Commercial Paper: Short term funding for the long term? David Blake

As rolling local authority loans becomes a mainstay of funding strategies, treasury managers are starting to plan for the longer term to ensure this approach remains cost effective and low risk. Commercial paper could unlock the potential to double the funding pool available to local authorities borrowing at the short end of the yield curve.

Over 70 local authorities now have short term debt portfolios in excess of £50 million and are reaping the benefits of cheap, flexible funding. As authorities become more reliant on this type of rolling debt, exposure to interest rate and refinancing risk has increased. While this is largely mitigated by ready access to the Public Works Loan Board, an excellent backup facility allowing quick switches into long-term debt, rates are typically 80 basis points above short-term local authority levels and the shortest duration available is one year.

In order to help authorities manage risk and provide an alternative source of low cost funding, Arlingclose has partnered with the MBA to develop a short term loan product backed by commercial paper, available to English local authorities in the first instance.

Perhaps the first question local authorities will ask is why bother? The LA-to-LA market is currently flooded with liquidity, yields are extremely low and there is an efficient route to market by traditional voice brokers or low cost trading platforms. However, the reliance on a single type of lender (local authorities) with annual cash flows mirroring borrowers (also local authorities) can have a dramatic effect on funding availability at key times. This was seen in March 2020 during the early part of the COVID 19 pandemic, when local authority liquidity dried up and interest rates shot up to over 2% above Bank Rate. Local authorities taking a more strategic approach to managing short term funding portfolios will want to see a greater diversification across their funders. This will also help to reduce local government policy risk.

Commercial paper (CP) is a short-term loan product issued in public debt markets with a duration typically less than one year. The paper is usually rated by at least two rating agencies with funding programmes from single issuers in excess of several £100 million. Banks and corporates use this market to raise funding as part of a low cost, rolling short term programme with frequent refinancing occurring under umbrella documentation. The Bank of England records gross monthly CP issuance denominated in sterling at around £15 billion. The paper is hoovered up by money market funds, banks, corporates, governments and institutional investors looking for highly liquid short term havens for cash. As you would expect, rates on highly rated CP are super low, currently below Bank Rate.

By aggregating demand across authorities, Arlingclose and the MBA can help authorities access this funding, overcoming the hurdles they would otherwise face as a single name issuer. There is no requirement for borrowing authorities to obtain a credit rating and the minimum funding size is just £25 million. Importantly, each authority is only responsible for guaranteeing their own debt; they do not guarantee the debt of their peers or the agency.

The benefits of this type of new loan product go beyond diversification. By tapping into a more liquid and reliable funding source, Arlingclose believe interest rates will become more predictable and will not suffer the vagaries of the LA-to-LA market. Authorities will also save time when administering portfolios, with offers available in larger sizes, requiring less frequent dealing and benefiting a more strategic approach to managing maturity dates and short-term refinancing risk. We also expect lower average rates too, particularly beyond six months where the LA-to-LA market becomes a bit more patchy.

Softer benefits include support to the Municipal Bond Agency, an organisation that has been able to put downward pressure on PWLB margins via public bond issues. Issuing public debt will also help improve investor’s knowledge of local authority credit, providing increased interactions with investors, leading to further product development and diversification.

Clearly this type of new initiative will take a while to establish, but it makes sense to undertake this work while the good times roll in the inter local authority market, rather than waiting for the next squeeze on liquidity. Local authorities are now taking a more strategic approach to the management of short-term debt portfolios. This includes planning for a time when “LA to LA” may become less readily available or attractive and establishing new products and processes that can reduce risk and save local authority treasury teams time and money.

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