UK DMO Roundtable 2012

Gilts: a product for all seasons?

The summer of 2012 will be remembered for the discovery of the Higgs boson, a Brit winning the Tour de France for the first time and the resounding success of the Games of the 30th Olympiad in . For investors in Gilts, events also took on an historic hue when yields plummeted to their lowest level since the reign of Queen Anne. The reasons for this remarkable rally are complex and intertwined. The of has embarked on an unprecedented asset purchase programme and now owns about one-third of nominal UK government debt. A deep and sophisticated domestic investor base has a continuing demand for Gilts as the liability-matching asset. But another important driver has been the seemingly intractable crisis in the eurozone. This has given sterling assets an unusual safe haven status and the government’s fiscal rectitude has protected Gilts AAA status, for now. To disentangle these themes EuroWeek assembled a distinguished panel of market participants. They are convinced that Gilts will be able to weather most storms. However, the possible withdrawal of QE after three years and three rounds will present a challenge.

Participants in the roundtable were: Bruce Kellaway, head of rates trading, Lloyds Bank Wholesale Banking & Markets Romuald Balax, head of SSA (sovereign, supranational Robert Stheeman, chief executive, Debt and agency) syndicate, Royal Bank of Management Office Allegra Berman, vice chairman of global capital markets, Francis Todd, managing director and head of Gilts trad- global head of SSA fixed income and co-head of Europe- ing, Goldman Sachs an debt capital markets, UBS Andrew Capon, contributing editor, EuroWeek

EUROWEEK: The best way to set the scene and con- outlook of the UK economy with prices set by a more sider the outlook for Gilts may be to put the market domestically-oriented group of investors. in the broader macroeconomic context. In the sum- The UK is not Japan MkII. But the macro-economic mer benchmark yields reached lows last seen when outlook does remain uncertain. Europe represents about the was issuing debt to fund the 50% of our trade and growth prospects there are poor. War of the Spanish Succession (1701-1714). Clearly, There is a dual impact on Gilts from Europe: first, a safe what has been priced in does not suggest a rosy eco- haven bid, because the UK is not part of the euro; and nomic outlook. But how bad is it? Is the UK about to second the impact from weakness in a major trading suffer its own Japan-style lost decade and perhaps partner. deflation or disinflation? The core UK economy is not as weak as is currently being priced by the short-end of the Gilt market. Bruce Kellaway, Lloyds: The UK curve is not pricing in Clearly, there is a lack of confidence among corporates anything quite so extreme, rather this is a tale of two and retail, but the data is noisy. The seeming paradox of curves. At the short-end of the curve, out to 10 years, weak growth and rising employement is just one mani- there is a strong safe haven bid. To some degree rates festation of that. are being artificially suppressed by that. The longer end of the curve is probably a better reflection of the true Allegra Berman, UBS: Yields are low, which in part

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reflect both disappointing growth and an uncertain Francis Todd, Goldman Sachs: I am less convinced that economic outlook for the UK so no signs of inflation or QE is designed to keep yields low. Indeed, the MPC has higher interest rates. But a large degree of that economic stated that one sign that QE was working would be that uncertainty is driven by what is happening in Europe yields could not be induced to fall further. I have always and a pervasive lack of growth and global demand. That maintained that there is life in the Gilt market beyond has exacerbated the amount of safe haven buying we QE. Investors will buy and sell Gilts for reasons other have seen for Gilts, as outside the eurozone government than what the Bank is doing, including their general bond markets. Anyone forecasting growth prospects views on economic growth and their risk appetite. It is from Gilt yields is likely to reach the wrong conclusions clear that recently investors have had a relatively dim because of the significant flight to safety that has unfold- view of growth prospects and have put a high value on ed across markets. capital preservation. But those views will likely change change. I agree with Robert’s previous point that if high- Robert Stheeman, DMO: Certainly the DMO is conscious er yields occurred for good reasons, improved growth that if some of the current yield gains are due to safe prospects for example, that would be a very good thing haven flows, it is entirely conceivable that those will which I expect the Government would acknowledge as be unwound. There could be an upward movement in an overall positive despite its implications for funding yields, but it is very hard to say that there is any one costs. particular cause for yields to be where they are now. There are so many intertwined reasons. EUROWEEK: In spite of the enormous scope of QE, An obvious influence, in addition to safe haven flows, the Bank of England is not the only buyer. But, we is quantitative easing (QE). There is also the influence of also know that the UK institutions are holding a various elements of demand coming from different quar- smaller percentage of Gilts that has historically been ters, such as the domestic pension fund industry at the the case, though the market is far bigger. Who are the long end. They all combine. When yields do start to rise new players in Gilts? again, the reasons for their rising may not necessarily all be negative. They could actually be quite positive. Stheeman, DMO: There has been an almost constant increase over the past decade of overseas buyers. To a large extent that has been focused on the short end of the market, although that is evolving. There is increasing international interest in longer maturities. Overseas buyers own a record amount of Gilts and in percentage terms they are also far more significant. The UK domestic pension funds do not dominate the overall portfolio to the same extent that they did 10 years ago, when they accounted for approximately two thirds of the entire portfolio. In nominal terms, of course, they hold more Gilts because issuance has risen. That bid from these institutions, particularly at the long end of the curve, has not gone away. LDI [liability- driven investment] is still shaping a lot of pension port- folios. There may be times when yields or break-evens Robert Stheeman, are not at the levels that entice them into a market, but DMO in general demand seems to be pretty robust. The bank- ing sector is another new source of demand, because of EUROWEEK: Perhaps we should try to disentan- the need to put liquidity buffers in place. gle some of these intertwined factors. QE is clearly designed to have an impact on the economy by keep- EUROWEEK: Are the overseas buyers asset allocators ing yields low. It has worked because we have seen ranging around the rates world, or are they domi- negative real rates. But that also suggests that these nated by official institutions, the reserve managers at safe haven flows are completely price insensitive. central and sovereign wealth funds?

Romuald Balax, RBS: This is clearly a highly unusual Berman, UBS: Without a doubt, official institutions are environment. Negative rates started in Denmark then the dominant factor in the overseas buying. This is not Germany. They do makes sense in the context of mas- just a sterling or UK story, as there is a strong desire sive and unprecedented risk aversion and derisking of to diversify reserves and we have also seen buying of balance sheets which isn’t just a UK or a European phen- Australia and Canada, for example. The UK has certainly emenon but is a global one. Investors are willing to treat been a major beneficiary of this trend. As Robert men- negative yields the same way as they they might paying tioned, central banks have traditionally been buyers at an premium. They are motivated by return of the shorter-end of the sterling nominal curve. That is capital not return on capital. changing. They are extending maturities and there is Does QE influence yields and then the real economy? more demand for inflation-linked Gilts. Of course it does at least for rates, but by how much is very hard to say. There is no direct way to observe Stheeman, DMO: Sterling as a percentage of global the actual effects of QE: we can only try to assess what bond indices is the highest it has been for a generation. would have happened in the abscence of QE and build Though reserve managers are unlikely to follow these ‘alternative histories’. By the time a few Ph.D. theses are indices blindly it is probably worth noting. Sterling is written, we may get close to an answer. not a reserve currency with the same status of the dollar

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or even the euro, but there has been a notable increase Berman, UBS: The ‘Balkanization’ is absolutely clear. in the size of overall reserves. A small shift can have a Every time the eurozone crisis lurches from bad to very big impact on Gilts. worse that trend becomes more pronounced. Investors become more fixated on buying what they know best, EUROWEEK: Is this just another facet of safe haven which tends to be what is in their back yard. They buy buying and the eurozone crisis? names that they know and with which they feel most comfortable. That is true both in the rates and credit Berman, UBS: To some extent, but I do not think it can worlds. be dismissed as a short-term phenomenon or simply It is more marked in the periphery because of the knee-jerk reaction. Things could change: the UK econo- stronger threat of exit from the eurozone. It makes my could deteriorate badly and the sovereign could get sense for Italian investors to hold Italian assets, or a downgraded, although I do not feel that is particularly Spanish investor Spanish assets, as they believe they likely. There is long-term support for Gilts regardless will share the same fate as their own sovereign, should of what happens in Europe. The allocation to sterling is a euro exit occur. more long-term structural rather than purely short-term tactical. EUROWEEK: We have spent a lot of time talking about QE and safe haven flows. Robert, would it be fair to say the DMO is ambivalent about who the buyers of Gilts are as long as you meet your remit and the market operates smoothly?

