Local authorities are being offered income strip and inflation linked debt by an increasing number of institutions. While these deals may appear to have a low initial cost, we highlight below five issues to consider and examine why some authorities are choosing to exit these deals early.
Net inflation exposure: A typical income strip deal, or inflation linked debt, is often sold on the basis that inflation linked payments will correlate with revenue streams on underlying assets or projects. However, we encourage authorities to consider their broader net exposure to rates and the reliability of projections on indexed linked revenues. For example, social housing rents will not always match inflation and weaker demand for car parking and retail outlets can lead to revenue streams that fall short of expectations. While the risk of higher costs can be limited using an inflation collar, often provided with a cap of 5% and a floor at 0%, this still represents funding with a wide range of uncertainty.
Increasing debt obligations: The principal on index linked debt will typically increase over time, with interest payments linked to this inflating notional amount. This could have implications for regulation, treasury management controls and the proportionality of debt.
Accounting treatment: Arlingclose has reviewed some income strips where auditors have insisted the instrument is treated as an inflation linked loan. This requires the borrower to remeasure the present value of the loan each year, based on implied market inflation expectations, and apply an effective interest rate. This can mean costs in the early years that are well above contractual cash payments, with lower revenue charges towards the end of the agreement.
Added complexity: Transactions are often complex with features such as inflation collars, the sale and leaseback of property, and local authority guarantees. This can make it hard to compare these products to conventional debt; the pricing can also be opaque and based on unconventional assumptions on future inflation. Income strip arrangements can have additional favourable attributes, including the transfer of construction risk and delivery of outcomes on property development or new housing. However, the borrower will need to undertake option appraisals on the most appropriate funding and delivery model.
Lender margin: Behind most deals will be a pension or insurance fund seeking a long-term index linked income stream from a highly rated institution, supported by central government, with a significant margin over gilt yields. Margins are likely to be well above alternative funding such as the Public Works Loan Board Housing Rate or UK Infrastructure Bank loans, both currently at gilt yields plus 40 basis points.
With the above in mind, Arlingclose recommend careful due diligence and option appraisal before entering these transactions. Following the recent surge in inflation, some authorities that have undertaken income strips or indexed linked debt are finding cost are much higher than projected.
However, there may be scope to exit these deals early. The recent increase in both indexed linked gilt yields and local authority credit spreads make it possible to refinance these transactions, removing many of the issues identified above. Arlingclose has recently advised a local authority on the refinancing of an income strip deal, securing a favourable settlement, removing uncertainty, and allowing the Council to regain control of a key town centre asset.
If you would like to discuss opportunities to refinance existing debt deals or need independent advice on assessing proposals, please contact us.
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