Sponsored Q&A: Jean Christophe and Edward Simons of pbb talk to Room151 about forward starting loans.
Q: Tell us about your recent activity as a lender to UK local authorities
Jean Christophe (JC): We are committed to the UK public sector market and last year increased resource in London with the addition of Edward to the team.
In terms of business, we have agreed two forward-starting loans to date — £20m with Midlothian and, more recently, £20m with Barnsley — and have a number of active discussions progressing with other English and Scottish local authorities. This indicates that we have a product of interest to the sector.
Q: Tell us about ‘forward-starting’ loans. How do they work and is the major benefit the interest rate hedge?
Edward Simons (ES): A forward-starting loan is simply a loan where the interest rate (typically fixed) is agreed up-front with a predetermined drawdown date.
The value to a council is locking in a fixed rate today but not having a negative cost of carry for the forward starting period — which is typically two to four years.
While the forward starting element is what drives a lot of the value, an additional benefit is pbb’s ability to tailor the repayment schedule to the borrower’s requirements. That can be helpful in matching cashflows to a particular project.
JC: In terms of value, we’ve been consistently providing indicative, fixed-rate pricing that is competitive with PWLB certainty rate for an equivalent structure — whether it is maturity, equal instalment payment or annuity.
Councils recognise the economic value of a forward-starting loan when compared to the fixed rate on the current — as well as the projected — PWLB certainty pricing for an equivalent structure. In addition, there is strategic value in managing a portion of the council’s future interest rate risk.
Q: Why does pbb believe there is growth in the UK market for specialised lenders, like pbb, in the public investment space?
ES: At the macro level, the metrics suggest plenty of opportunity for pbb — with over £7bn of PWLB loans maturing in the next three years and an intra-local authority lending market of over £10bn.
At the individual council level, we have been working our way through the recently approved treasury management strategies to identify local authorities that have a funding requirement over the next four years and meet our lending requirements.
For councils with PWLB maturities and/or funding requirements for capital expenditure over the next four years, a forward-starting loan allows the local authority to manage future interest rate risk while avoiding the negative cost of carry.
A forward starting loan enables a council to continue a strategy of internal borrowing and/or using short term debt — at least for the forward starting period — instead of borrowing in advance of need.
Current discussions with councils are focused on forward starting loans with long duration — 15 year maturity loans and 30 year amortising loans — and a range of repayment structures including equal instalment payments, annuity, tailored and maturity.
Q: What are the challenges you face?
ES: One challenge is getting engagement on what is a new product for most councils. However, with Midlothian and Barnsley, councils have two reference points to help with their assessment.
One of the great characteristics of the sector is the willingness to help by sharing information and experiences.
Another challenge we have is market conditions and how long current conditions might last.
Right now, I would describe conditions as benign. While there is frustration with the level of investment income that councils can generate on cash, the positive side of the coin is the historically low cost of debt.
Councils’ ability to borrow on a spot or forward-starting basis for long duration at sub-3% fixed rates represents economic and strategic value. That’s what is driving a lot of our activity at present — a sense of urgency. Ideally, I would not have councils telling me next year that they felt they had missed an opportunity in 2018.
Q: At £20m, the Midlothian and Barnsley loans are relatively small. How do you make that work for you and for the council?
JC: pbb is interested in developing long-term relationships with councils. £20m is the minimum ticket that we would consider for financing public investments.
Although the loan ticket size might be relatively small, our aim is to build up a portfolio over time. Having said that, we have expressed direct interest to select local authorities for up to £100m.
ES: One of the points we make to councils is that once you have done one transaction with pbb, you are familiar with our process and loan documents. That provides an opportunity to enter into further loans in the future — which is consistent with our relationship focus.
Q: How do you assess the risk of lending to UK councils?
JC: The bank has an independent and experienced credit risk team which assesses the risk assumed from each transaction with local authorities across Europe.
pbb makes use of internal credit risk models regulated and approved by the German financial regulator (BaFin) to assess and effectively score the credit risk assumed by each loan.
In addition to financial metrics, the analysis includes qualitative factors such as the local and national economic environment and demographics. Together these elements provide a “full picture” that is the basis for the bank’s credit decision.
ES: pbb has a very positive view on the UK local government sector, based on our analysis of the legislative and regulatory environment and recognition of its infrastructural importance. In general, our expectation is that the probability of default is low. However, we do not regard councils as an homogeneous group.
Q: What is pbb’s focus in the UK public sector?
ES: While our principal focus is — and will continue to be — on direct lending to local authorities, we are also monitoring the development and needs of the combined authorities.
We’re also following the progression in the national debate on housing and, with our London-based real estate colleagues, are looking at the emerging opportunity of lending to housing projects where our loans would benefit from the direct support of a local authority.
JC: We have substantial experience in lending to local authority regeneration and housing projects in France and Germany and are keen to develop opportunities in that space as it represents an opportunity for our two strategic businesses — public investment finance and real estate finance.
Jean Christophe is Head of Public Investment Finance at pbb Deutsche Pfandbriefbank.
Edward Simons is Director, Public Investment Finance in pbb London Branch
*pbb Deutsche Pfandbriefbank is a supporter of Room151.