Stheeman, DMO: That is broadly correct. We do not aim to encourage one particular part of the investor base to the detriment of others. In fact it is probably unrealistic for us to attempt to do that. The DMO does not have the tools. Which constituency represents the largest or third largest part of the investor base depends entirely on what those investors themselves choose to buy. If, for example, at some point in the future, inter- national investors decide to decrease their holdings in Gilts, the marginal buyer should then appear from some other part of the investor base. So long as there is always a marginal buyer in the broad investor base that Allegra Berman, feels there is value, the market should be able to adjust UBS in price, to let that process happen. Kellaway, Lloyds: There was another big influx of new That adjustment process is critical. A key issue for overseas buyers in the early part of last year. The the DMO is to try to ensure that the market remains as problems in the eurozone played a part. There was liquid as possible and as orderly as possible, under all something potentially very dramatic happening on our circumstances, to allow that process to unfold without doorstep, while the UK has a stable government, cred- price discontinuities. ible fiscal policy, a large tax base, an open economy and an AAA rating and the Gilt market benefitted. EUROWEEK: Perhaps that is a good point at which to turn the discussion back to the UK, QE and the Balax, RBS: Those factors mentionned are the key points domestic investor base. Are you all assuming that of differentiation versus Europe. The eurozone crisis has come November, more QE is announced? highlighted perhaps one thing above all else: investors focused on the divergences within European countries Berman, UBS: We do not think it is a given. on stability of political leaderships, fiscal policies etc. The danger of unco-ordinated fiscal policies became Balax, RBS: We are leaning towards there being more central to bond markets’ thinking after years of failing QE, perhaps another £50bn billion, but it is linked to to consider those. In comparison to Europe taken on other decisions and outcomes elswhere in Europe and aggregate, the United Kingdom offers a considerably USA. QE in the UK will depend on the state of the higher clarity and investors are rewarding it. domestic economy and the international outlook. By November the Bank of England may also have a better Stheeman, DMO: That is the difference. We do not face idea of how other measures that were introduced over these issues in the UK. I suspect it is something that summer are working, such as credit easing. For the Gilt international investors have focused on for the first market, operationally, more QE is not a big issue. The time in any great detail. They realise that that the whole market makers know how to handle it now; this is part institutional framework and the arrangements that we of their expertise. have here are pretty sound. It is one of those lessons it is hard to unlearn. EUROWEEK: Has there been diminishing marginal utility from QE? EUROWEEK: Within the periphery in particular and among banks we have seen this phenemonen of Balax, RBS: That is probably true of all policy measures. ‘Balkanization’ retreating behind home borders? Is The first rate cut, or the first round of QE will always that being played out in bond markets and is the UK have the biggest impact. Sometimes just talking about a immune? new initiative is enough; remember the period of ‘ver-

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bal QE’ in the US? That was enough to move the mar- has been a beneficiary. The Gilt market has been able to ket, if only temporarily. accommodate, in a relatively short period of time, the entrance of a completely new buyer. It has been able Kellaway, Lloyds: It is interesting that authorities have to buy without any significant disruption 30% of the recently looked more creatively at what the transfer market. mechanisms of policy are and how to get the credit multiplier working. Funding for lending is a good exam- EUROWEEK: Is that the experience of the GEMMs ple, addressing the disconnect between where policy here? Has QE worked smoothly? rates are and where mortgage holders can actually bor- row. In future I expect QE is far from being the only Todd, Goldman Sachs: I made the point earlier that policy tool. there is life in the Gilt market beyond QE. In no sense is the market dependent on QE for liquidity. But, I EUROWEEK: Broadly quantitative easing is a mone- concur that the programme has worked reasonably tary tool aimed at the price of money and credit eas- smoothly, and the ease with which the Bank has been ing is about further boosting the quantity of money? able to buy the Gilts, and indeed the ease with which the Government has funded itself over the past several Balax, RBS: And the velocity of money: that is the years, is testament to the GEMM market maker model. problem now. Liquidity is abundant, rates are low but Good repo liquidity helps, naturally, but the main factor is money flowing into the real economy? It is an ambi- is that there are a good number of competitive GEMMs tious set of goals, but worth trying. now, and the market appears to me to be extremely efficient.

Stheeman, DMO: Defining liquidity in any market, particularly one that trades OTC [over the counter] is notoriously subjective. But the liquidity ratio measure we use has increased over 2011-2012. That provides us with a good degree of comfort. Another point worth mentioning is that the incidence of settlement fails in the market is low and low by comparative international standards as well. Intuitively, high liquidity and low fails are two sides of the same coin.

EUROWEEK: Is that another reflection of the chang- ing investor base? UK pension funds and insurance companies buying long-dated are presumably often buying to hold to maturity? Romuald Balax, Royal Stheeman, DMO: To a degree, but there are a number of Berman, UBS: There is nothing wrong at all with these factors. One is that as issuance has increased, not just ambitions, particularly given the recent poor data on of long-dated nominal bonds and linkers but across the growth. From the outset of QE in the UK, it is clear that curve. Shorter-dated and medium maturity Gilts were the message was to be a very strong one. There was ini- a part of the market that was arguably starved of issu- tially an element of “shock and awe” which comes with ance for many years. In most government bond markets any big new initiative and that element of shock is less- this is the most liquid part of the curve. The UK was ened over time with new iterations of the same policy. not issuing much there. There are technical, or market That does not mean, however, that QE is ineffective. structure, considerations as well. The issuance of 10 No one knows the exact extent to which these policies year Gilts has expanded markedly. That is the bond will work. But they are important because they send a deliverable into the futures contract, so that will drive very strong message to the market that UK policymakers turnover and liquidity. continue to think creatively and are not running out of ammunition. The power of that messaging should not Berman, UBS: Regulation and the balance sheet position be underestimated. of the banks and GEMMs are factors. Pre-crisis it was not really a consideration. But now in general banks are EUROWEEK: If there are so many eager buyers of not comfortable holding large inventory positions over Gilts is there a danger they are being crowded out by the medium term, so that drives turnover as well, as continuing QE? dealers look quickly to move their positions.

Stheeman, DMO: The Bank of England has set a self- EUROWEEK: We have talked about the institutional imposed limit of buying no more of 70% of any individ- structure of the UK as an issuer as a strength. The ual Gilt issue and there are other rules set out about the UK still enjoys the privelege of seigniorage, we con- operation of QE. The proper functioning of the market trol our monetary policy and can print money. How for all concerned constituencies and investors is an issue important also is the governance framework in place which is well understood by the Bank of England. around what the DMO does? It is up to the Monetary Policy Committee whether it decides to do more QE or not. The job of the DMO is Berman, UBS: The DMO is very transparent about how debt management. But the Bank of England understands it operates. It sets the bar high for every other sovereign why an efficient market for trading Gilts is important; it issuer.

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Balax, RBS: GEMMs get extraordinary clarity from the EUROWEEK: The regulatory pressure on banks has DMO. Remits are clear, the DMO runs consultations been raised in passing at various points in the dis- and the feedback from the formal and informal meet- cussion. Does being a GEMM and committing costly ings is very valuable. balance sheet receive sufficient recompense?

Todd, Goldman Sachs: We have always been of the view Kellaway, Lloyds: Lloyds is at the heart of funding the that the UK DMO sets a very high standard in terms UK across all sectors: government, corporate and insti- of transparency and predictability, which contributes tutional. It makes a great deal of sense for Lloyds to to market liquidity and, more importantly for the have connectivity with originators of debt and investors Government, contributes to more cost effective funding in debt. The government is a major debt issuer so hav- over the long term. ing a GEMM is important for us. It’s not the case that every time we buy or sell a Gilt we make money, but Stheeman, DMO: That is all very gratifying. We place a the GEMM is certainly not a loss leader. huge amount of emphasis on the notion of transparen- cy. But the DMO also places an equal wieght on predict- Berman, UBS: Being a GEMM is still an essential part ability. We do not like springing surprises to the mar- of a client-focused, UK fixed income platform. It is also ket. The amount of time in advance that we announce an essential part of having a credible government bond our plans is one element. market presence in Europe. The economics of the mar- But transparency and predictability are not entirely ket have also evolved. It is rare now to see over-bidding altruistic traits. They are also in our best interests. The in auctions and that used to be standard, much to the last thing I would want is to report back to the Treasury annoyance of GEMMs. There is a lot of investor activ- that the cost of borrowing had increased because the ity and turnover is up. It is a profitable business on a market was charging an uncertainty premium. It is a standalone basis as it needs to be in order to keep the virtue to be as predictable, as clear, and as transparent market healthy over the long term. as possible to the market because it creates the best pos- sible environment for issuance. Balax, RBS: The idea that you run a primary dealer- The observation about the separation of debt manage- ship as a loss leader is completely out of date. Banks ment from monetary policy is also well made. When have changed their models across all major curren- setting monetary policy it is difficult, if not impossible, cies and banks are now picking battles very carefully. to operate with that same level of predictability. Debt Profitability and that has to be clear at the level of indi- management and monetary policy are two fundamen- vidual government bond trading desks: it is no longer tally different things. They operate over two very dif- good enough to make vague assumptions about ancil- ferent time horizons. lary business. Debt management, and our own debt management Being a GEMM is obviously an essential part of RBS’s objective, by definition is long-term policy. That is how fixed income offering and it connects to many other we view its instituional context and the policies that parts of the group. We are handling an important fran- frame it. Monetary policy, by necessity, has to operate chise based on our role as a GEMM where servicing the with a shorter time horizon. It has to be more reactive needs of our clients is paramount, but is still run as a to events in the wider economy. profit centre.

