GLA: Our inflation-linked bond to fund Northern Line extension

Prior to this, Sterling inflation-linked bonds have only been available with links to the Retail Price Index (RPI).

In partnership with the Treasury, Wandsworth and Lambeth LBCs, the GLA and Transport for London are committed to assisting the development of Battersea Power Station and the surrounding area. Transport links are key to the regeneration and a centrepiece of the public sector’s involvement is an extension to the Northern Line into the area to improve access.

The capital expenditure implications of this are in the region of £1bn and borrowing was the only feasible source of finance. The sources of funding to service and repay this are up-front development tariffs (e.g. community infrastructure levy or section 106 payments) and gradual growth in business rates, captured by means of an enterprise zone.

It was more efficient for all the available revenue streams to be pooled and a single borrower tasked with constructing a matching debt portfolio. A combination of existing taxation powers and experience of large-scale borrowing, including using capital markets, made the GLA a natural choice.

The GLA’s role in financing major projects across London means that servicing debt already constitutes over 40% of the GLA’s net service expenditure. Risk management is therefore an overarching priority for the group treasury team. This has been delivered very successfully so far, reflected in the maintenance of a AA+ credit rating, with a stable outlook, while borrowing has risen from nil to over £3.5bn since 2010. So, despite a strong case for prudential borrowing, we constructed a debt portfolio that will be robustly affordable across a range of economic scenarios.

The rates income from the enterprise zone is linked to annual inflation; therefore, there is a risk that inflation will fall short of model assumptions and income will be lower than expected. Although we believe fixed interest rates are very low in absolute terms at present, we felt that the project would be more secure if the repayments on at least part of the debt portfolio would mirror any rise or fall in revenues.

With uncertainty over powers to use derivatives, our only option to deliver this hedge was to borrow on an inflation-linked basis. This was not an option through the Public Works Loan Board, so we decided to explore the capital markets. We focused our sales efforts on pension funds, including the local government pension scheme, and insurers, having spotted a natural synergy with their need to hedge inflation-linked liabilities.

After months of modelling to best match our cash flow requirements with those of potential investors, we identified a £200m, 25-year deal, repaying over the last five years. Following extensive pricing discussions, a single investor stood out with their offer and the deal was agreed bilaterally.

We agreed to use CPI rather than RPI as it was a better match for the pension liabilities in question, and the GLA was happy to take the risk of unexpected mismatches between the two indices (we assume RPI on average will be higher).

These terms enabled us to achieve a very keen price, and although hedging was the primary motivation, it is likely that there will be significant cost benefits. Caution should be applied when interpreting comparisons between fixed and index-linked borrowing, but if the Bank of England is successful in maintaining CPI around 2%, the net present value of the saving of our bond versus the equivalent PWLB project rate will be circa £34m. Indeed, CPI would need to exceed 2.9% on average over the next 25 years in order for the deal to cost more.

As with our previous bond, we elected to use the economical and effective special purpose vehicle, Community Finance Company 1 plc. This platform, available to the GLA or its local government partners, was set up by Lloyds Bank on our behalf as part of a long-running and valuable partnership with the bank. This expedited much of the legal and commercial work that can accompany bond transactions, so helped us to contain cost and move quickly.

Inflation-linked borrowing may well play a growing role in local government, as retained business rates play a greater part in funding arrangements. It is important to fully understand the implications and the modelling involved is complicated; however, as this transaction proves, the benefits can justify the necessary investment of time and resources.

Subject to capacity, the GLA is very happy to share its experiences with other authorities, either informally or through the growing treasury management shared-service.

Luke Webster, group treasury and chief investment officer, Greater London Authority

Picture credit: Loco Steve