Government Bonds: Are they about to make a come back?

1st September 2011

Thirty years and more ago, money pages carried adverts such as "Borough of Utopia – 4.5% fixed for three years – minimum £500" or "Paradise County Council – 5% fixed for five years – minimum £200."

For small investors, they were an alternative to National Savings (now NS&I)   or the local building society.

Then in the 1980s they disappeared – made redundant by changes in local government financing, the growth of corporate bonds and the then rampant inflation.

Now they could be due for a rebirth (as reported here on the website Inside Housing but councils be looking for investments in the millions, not slices of £200 or £500.

Why are local authority bonds back on the agenda?

Councils have not stopped borrowing. Instead of tapping investors, however, they've tended to go to the Treasury-backed Public Works Loans Board. Until recently, the PWLB lent to local authorities at around 15 to 20 basis points (0.15% to 0.20%) higher than the government's own borrowing costs.

This was cheaper than capital markets, avoiding issuing costs (important especially for the smaller authority) and the premium buyers would demand to reflect a perceived higher default risk.

But now, with the squeeze on local authority finance, the PWLB has increased the premium over government rates to 100 basis points (1.00%).

Additionally, councils face cuts in central government funding of a quarter before 2015 and extra council housing costs due to reductions in the Housing Revenue Account subsidy.

So it makes sense for councils to explore other financing avenues.

What's happening now?

Councils are talking to advisers. The most visible has been Wandsworth, the London borough that became a Thatcherite pin-up thanks to its zero poll tax rate – it still has a very low council tax.

But many others are also talking to banks and brokers. All focus on big institutions although any future offerings could appear in sterling bond funds including Isas.

Smaller councils especially realise it would make sense to issue bonds as part of a larger consortium, benefiting from economies of scale. Some authorities may only need £40m to £100m – banks reckon that costs soar at these levels and only councils needing £250m or more can go it alone.

So the Local Government Association is looking combining offerings from various authorities in a way that will satisfy investors' credit risk criteria. Many institutional investors, including bond funds, have already bought into regional and local government bonds in Europe and North America. So the concept is well rehearsed.

What will be issued?

Assuming the plans go forward, pricing becomes the main unknown.

Earlier this year, the Greater London Authority sold £600m of bonds to help finance Crossrail at around 80 basis points (0.80%) above UK government bonds.

This premium could be lower for the best rated local authorities. Purchasers will have to take currency risks and future interest rate moves into account as well as the creditworthiness of each issuer. Wandsworth is now near to issuing a £250m bond. These bonds will be traded much like gilts – and there should be nothing to prevent individual investors buying small tranches. With other bonds in the pipeline, the market will be in billions.

What are the risk factors?

A higher yield but backed by the triple A-rated UK government could be enticing. No UK authority – unlike some in the US – has ever defaulted so while the bonds will not be triple A, they won't be far off.

However, buyers will want guarantees that there will be no repetition of the Hammersmith and Fulham debacle nearly 25 years ago. This council lost millions betting with derivatives that interest rates would fall. Instead, they rose, leaving banks to pick up the losses. In a world awash with financial engineering, investors may be happiest with plain vanilla.


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