EUROWEEK: What is the biggest concern for inves- EUROWEEK: One more question for the GEMMs tors in the Gilt market over the next 12 months? Is it here, should the UK vary its mixture of mini-tenders, UK politics perhaps? Is the coalition unravelling? auctions and syndications, or is the balance about right? Balax, RBS: The single biggest factor is uncertainty around QE. More QE, less QE, or no QE? Each one of Kellaway, Lloyds: The DMO is very good at consulting these eventualities is possible and we could get to hear with the GEMMs. As a result the mix is a good one. something as soon as November. That will be the big If we felt any different we would be able to voice our market mover. There are variations on this theme as concerns and the DMO is good at listening. The UK well. For example, the Bank of England could announce currently funds across a broad range of maturities suc- what will happen to the stock of Gilts it has already cessfully, which suggests there is nothing fundamentally acquired. wrong. Other than QE there are no obvious UK specific tail- risks. The biggest exogenous risk remains Europe and a EUROWEEK: A lot of my time in recent weeks has worsening of the situation there. In spite of all that has been spent talking to investors in Gilts, particularly been done and the endless rounds of negotiation it still the UK investor base. Among asset allocators there is not possible to say with a strong degree of confidence a general feeling that the risk-reward profile of Gilts that there will not be more eurozone crises. That could is far from positive. Liability-driven investors are say- hit the UK through the banking system. ing that yields at these levels simply do not work. Is QE and safe haven flows disenfranchising domestic Berman, UBS: Even a downgrade from the credit rating investors? agencies would not necessarily trigger a sell-off. For domestic UK investors it makes little sense to sell the Kellaway, Lloyds: LDI managers are certainly price sensi- liability-hedging asset. As has been said, reserve diver- tive. There is a large disconnect in the curve, with low sification is the primary driver of overseas buying and yields to 10 years, showing that at least part of the there are not that many liquid triple AAA or AA assets investor base is concerned less about yield and more out there. QE is the biggest unknown for the market. about the return of capital. But that tends not to be

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pension pension funds to discount future liabilities by reference to the Gilts curve. If you want to hedge those liabilities, Gilts are unavoidable in the long run. Derisking might be paused, or delayed, but it can- not be stopped and will not be reversed because UK pension funds still hold far too many equities in their overall portfolios. The allocations are still a bit higher than is typical in mature European pension markets such as the Netherlands. LDI managers sometimes need a better yield level, or a little sell-off to feel comfortable, but as soon as it happens, they are there in size. We have seen it every single time on the long end syndications, they do show up. So we think that the pension fund bid is here, not only now, but here to stay for a very long time. Only Bruce Kellaway, regulation can change that. Lloyds bank EUROWEEK: Regulation has changed in some coun- domestic investors such as pension funds and insurers. tries, Denmark for example. Also does it make sense Beyond 10 years, pension funds are being highly selec- it make sense to derisk at these levels when defined tive about when they buy and what they buy. For them benefit fund solvency ratios, according to Mercer, are Gilts are typically a very long term investment and they typically below 90%? Would it not be better to wait want an interest rate hedge and an inflation hedge. for higher trigger rates for yields? There are not many pension funds that believe yields of 3% over 30 years make sense and that is entirely under- Balax, RBS: Trigger rates are moving targets. Pension standable. funds cannot afford to stand still. There are many pen- sion funds with solvency ratios around 80% which is Stheeman, DMO: Underlying pension fund demand where European regulators have typically taken action. remains very strong, but there will be times when it It is a very significant issue and there is a lot of poten- manifests itself more, if they feel that the actual yield at tial money that could still flow into Gilts from derisk- a given point is particularly attractive, and less if they ing. Some countries have changed their discounting do not. That is another good reason to think that the rules. Solvency II has changed the rules for insurers. But market can and will adjust to price changes, because the for UK pension funds there have been no changes. Gilts underlying demand at the right price is there even if it are the benchmark. comes from different constituencies. The DMO and UK government has benefited hugely Todd, Goldman Sachs: The regulations in the UK are from the depth and sophistcation of our domestic based on sound principles and it would be extremely pension fund and insurance company industry. It has surprising to see an arbitrary change. I agree that there enabled us to issue an extraordinary amount, by inter- is more de-risking to be done, but pension funds seem national standards, of long dated debt. The average to have become a little more opportunistic in recent maturity of our debt is nearly 15 years, and that is a years, waiting for what they view as the appropriate lev- complete outlier. It is something that the credit rating els to hedge, rather than acting with the urgency seen agencies have recently focused on. It has only been previously. possible because over the years UK pension funds have been such a strong source of demand. EUROWEEK: Assuming we at some point get to a The DMO has met that demand, willingly, in all post-QE market, the first stage being a halt to buy- maturities up to 50 years. For us these long-dated bonds ing, what do we think the yield curve would look are not odd or esoteric but an essential part of what like? Up until 2008, because of this demand for the we do. We issue across the curve in a huge number of long-end, it was inverted. There are perhaps these maturities, and that has undoubtedly helped keep rollo- buyers on the margins, waiting for yields to rise so ver risk to a minimum. That may not have seemed so they can derisk with liability matching assets. Do you important 10 years ago, but the whole question of refi- think the curve will go back to inversion, or that that nancing risk has become a very big issue. the long end will stay very flat? The eurozone is the current focus, but this is also true of other important sovereign bond markets. The UK is Stheeman, DMO: If no one else will venture an opinion blessed because we have this natural constituency of I will do so, but only on the basis that it is noted in the buyers. You cannot create demand for long-dated assets record that the opposite will probably happen. You are overnight. right to point out that yield curve was inverted for a very long period of time. It is probably fair to say that EUROWEEK: Is that tail-wind still behind long-dated this was an unusual state of affairs for a government Gilts or has the effect of QE stopped the de-risking of bond market. The demand of a maturing pension fund defined benefit pension schemes? investor base for long-dated assets was certainly impor- tant. Balax, RBS: If you are feeling brave you can wait for However, so was significantly reduced government yields to get to the level you precisely want, but that bond issuance. The supply of Gilts from the mid-1990s, does not seem a sensible strategy to me. The impera- until about 2006 was very limited. Even under the tive to de-risk is still there. In the UK, regulation forces most optimistic scenarios, government bond supply for

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the foreseeable future is likely to remain at elevated lev- Government bond markets do have a value which els, certainly by historical standards. For that reason, it goes beyond a state financing function. They can be a would be surprising to see the curve significantly invert broader public good. They act as a pricing benchmark in the near future. or mechanism for the market. Australia did a study of this about 10 years or so ago, which found that though Berman, UBS: If we go back to Gilt issuance of £50bn the government bond market was almost unnecessry for a year, it is indeed possible that the yield curve inverts funding, it had positive benefits for the corporate bond because of the demand from domestic investors for sector. long-dated assets. But even in a post-QE environment it We do try and take into account wider issues, issues feels less likely to happen with issuance of £150bn plus. that perhaps have a benefit for the financial sector, or for the corporate sector. That does not mean that we Balax, RBS: Thinking about the post-QE world begs can act or should act outside our mandate. It means that another question which is what happens to the stock of we need to be aware that our actions can have conse- debt? It is very difficult to sell it back to the market so quences beyond the narrowest definition of our debt that is unlikely. It will probably be allowed to mature management remit. and roll-off. The yield curve question is interesting but very complex. In the eurozone in particular, we see a EUROWEEK: Is there anything that the DMO should steepening of the curves. be doing that it is not currently? Are there parts of A big structural change is going on at the long end, the curve that need to be added to? Should there be due to Solvency II. There is reduced demand for very many more linkers? Is there demand for even long- long-dated cash bonds and swaps got hit too. er-dated issuance, perhaps a perpetual or century The UK may be different because of the pension bond? funds and LDI. If I had to make a bet it is possible that the UK curve would return to some degree of inversion Kellaway, Lloyds: A floating rate bond would be very in the long end. well received, particularly by the sec- tor. I would question whether there is any real demand Todd, Goldman Sachs: What happens to the Bank of for very long-dated assets. There is no natural hedging England’s stock of Gilts is an open question. Presumably demand. As defined benefit schemes close or de-risk, some of the Gilts will be held until maturity. But the the length of their liabilites is declining. sort of environment in which the MPC has to make a decision to do something else will be one of much Berman, UBS: A floating rate instrument of some sort healthier growth and presumably a much lower deficit, would be in demand if structured correctly and could possibly even a surplus. Some investors might be rather become an important tool for the market. keen to buy certain Gilt maturities at that time, but as with everything, it will come down to investors’ views Balax, RBS: For the DMO I imagine that the point of and market pricing. issuing new instruments or maturities is that they meet a need and there will be repeat business: this is EUROWEEK: This is slightly difficult question to the opposite of an ‘arbitrage trade’. We can all think phrase, but to what extent does the mandate of the about products that can be opportunistically issued. DMO encompass what you might call common good There are always easy, slam-dunk arbitrage trades in of the UK? There is this demand from pension funds foreign curencies for example. But the way to get the for long dated assets, both nominal and inflation- support of GEMMs and investors is to take a long- linked. How cognisant of this is the DMO and does it term view and it narrows down the options. I agree shape your decisions? that a floating rate note would be worthwhile. There is demand and there has already been supranational Stheeman, DMO: We are very cognisant of the needs of issuance. UK pension funds and insurers and the pressures under which they operate. But, we have a debt management Stheeman, DMO: When it comes to innovations, we objective, which in itself arguably contains all the con- always have an open mind. But the bar to introduce tradictions that make such judgements and decisions new instruments must by definition be set pretty difficult. The goal is long-term cost minimization, sub- high. That is for reasons that have already been ject to risk. There is a trade off there, but the focus has mentioned: it has to be sustainable; in the long-term to be on cost minimisation. interest of the broad market; and it cannot be seen as We do not have a debt management objective which opportunistic. says that we should be to take into account the special Being classed as an opportunist is the cardinal sin for requirements of any one particular part of the investor a debt manager. The DMO does not want to go down base, however valid and important those needs might that route. At a slightly deeper level there is something be. It is fundamental for any agency of government to be said for this notion of serving a broader constitu- that it is not given conflicting objectives, because they ency, one broader than even the GEMMs and Gilt become almost impossible to resolve. investors, important as they are. Were we, for instance, required to look after the The government as the sovereign issuer of debt, needs of a particular investor group, the pension fund provides the building blocks for the capital markets. industry in your example, to the detriment of cost mini- Nominal bonds and inflation-linked certainly serve that misation, we would find ourselves in an awful quan- purpose of providing a curve for other issuance. What dary. How far do you go? That is why the focus has to we should avoid at all costs is rushing into faddish be cost minimisation. products to try to shave a few basis points of funding However, it is a very valid point that you make. costs here and there.

