed to a matter of weeks for PWLB finance. And any local authority considering issuing a bond should get advice and assistance from outside professionals.
Credit rating agencies expect increased reporting rigour from bond issuers. This reporting is public. Local authorities considering the bond route need to think very carefully about whether they will be comfortable with having a credit rating – a very public statement about their credit worthiness.
However, other non-cost factors make bonds attractive. Some local authorities are keen on the idea of raising finance directly from the market without having to rely on central government. This links with the devolution agenda – making authorities more self-sufficient in getting capital projects off the ground which they feel are the best placed to help their local economies and communities.
And a bond is not the only financial market option. Local authorities could look at direct arrangements with pension and insurance funds, so that these funds can help finance infrastructure in a region. This could work well on a localised level, matching the investor and the investee to fund projects that can generate economic opportunities and better meet local needs in the area. Because of the transaction costs and the time and effort involved, we believe that public bonds are an option mainly for local authorities wanting to borrow sums of £100m and more. But we do believe that bonds are a serious and feasible alternative that any authority wanting to raise these sorts of sums should consider, and in having announced additional borrowing powers for local authorities is his 2016 Autumn Statement, the chancellor seems to agree.
Today, local authorities have choices when raising capital finance. The bond option is achievable and can represent value for money, as our experience in advising clients has shown. Issuing a bond can better match finance costs with income streams and give good value for money over the life of a project. And getting the capital markets engaged in regional infrastructure can enable local authorities to play the greater role they have always wanted to in powering growth within their region – shaping the economic future of their communities.
Gwyn Llewelyn is a director in the Infrastructure Advisory Group at KPMG.