UK Capital Markets 2012 EuroWeek 47 Public Sector Borrowers

New era dawns for UK public sector debt Government measures, such as plans to guarantee £10bn of housing association debt and set up a UK version of KfW, could bring far-reaching change to public sector borrowing. Will they succeed, and what will that mean for established borrowers like Network Rail? Tessa Wilkie reports.

K public sector borrowing is debt to boost their liquidity coverage “The argument going to get a lot more excit- ratios in anticipation of the imple- for a single Uing in the next 12 months. mentation of Basel III, due to become aggregator to The government announced on Sep- law in 2013. act as an issuing tember 6 that it would guarantee up Banks and building societies held entity [for housing to £10bn of housing association debt, 9.3% of all Gilts in the first quarter associations] as part of a stimulus package for the of 2012 — the last quarter for which would be useful UK housing market. This will intro- data is available. In the third quarter of in that investors duce the only debt with an explicit 2008 they held just 0.6%, according would only have UK government guarantee, apart from to the Office for National Statistics. one structure to that of Network Rail. Grodzki says banks would have Richard Tynan, analyse” But the plan is proving controver- more to gain than institutional inves- sial. Some institutional investors are tors from guarantees on housing asso- not impressed. ciation paper, partly because they are Another option for housing asso- Institutional buyers would pre- more capital-constrained than insur- ciations is private placements, though fer a more nuanced form of credit ance companies. “Especially if gov- the UK investor base remains small. enhancement, says Georg Grodzki, ernment guaranteed social housing “We have been highlighting ster- head of credit research at Legal & bonds are eligible as tier one assets ling private placements for smaller General Investment Management in under the Basel III liquid coverage issuers, a system like the US private London: “The inevitable reduction in ratio rules,” Grodzi adds, “banks are placement-style of issuance would yields would most likely offset the likely to become their main buyers.” work very well,” says Ramzan. “But moderate advantage of lower solvency They may be particularly keen on we need to get investors over the capital requirements which a gov- it, because it should pay a premium perceived lack of liquidity in small ernment guarantee would bring for over Network Rail. private placements, and the resultant insurance companies.” But much remains to be worked divergent expectations regarding pric- At the moment the not-for-profit through. One question that would ing. The perceived illiquidity of pri- social housing providers’ bonds trade affect pricing greatly is in what form vate placements is illusory — there’s anywhere between 110bp and 240bp the guaranteed debt would hit the not a lot of liquidity in sterling public over Gilts, depending on the size market. Would individual associa- benchmarks in this sector anyway.” of their borrowing programme, the tions launch their own deals or would issuer’s credit quality and investors’ some form of aggregated issuer need UK KfW? familiarity with the credit. A govern- to be created? A still more intriguing prospect is the ment guarantee would sharply reduce Such a vehicle could be especially government’s recently announced plan these spreads. useful for smaller associations with- to create a state-backed small business “A couple of investors are tell- out enough funding needs to sell a bank, inspired by Germany’s KfW and ing us that they’re full on govern- benchmark bond — though such the US Small Business Administra- ment guaranteed debt and that what aggregators, like The Housing Finance tion. Business secretary Vince Cable they really want is yield,” says Farouk Corporation — exist already. confirmed on September 24 that the Ramzan, head of corporate debt capi- “The argument for a single aggre- government was moving ahead with tal markets at Lloyds Bank Wholesale gator to act as an issuing entity would the idea. Banking & Markets in London. “They be useful in that investors would only The plan is for the government to don’t want to hold bonds that are, have one structure to analyse,” says provide £1bn of public money and in effect, as safe as they were before, Richard Tynan, head of corporate perhaps attract an additional £1bn of but which are priced at a much lower sterling syndicate at RBS in London. private capital. It will then leverage yield. It remains to be seen how the “Smaller borrowers with less sophis- that £2bn in the capital markets, to rest of the market reacts.” ticated funding departments could support about £10bn of SME lending. arguably save on both documenta- Such an issuer would likely be wel- Good for some tion and advisory costs. However, it’s comed with open arms, if the recep- One group of investors that might lap important to get the overall structure tion to similar credits is anything to up this debt is bank treasuries. They right, so that it’s something useful for go by. Transport for London showed have become big buyers of UK gov- both issuers and investors to partici- earlier this year just how popular rare ernment and government guaranteed pate in.” public sector agency debt can be. It 48 EuroWeek UK Capital Markets 2012 Public Sector Borrowers

has £1.6bn of debt to raise, and plans Nevertheless, bankers had been year shows that it’s not completely to do this in the bond markets over working on bringing local authorities immune to macro issues, but it has the next three years, not having issued to the market since the Conservative- been very stable.” a benchmark bond since 2006. Liberal Democrat coalition govern- The issuer has used this increased The Aa1/AA+/AA+ rated issuer ment announced in its October attention from international investors wasted no time, launching a 30 year 2010 Spending Review that it would to print some impressive dollar bonds bond on July 12 and a 10 year on raise the cost at which local authori- this year. In June it sold a highly suc- July 31. ties could borrow from the Public cessful 144A trade — a $1.5bn three Investors placed £750m of orders Works Loans Board from 11bp-15bp year that attracted the largest book for the 30 year, allowing the issuer to over Gilts to 100bp over. This sharp the issuer had ever seen in dollars, of print a £500m trade — an impres- rise spurred many local authorities to $2.6bn, and was priced at the tightest sive amount for the sterling market think afresh of funding through the spread since the Lehman Brothers cri- — at 98bp over Gilts. By the time capital markets. sis in September 2008. TfL announced the second deal, that Greater London Authority was the , , Goldman bond had tightened to 82bp/85bp, first to do so. It priced its first bond in Sachs and JP Morgan priced the trade enabling TfL to raise another £500m July 2011 — a £600m note at 80bp at mid-swaps plus 2bp, equivalent to at 88bp over. over Gilts — proceeds from which 29bp over Treasuries. were earmarked for the £14.8bn “Although most of the growth in No authority Crossrail project. Those bonds were demand for Network Rail this year While some of the government’s pol- trading at 98bp/88bp over Gilts in has come from existing investors, it icy announcements this year are likely mid-September. has also been able to expand its buyer to feed more highly rated bonds to GLA — rated AA+ — is likely to base significantly by the addition of investors, others militate against be one of the tightest priced issuers in 144A language [in January 2011],” issuance. its class. It may also be the only one. says Reid. “It has been extremely suc- In August it dealt a blow to the With the discounted PWLB funding cessful here as well — its pricing prospect of deals from local author- now at least as cheap as authorities compared to its peers in dollars has ity borrowers by offering a 20bp could get in the capital markets, the improved substantially.” discount on loans from the Public incentive to issue has gone. The issuer’s previous three year Works Loans Board for councils that dollar deal — in January — was a improved information on their bor- Stellar year for UK rail $1bn trade that attracted a $2bn book. rowing and capital spending plans. What investors will be able to rely Sold through Mer- That means qualifying local on is Network Rail. The owner of the rill Lynch, Citi and Morgan Stanley, it authorities could borrow from the UK’s railway network, renationalised marked the first time the issuer had government at 80bp over Gilts — in 2002, has enjoyed strong demand been able to print inside a KfW re- much cheaper than they could in pub- all year. offer level. lic or even private markets. It has drawn growing attention In sterling, new public sector bor- The UK is unusual among devel- from investors outside the UK, who rowers might encroach on Network oped nations in having no munici- are switching some of their hold- Rail’s investor base a little, but it has pal or regional bond issuers to speak ings from agencies based in eurozone the option to fund in other markets of. Some local authorities have issued countries to those outside. as well. And while investors have been bonds in the past but the scandal over “SSA investors aren’t worried about concerned about ultra-low yields, the London borough of Hammersmith credit risk per se, but they are con- Network Rail offers proportionately & Fulham’s huge derivatives losses in cerned about spread volatility,” says good value over Gilts. the lateAssets 1980s swap has spreads made of the KfW idea and ofNetwork RailGuy 2 016Reid, bonds head in ofdollars frequent borrower “Demand for Network Rail in local councils in the financial markets coverage at UBS in London. “Net- sterling remains extremely robust, a queasy one for many Britons. work Rail’s trading performance this and there is more demand from UK investors than we have seen in recent Assets swap spreads of KfW and Network Rail 2016 bonds in dollars years,” says Reid. “Although Net- work Rail yields in sterling are low, 40 this is indicative of the environment bp Network Rail KfW 35 we are in and as a percentage of the underlying Gilt yield it remains 30 attractive.”

25 The borrower isn’t worried either. “Network Rail is an established issuer 20 in the international capital markets, 15 issuing £4bn-£6bn annually since the programme was established in 2004, 10 so I do not believe that [new public 5 sector issuers in the UK] will affect demand for Network Rail’s bonds,” 0 19 Sep 11 19 Dec 11 19 Mar 12 19 Jun 12 19 Sep 12 says Samantha Pitt, group treasurer -5 at Network Rail. “Network Rail has a truly global investor base, with cen- -10 tral banks and US investors being key Source: Markit investors in our bonds.” UK Capital Markets 2012 EuroWeek 49 Source: Markit Sterling as a Currency for Global Issuers

Niche status ditched as global issuers flock to sterling Flexible, diverse, cost-effective and deep, the sterling bond market is increasingly hard to ignore if you are a global borrower. Jo Richards looks into how and why sterling has evolved from a niche market into a core currency for foreign issuers.

ith its shiny new status as “Duration, the safe haven currency of flexibility and WEurope, its ability to provide diversification duration at an attractive cost, a diverse are the main range of instruments, the willing par- attractions for ticipation of a unique and undersup- non-UK issuers” plied domestic investor base and grow- ing international demand, the sterling bond market has become an increas- ingly important source of funding for international issuers. Robin Stoole, This year it has enticed a record Lloyds Bank number of them — from the triple-A sovereigns, supranationals and agencies “There is an enormous bid for new to single-A corporates with a handful names giving diversification away from of financial institutions in between — Europe, which I believe will keep going and it is easy to see why. through Q1 and Q2 of next year,” he “Duration, flexibility and diversi- says. fication are the main attractions for Donlon says the fact that BHP Bil- non-UK issuers,” says Robin Stoole, liton was able to issue a large sterling managing director, head of bond syndi- debut on September 19 — a £1.75bn cate at Lloyds Bank Wholesale Banking seven and 30 year bond lead managed & Markets. by JP Morgan, Lloyds and UBS — with- “While some international borrow- out a roadshow should encourage bor- ers do need sterling and hence issue rowers which had previously hesitated directly in the currency, others because of the investor relations work the market purely for a combination of traditionally involved in accessing the investor diversification and, oftentimes, sterling investor base. arbitrage.” “That deal marked a sea-change in The figures speak for themselves. As the sterling market,” he says. “It means at September 21, 2012, non-UK issuers that well known international compa- had issued over £43bn ($70.3bn) com- nies can do deals without sending big pared with £39bn ($63.9bn) for the teams over to the UK, something they whole of 2011. And more supply is on might have thought was not worth the way, say UK bankers. their while without certainty of “I think the fourth quarter will execution.” remain strong as I do not see any of Also, the precedents set by the likes the dynamics changing so the rationale of AT&T, America Móvil, Time Warner for buying sterling will remain,” says Cable and Siemens, all of which have Myles Clarke, global head of syndicate executed big, cost-effective trades at the at Royal Bank of Scotland. long end of the market this year, should “I do not see a silver bullet coming make it easier to convince the smaller out of Europe and, while the UK’s fiscal corporates that they can achieve size in policy continues to work for the inter- the sterling market. national investor base and with more And the audience is there for them QE expected in November, a number to do so, particularly the UK-based of factors will keep yields low and funds, which, in the last decade, have swap spreads wide. This should result had a mass concentration in European in more US and other blue chip issuers names so have been overly exposed coming to the market before year end.” to certain areas of Europe, which has Barry Donlon, head of corporate turned out to be very expensive for syndicate at UBS, agrees. them. 50 EuroWeek UK Capital Markets 2012 Sterling as a Currency for Global Issuers

“I think the fourth case that investors recognise the need “Demand continues to be very quarter will to diversify and they are willing to UK-centric, concentrated in the clas- remain strong as pay for it.” sic few hands of insurers, pension I do not see any funds and some asset managers,” he of the dynamics Duration, duration, duration says. changing so Apart from its appeal as the least vol- “These investors all tell you they the rationale for atile currency in Europe, arguably the can buy euros and dollars and swap buying sterling will main attraction of the sterling market it back to sterling but really they only remain” is its ability to offer duration way buy in size in sterling. So, if you have beyond other markets and in off-the- a big issuer which wants to have Myles Clarke, run maturities that are not available diversification and hit that pension Royal Bank of Scotland in other sectors. money in the UK, the only way to The euro market, for example, get them into your investor base is to “There is a big push by these rarely provides opportunities beyond issue in sterling. In that sense, there is funds to diversify, creating a receptive 15 years and while the dollar market a big future for the sterling market.” market for names like AT&T, BHP Bil- does offer duration, it is only in five, Stoole at Lloyds, which led the liton and other blue chip corporates,” 10 and 30 years. By contrast, issuers sterling tranche of the BHP Billiton says Donlon. can pick their spot in sterling out to transaction along with JP Morgan and 50 years. UBS, says he saw some of the largest Saving pennies “The real beauty of the sterling orders he has ever seen from the big Frazer Ross, managing director of market is the ability to provide ultra- UK accounts in the BHP transaction. corporate syndicate at Deutsche long maturities,” says Marco Baldini, “This is partly because it is a high Bank, which was on the top line for head of European corporate syndicate quality new name — so they were the AT&T, Time Warner Cable and at Barclays in London. bound to have substantial room for America Móvil deals, confirms that “In dollars, maturities for cor- the name — but also because there companies like these, which have no porates are confined to five, 10 or are just not enough assets for them operations in the UK, only issue in 30 years with nothing in between, to buy. sterling because it offers arbitrage — which is why issuers like Time Warn- “We had very and tenor if they need it. er Cable and AT&T like to come to the nice support “Ultimately it all comes down to sterling market — because they can from central cost,” he says. fill in their curves between 10s and banks and we Ross reckons borrowers save any- 30s. That also plays into the hands had new sterling where between 20bp and 50bp on of the life funds and pension funds investors that do sterling trades. which are very long dated in their not frequently “When you look at the value of view of the market. Gaz de France get a chance 30bp on a £1bn 30 year trade, you issued a £1.1bn 50 year — that abil- to consider are talking 10s of millions of dollars ity to get beyond 30 years is some- investments in annually, which is a powerful reason thing unique to sterling.” George Richardson, World Bank” to look at sterling,” he says. World Bank AT&T, which issued a £1.25bn Not enough bond 2044 bond in May at a spread of to go around “One of the reasons for the dearth 173bp over Gilts, was estimated to The UK insurance companies and of assets is that the traditional users have saved 25bp on what it would pension funds — which typically of the sterling market, UK borrowers have cost in the dollar market. favour long dated securities — are with sterling needs, have relied unu- “One of the consequences of the hungry for assets and there is simply sually heavily on the Yankee market financial crisis has been a profound not enough product being issued, instead because it has been so cost- effect on the cross-currency bases, particularly at the long end, to satisfy competitive during 2012. The Yankee principally due to an excess of syn- their demand. market has been a huge drain on thetic creation of dollar assets,” says “There is a very, very strong bid already constrained supply dynamics.” Lloyds’ Stoole. for long dated product and lots of “Before the crisis you rarely fac- cash available but not enough issu- Expanding investor base tored it into considerations around ance,” says RBS’s Clarke. While remaining an essentially cost-effectiveness because it would “The £1.25bn deal for AT&T domestic investor-driven market, the be worth a basis point or two. Now shows the strength of that bid and the increasing involvement of interna- it has a very significant impact on lack of candidates to fill it. There is tional investors, be it the central whether issuance in a given cur- not enough domestic issuance as the banks or continental asset managers, rency and swapping is cost-effective number of single-A blue-chip corpo- has broadened its appeal as an issuing or not.” rates looking for funding [is limited]. vehicle for all issuers. And while non-UK issuers would Some, like Tesco, for example, will “There has been more internation- have had to pay a premium to domes- only issue every few years while oth- al demand in sterling than in the past, tic borrowers before the crisis, they ers are very well funded.” which is a result of the eurozone debt are now able to access the sterling And, according to Jean-Marc crisis” says Guy Reid, head of fre- market at flat, if not tighter levels. Mercier, global head of syndicate at quent borrower origination at UBS. “Pre-crisis, people would buy HSBC, the only meaningful way to “It is not just the Asian central non-European names but at a spread,” penetrate the UK investor base is to banks, which have always run sterling says UBS’s Donlon. “Now it is the issue directly in sterling. portfolios, but there has also been a UK Capital Markets 2012 EuroWeek 51 Sterling as a Currency for Global Issuers

lot of European real money demand “It is not just the From niche to core for sterling plus demand from Swiss Asian central The volume of non-domestic SSAs is and retail.” banks — there close to last year’s total issuance of The EIB, which is the largest ster- has also been a £21bn and bankers expect that figure ling issuer outside the UK Debt Man- lot of European to increase to around £30bn by year agement Office, is among those expe- real money end with several issuers now consid- riencing new demand for its sterling demand for ering sterling as their third core mar- bonds this year. sterling” ket after dollars and euros. “We have seen names that were To a large extent, the increase in absent from the market for quite a supply is down to the Bank of Eng- while with a few new investors par- Guy Reid, land’s latest round of quantitative ticipating this year,” says Richard UBS easing (QE) and the shortage of Gilts, Teichmeister, the EIB’s head of fund- particularly at the front end of the ing — Europe (excluding euro) and volumes in this asset class and the curve. Africa. number of new names jumping on “With £375bn of QE planned or The World Bank had a similar the FRN bandwagon has offered executed and Gilt yields at the front experience when it issued an £800m investors a diverse pool of supply. end at extremely low levels — Sep- December 2014 fixed rate bond in While the EIB has always been tember 2014 Gilt yields hit a recent February. active in floating rate sterling and low of around 4bp and the Septem- “We had very nice support from has a number of lines outstanding of ber 2015 8bp — SSA deals coming at central banks and we had new ster- benchmark size, this year, the market the front end at 60bp or 70bp over ling investors that do not frequently has seen a diversification of issuers Gilts are a very appealing prospect get a chance to consider investments with the likes of Cades, L-Bank, FMS for an investor looking to enhance in World Bank,” says George Rich- Wertmanagement, KfW, NRW.Bank yield,” says James Solomon, sterling ardson, World Bank’s head of capital and Land NRW all taking decent vol- syndicate manager at RBC Capital markets in Washington. umes out of the market. Markets. Bill Northfield, head of SSA origi- The EIB has raised 50% of its ster- Cades is one of the issuers for nation at Deutsche Bank, says that ling funding in floating rate format which sterling is becoming more of the number of central banks invested this year, including a £1bn tap in July, a core market. Until mid-2010, the in sterling has expanded to nearly a the EIB’s largest ever tap exercise. borrower viewed sterling as a private dozen compared with two or three “So far we have issued a bit more placement market where it issued years ago when only a handful were than £4bn, 50% of which has been in only when there was an arbitrage. active. floating rate format, which is relative- Then it realised the potential offered “This is a notable development for ly unusual for us, as fixed rate issu- by sterling and now considers it to the central bank community,” he says. ance has traditionally been our main be a sector that can provide large vol- “And there are a number of differ- funding source in sterling,” says EIB’s ume as well as arbitrage, diversifica- ent investors coming on board with Teichmeister. tion and flexibility. For the past two respect to broadening the investor “In the past, floating rate notes base. More real money investors on would be sold mainly to bank treas- “In the past, the continent and in Asia are buying uries but this year the investor base floating rate sterling, all competing for the rela- has expanded to include central banks notes would be tively small pool of supply. For exam- and asset managers, which in previ- sold mainly to ple, some 80% of the £500m five ous years, would not have been inter- bank treasuries year Finland FRN earlier this year was ested. For example, 50% of the £1bn but this year the sold internationally to central banks tap of our January 2016 floater issued investor base and official institutions, compared to on 20 July was sold to central banks.” has expanded to include central around 18% of the £500m five year UBS’s Reid explains the prolifera- banks and asset Finland FRN sold to this same inves- tion of FRN issuance being the result Richard Teichmeister, managers” tor class in 2010.” of SSA spreads entering plus EIB territory. Floating phenomenon “We are in an environment where The floating rate sector has provided the economics work for the issuers years, Cades has raised around 7% non-domestic issuers, principally the and FRNs appeal to investors who are of its roughly €28bn long term pro- sovereign, supranationals and agen- faced with low Gilt yields,” he says. gramme in the sterling market. cies, with a vast source of funding “Although investors are not antici- “We consider sterling as well in 2012, as bank treasuries flush pating a rise in base rates many are as dollars as diversification mar- with cash from their central banks, concerned about a more general sell- kets where arbitrage is not the most have looked for short dated assets in off in fixed rate yields and the capital important factor,” says Pierre Hainry, which to park their money. Year to loss this results in. The demand for deputy head of funding at Cades. date, issuance has exceeded £19bn sterling floaters is very diverse. Some “It is also a useful market because compared with £18bn for the whole central banks are buyers and that from time to time we can issue taps of last year. pool of money is growing, but there that can be driven by two or three Central banks are growing buyers is also a lot of demand from UK real investors. The size of the tap can of the product, as are the UK asset money and European retail inves- also be the same size as the original managers. As a result, the triple-A tors aside from the more usual bank issue, which is not something we can SSAs have been able to raise large treasuries.” achieve in the dollar market.” 52 EuroWeek UK Capital Markets 2012 Blue Chip Companies

Have UK blue chips never had it so good? Top rated UK corporate borrowers are usually popular with bond investors, but recently they have enjoyed a particularly keen following, thanks to the perception of the UK as a safe haven. Companies can connect with a wide variety of investors in different markets, to pick up remarkably cheap funding. Nina Flitman asks how the UK blue chips are making the most of their golden status.

he UK’s investment grade corpo- “A UK corporate borrower’s posi- “There’s been rate borrowers have long been tion in Europe is a good one right a general Tknown for being selective about now,” says Rob Ritchie, head of cor- deleveraging of their funding options and sensitive on porate debt capital markets in western corporates, and pricing, to the point of being fussy. But Europe at Goldman Sachs in London. that’s allowed although they are only interested in “In some regions, particularly in south- borrowers to be the markets with the most preferential ern Europe, companies have had to go more selective issuance conditions, in the past year beyond the capital markets and their going forward they have found their funding options banks to get their funding done. In about which becoming ever broader, as investor some cases they’ve had to turn to non- markets they want demand for their paper has swollen. traditional forms of financing against Simon Allocca, to approach” “UK blue chip companies have their assets to gain liquidity. We’ve not Lloyds Bank always had the capacity to raise debt really seen that problem in the UK, in different tenors, currencies and for- where ratings are still good, balance lot of activity in the dollar market.” mats,” says Philippe Bradshaw, head sheets are strong and borrowers have Investors in the US are particu- of European corporate syndicate at reasonable liquidity.” larly open to UK borrowers, recognis- Royal Bank of Scotland in London. “But The result has been credit spreads ing their status as safe haven European when you have markets that are risk- grinding tighter, to the point where names. off, and have been for the last 2-1/2 Farouk Ramzan, head of corporate “The Yankee market has remained years, the opportunities have increased debt capital markets at Lloyds Bank in difficult for peripheral borrowers over even more. Blue chips are seen as a safe London, says they are “challenging the the last 18 months, however UK names haven, and when investors have limited tight levels last seen in the halcyon days have had better access,” says Barry Don- options about where to put their cash, of 2006 and 2007”. lon, head of corporate syndicate at UBS it’s an obvious choice.” The tightening has become acute in London. “This is down to the UK This demand means the bond mar- during the keen surge of corporate having an independent currency and ket is unusually attractive for the UK’s bond buying in September. “On aver- being perceived as less heavily correlat- strong corporate credits, and even for age,” Ramzan says, “the new issue pre- ed to the volatility in the eurozone. US those with weaker or cross-over ratings. mium for low beta, defensive issuers investors buying UK blue chip paper Rates are low and spreads are tight. is between zero and 5bp compared to can add exposure to Europe without Like those of Germany, the Netherlands their outstanding curve. This reflects feeling vulnerable.” and the Nordic region, UK companies the technical imbalance between sup- In May alone, GlaxoSmithKline are seen as a safe haven for investors, ply and demand in the primary market raised $5bn, Diageo $2.5bn, BP $3bn, with a degree of protection from the — given that corporate bonds are the BAT $2bn and Pearson $500m. eurozone crisis. They have been tak- asset class of choice at the moment — And at the end of July, Unilever, ing advantage of this to price bonds at and that secondary market liquidity is the UK-Dutch food and household aggressive funding costs, compared to really thin.” products group, raised $450m of three their own past levels and to some of year bonds and $550m of five years their European peers. Go west! at record low coupons of 0.45% and Demand is especially strong in the US 0.85%. “Blue chips are market, which offers the best visibility Although some bankers are wor- seen as a safe about the size of funding available at ried about whether the US market haven, and when the most cost-effective pricing. will be able to continue to take up investors have “This year, the dollar market has the slack, should the eurozone crisis limited options been very buoyant and UK blue chips worsen in the coming months, for the about where to are really taking advantage of it,” says moment there is capacity for borrow- put their cash, Ramzan. “You have low execution ers to issue jumbo deals. By doing so, it’s an obvious choice” risk, there’s a lot of demand, pricing is while remaining an infrequent issuer, good and swap markets are reasonably UK borrowers can preserve their rarity Philippe Bradshaw, benign, although this can shift. There’s value, yet create a liquid, performing Royal Bank of Scotland a lot of investor interest and money benchmark that can be used as a refer- there, so it’s not surprising that there’s a ence for pricing future deals. 54 EuroWeek UK Capital Markets 2012 Blue Chip Companies

“There’s a lot of “Investors can’t find enough supply diversification opportunity, it issued its investor interest of straight, unsecured bonds and are debut Australian dollar bond. and money showing more flexibility now than a “BP is a good example of a compa- there, so it’s not few months ago,” says Bradshaw. “It’s ny that looks around by jurisdiction to surprising that pushing the investors at big institutions establish the best market and currency there’s a lot of to be more flexible, to look at alterna- from a price perspective,” says Donlon activity in the tives to plain vanilla bonds.” of UBS, which led the deal with ANZ. dollar market” “This summer, it turned out to be Aus- New horizons tralian dollars and Eurodollars, and by One option is hybrid capital. This sum- taking this approach they have sourced Farouk Ramzan, mer BG Energy and SSE, the former extremely cost-effective funding.” Lloyds Bank Scottish and Southern Energy, raised £2.2bn between them in dollars — Fancy footwork “Rather than systematically going sold to Asian retail investors — euros That kind of approach to funding relies to various markets, some borrowers and sterling. on being flexible — having leeway in are just executing big old dollar deals,” UK blue chip borrowers are also your plans and the right documenta- says Ramzan. “The days of the jumbo interested in diversifying their fund- tion to be able to pounce opportunisti- dollar deal are not back, but if event ing outside these three core currencies. cally when a chance arises. risk is relatively low in dollars, execu- National Grid sold a rare Maple bond “Centrica had no immediate need tion risk is low, pricing is good — why of C$750m in September. for funds, but just felt that the condi- mess around? If you get a big dollar “There have been some — Uni- tions were right to issue,” says Ritchie deal done you can take a large piece of lever and others — that have gone to at Goldman Sachs, which led the 32 financing off the table and then look China to fund in renmimbi, among year sterling deal with Credit Suisse, to see if you can tactically arbitrage the other currencies,” says Ritchie. “But the Lloyds, Mitsubishi UFJ Securities, RBC other markets over the remainder of real question for UK blue chips is why Capital Markets and UBS. “We hadn’t the year.” would they go to the effort of diversi- originally planned for an August pric- fying with foreign currency funding, ing date as it’s usually so quiet, but we Investors get flexible when it’s likely that it’s as attractive or brought it forward as the market was This is not to say that UK borrowers more attractive in the dollar or ster- so supportive.” have moved away from the sterling and ling markets, which are so liquid right The enthusiasm of that back- euro markets. Their options are grow- now.” ing from the markets has ebbed and ing here, too, as investors, hungry “BP is a good flowed at times, as investors’ fears for paper, become ever more accom- example of a about Europe’s economy have fluctu- modating. company that ated and they have repositioned their Typically, issuers go to the euro looks around credit holdings. But in the main, UK market for tenors of one to 10 years, by jurisdiction corporates have been able to rely on while at longer maturities the sterling to establish the the bond market as they reduce their market beats all for depth and pricing. best market and loan funding. But this pattern is becoming more currency from a “There’s been a general deleverag- fluid. The scarcity of yield is tempting price perspective” ing of corporates, and that’s allowed European investors into longer maturi- borrowers to be more selective going ties — although UK issuers have not Barry Donlon, forward about which markets they explored this territory yet. And in ster- UBS want to approach,” says Simon Allocca, ling, as Ritchie explains: “With excep- head of loan markets at Lloyds Bank tionally strong retail flows into credit While the financial crisis has put a Wholesale Banking & Markets in Lon- funds there’s a short term bid develop- premium on funding diversity, many don. “This deleveraging has been by ing, allowing issuers to fund in sterling of the top UK borrowers had already way of loans rather than bonds and it at the shorter maturities.” The UK retail explored other markets before that. means they’re going to be in a better funds’ bid has been augmented by “Most of the UK corporates are not shape going into the future.” European investors moving money into purely UK names,” says Donlon. “Most The variety of borrowing options sterling this year as a diversification are geographically diversified from a open to UK blue chips is probably from the troubled euro. revenue perspective and because of broader than ever — allowing them to “Meanwhile, at the other end of the that, are more likely to have issued in feel confident about the future security market,” Ritchie adds, “pension funds a variety of currencies. It’s very hard of their funding. and insurers are still looking for yield as a borrower to establish yourself in “It’s no secret that we’ll be in a and are looking for very long dated a market during a period of volatility. different world in four or five years’ bonds.” But these UK blue chips are well estab- time,” says Bradshaw. “The balance The keenness of that bid was evi- lished, they have a good following and between loans and bonds is shift- dent at the end of August, when Cen- the investor base has stuck with them.” ing towards bonds. It is comforting trica, the gas, oil and electricity group, The issuer that exemplifies this for issuers going through this proc- sold a £500m 32 year bond that approach is BP. The oil group’s debt ess to know that the bond markets attracted a book of around £1.2bn and portfolio reflects the multitude of inter- are very co-operative for corporates, was priced with a minimal new issue national operations and assets it has to that they’re not getting stuck into a premium with a 4.25% coupon — finance. This year, it has borrowed in corner where they will have to pay up 0.125% tighter than the coupon on its the euro, US and Canadian dollar mar- to attract investors. It’s a very positive £750m 17 year bond in March. kets, and in August, finding another outlook.” UK Capital Markets 2012 EuroWeek 55 Midcap Companies

The unsqueezed middle: midcaps find new funders For medium sized companies with a decent track record and some financial skills, there are usually loans available. And banks see their bigger cousins in the FTSE 250 as prized clients. But as Jon Hay reports, the landscape is changing. Whether through necessity or choice, these companies are relying less on banks. As that happens, a wider choice of financing options is becoming available to firms on lower rungs of the size ladder.

he UK’s midcaps are on a roll. therapy in 2009, especially if their cov- “Capital is As this report went to press, the enants were in breach. Losing a couple available for TFTSE 250 index was within a of banks from a syndicate can be quite midmarket whisker of breaching the record level of painful, and that did happen, particu- companies, around 12,200 at which it has peaked larly as foreign banks retreated. but the lending twice before — in June 2007, just “Over the decades there’s been an environment before the credit crisis, and July 2011, ebb and flow of foreign bank inter- is certainly before the eurozone crisis. est in the UK midmarket,” says Alan changing” Some may read that as ominous. But Turner, head of debt finance at Barclays for midcap companies, it is a vote of Corporate. “The UK has a lot of attrac- confidence in their potential to grow. tions — the approach to risk and lend- Mike Marsh, The index has gained 18% this year, ing, the legal system, its international Goldman Sachs even as the UK has endured the second disposition. When times are tough and dip of a recession. What is going right? capital is scarce, some of them have clays, , HSBC, JP Morgan, “Not quite as much as the index to retrench to supporting their home Lloyds, Royal Bank of Canada and RBS. implies” might be the truest answer. market.” The midcap loan market resembles Although midcap stocks have risen, led The likes of Anglo Irish Bank have the large corporate one. The corporate by leisure-related sectors that imply gone, but Santander and Handelsbank- banking arms of the UK clearers handle confidence in the consumer economy, en are now fixtures on the UK scene. clients from turnovers of £15m up to they are still cheap relative to earnings the likes of Melrose and oilfield services and to other markets, such as the US. Time to save money group Petrofac, whose $1.2bn five year Strategically, most UK midcaps are Since 2010, loans have been plenti- revolver Barclays and Standard Char- sitting on their hands — and on piles ful enough for companies to focus on tered signed in September. of cash — waiting for the economy to squeezing down their borrowing mar- Facilities right down to £25m are pick up before embarking on M&A and gins and diversifying their funding. syndicated, even if only to a club of two big investments. “For FTSE 350 companies there is or three banks. Nevertheless, the stockmarket rise is no capital constraint,” says Nicholas “There’s a remarkable knowledge a sign that British firms have been able Bamber, head of investment grade bond and consistency about pricing in the to protect their profit margins through origination and private placements at loan market,” says one banker. “Mid- cost-cutting and globalisation, so that RBS in London. “Modestly levered mid- caps solicit feedback from all the banks, the crisis has damaged them much less caps can borrow money from banks the banks give comparable pricing, it’s than feared. at 200bp or 250bp over Libor or 3% not difficult to work out what’s going Indeed, UK Plc’s defensive wall of all-in. In the bond market they can pay on. So there’s a market par for a certain gold, estimated at £750bn, is one rea- 4% or 5%, depending on credit quality. credit quality.” Banks will then lend at a son why the economy is so sluggish. Those are the cheapest prices corporates sub-par level, depending on how much If companies would spend a tenth of have ever been able to borrow at.” ancillary business they expect to get. that wealth, the Bank of England might Most midcaps are not rushing to Is this an idyllic world, about to be not have to print so many pounds to exploit this plentiful finance. Exceptions swept away? In the City, all you hear is buy Gilts. include this year’s £1.5bn takeover by that “banks can’t lend” and even “banks What is clear is that UK midcaps, Melrose, the investment company, of shouldn’t lend — we should become in aggregate, are not struggling finan- Elster, a German maker of gas meters. intermediaries”. cially. “For midmarket companies with Melrose raised £1.2bn in a rights Ebitda of £50m-£100m we have yet to issue led by JP Morgan and Investec in A brush with Basel see an increase in default rates because August. Like many UK midcap ECM Opinions differ hugely on how Basel commercial lenders have restricted the deals, it was popular with investors III is going to change finance. Some flow of capital,” says Mike Marsh, head — who only wish there were more of believe the effect will be severe, mak- of EMEA high yield and leveraged loan them. ing it unprofitable for all but the most capital markets at Goldman Sachs. Melrose also obtained a £1.5bn highly rated banks to lend to compa- Some midcaps suffered shock multi-currency loan arranged by Bar- nies with ratings of triple- or lower. 56 EuroWeek UK Capital Markets 2012 Midcap Companies

Projections have been made that banks’ tapped the bond market, in public or “Due diligence corporate loan books in Europe will private form. The smaller they are, the is picking up need to shrink by 100s of billions. The more likely it is to have been a private and people are effect for smaller and weaker compa- deal.” beginning to call nies could be that they will have to pay Midcap UK public bond issuers this the bottom of the more for loans or borrow less. year have included Jaguar Land Rover, market” Others, however, believe the leading Virgin Media, Ineos, Eco-Bat and Afren banks have already taken Basel III on in the high yield market, Mobility board in their lending decisions. Operations Group and Gatwick Airport “We’re very conscious of Basel III in investment grade and Center Parcs and factor it into our conversations UK with a now-rare whole business Simon Palmer, with clients, including the net stable securitisation. Lloyds Bank funding ratio and liquidity cover- For many of these larger companies, age ratio,” says Simon Palmer, head of bonds are now the main source of debt. dollars and swap?” the complex deal team at Lloyds Bank It may not be cheaper, but treasurers no Lately, interest in PPs in the UK has Wholesale Banking & Markets. “All our longer want to have all their eggs in a been greatly stimulated by the finan- product development will be built with basket carried by the banks, in case they cial crisis. “If banks are delevering, you changing legislation in mind.” trip over. need real money to replace part of that If banks are already complying with Outside the special world of high lending,” argues Hutchinson. Basel III — and the four largest UK yield, however, the sterling and euro In March an industry taskforce, led banks are either there or nearly there — bond markets are not geared up to buy by Tim Breedon, CEO of Legal & Gen- then there need not be any great capital bonds of less than £250m or €500m. eral, reported to the government on squeeze to come. A growing alternative is the retail how to boost non-bank finance for UK “Most of Basel III is baked in,” says bond market. Workspace, which pro- business. Bamber at RBS. “I think banks will vides premises for small businesses in Among its recommendations were adapt, corporates will adapt, by diver- London, launched a £50m-£75m issue to encourage UK private placement sifying funding sources, especially in via Investec and Numis in Septem- investment through an initiative led by midcaps, not pushing for that drawn ber — its first non-bank debt in the the Association of Corporate Treasurers. debt from banks, and taking longer past five years. Workspace’s eight bank “Our cross-industry working group term debt from the bond market.” lenders were all happy to refinance its is looking at the barriers stopping a Martin O’Donovan, deputy policy facilities, but wanted to hold smaller UK private placement market devel- and technical director at the Association amounts. oping,” says O’Donovan at the ACT. of Corporate Treasurers, is still worried “From my perspective that’s sen- “There seem to be a mix of things that about Basel III. “The total quantum of sible anyway,” says Graham Clemett, are rather woolly and don’t stand up what banks are prepared to do for the the company’s CFO. “Now that rates to much scrutiny, like ‘we don’t invest same amount of capital will be substan- have come down so much, the pricing because there isn’t any precedent,’ tially less,” he says. “It plays out either makes bonds attractive.” through to quite serious barriers like in fewer credit facilities being available The retail bond, paying 6%, will Solvency II.” or they will ration it through pricing.” raise Workspace’s average cost of debt Like other insurers, Prudential is O’Donovan says the squeeze is being from 5.1% to 5.2%. But Clemett judges worried by Solvency II, about which it felt particularly in derivatives, where that worthwhile, as it will add a year to has been “making a lot of noise qui- banks are charging even investment average debt maturity, is fixed rate and etly”. grade borrowers 30bp-40bp more than unsecured — though with two straight- “It has the potential to discour- before for a currency swap — a cost forward financial covenants. age long term lending,” says Simon that is now affecting behaviour. Pilcher, CEO of fixed income at Pruden- Private passion tial’s investment arm M&G, “including Looking elsewhere But the favoured option for companies through corporate bonds, and to dis- Whether by push or pull, the sources of needing less than £250m, or lacking courage any lending to triple-B entities midcap finance are changing. “Capital is a rating, has long been the US private or lower, which typically characterise available for midmarket companies, but placement market. UK firms raised the infrastructure and private placement the lending environment is certainly about $10bn there last year, and some, markets. Perversely, if it is implemented changing,” says Marsh at Goldman. “We such as Cadogan Estates, source nearly in a careless fashion, it could increase are seeing the larger lending banks all their debt that way. risk within certain insurance com- reduce single company exposures, but Yet with the exception of Pruden- panies, by encouraging shorter term the emergence of new sources of capital tial’s M&G Investments, which has led investment.” for companies in this space a growth the way in Europe since 1997, and of There is evidence that Solvency II is in funds with strategies specifically Aviva, almost all the capital for PPs still already putting insurance companies off focused on midmarket corporates and comes from US-owned investors, even lending beyond seven years. the growth in the high yield bond mar- if leaders like MetLife and Pricoa have ket also offers a source of capital.” offices in London. Insurers become lenders This trend began before the finan- “The big question on private place- However, M&G has not waited for this cial crisis, and has been strengthened ments,” says Mark Hutchinson, head of to be resolved. In 2009, it raised a UK by it. “If you look at the FTSE 250 and alternative credit at M&G, “is can you Companies Financing Fund to fill the take out the investment trusts and non- get more interest from other institu- gap left by retreating banks by lend- UK resources companies,” says Bam- tional investors in the UK and Europe ing to medium-sized firms, using the ber, “probably 60% or 70% have now so companies don’t have to issue in investing skills M&G had gained over UK Capital Markets 2012 EuroWeek 57 Midcap Companies

many years in the US PP market. carry on building the business. cheaper funds, with higher leverage, M&G was also keen to expand this Institutional investors like Haymar- perhaps up to 90% of the assets. Lloyds kind of finance by bringing other ket Financial and Ares Management are is keen to grow this business. investors in. “These were good midcap increasingly seen in the UK midmarket, “The asset-based finance market, companies, which would be a good alongside the more established players which includes factoring and invoice debt investment for pension funds and like Prudential. discounting, is about 42,000 compa- insurance companies,” Hutchinson says. The government will lend £700m to nies, which in the scheme of UK Plc is So £1bn of the fund’s £1.5bn of com- mid-sized companies under its Business quite tiny,” says Ian Lomas, sales direc- mitted capital was raised from other Finance Partnership scheme, through tor at Lloyds TSB Commercial Finance. institutions, and £500m from Pru. commercially managed funds. “Research we undertook a few years Perhaps surprisingly, M&G was not “I do think the PP market will ago showed company uptake was like overwhelmed by demand for loans. The develop,” says Hutchinson. “But it’s a a funnel. About 90% were aware of the banks were supplying plenty of cheap misconception that you can suddenly product, about 50% had thought about debt, and it took time to convince com- get institutions to provide billions, like using it, but only about 1% had done panies to get involved. Nevertheless, turning on a switch. The institutional so.” from May 2010 momentum picked up. leveraged loan market took five or six Non-users thought discounting was After the first loan of £100m to trans- years to develop, and that was going expensive and administratively difficult, port group Stobart, which is develop- pretty fast.” but users rated it well on both counts. ing Southend Airport, six more £100m The Breedon Report’s estimate of loans were made in the next year, to a funding gap for British industry of When hope returns , Northgate and £84bn-£191bn over the next five years Because asset-based lending involves housebuilders Taylor Wimpey, Grainger looks daunting, though the reality may intimate knowledge of a company’s and Barratt Developments. The fund turn out far more benign. sales ledger, it gives banks a keen feel reached the end of its investment peri- for clients’ moods. od in mid-2012 with 11 loans made, Treasure in the ledger “Confidence amongst our customers totalling £930m, from its £1.5bn target. However, there are many other avenues returned quickly in 2009,” says Lomas. Hutchinson is pleased with the midcaps can explore. Breedon pointed “What’s quite interesting now is that progress, saying this kind of deal “is to stronger companies paying suppliers’ there seems to be an element of uncer- now on the menu of options for a suit- invoices faster, and using their consid- tainty again — albeit nowhere near ably sized company thinking about long erable financial resources to support what it was in 2008. We are seeing an term financing”. smaller firms with supply chain finance. increase in undrawn availability in our Suddenly, there are signs of other Asset-based lending also looks sorely clients’ facilities to about 20%-25% — institutions exploring midmarket lend- underused. Invoice discounting allows it’s been increasing a couple of percent- ing. Goldman Sachs has recently agreed companies to electronically sell their age points a month all year.” a refinancing of the senior debt of IMO receivables to a bank or other finan- That is a measure of the slowdown Car Wash, a company owned by banks cier, in return for a cash advance that is in the economy. Palmer in Lloyds’ and hedge funds since its debts had to repaid, less interest, when their custom- complex deal team believes fear of the be restructured after a Carlyle Group ers pay their invoices. Loans can also be eurozone crisis remains a dampener on LBO. The facility will be underwrit- secured on machinery or stock. corporate spirits in the UK. “Ongoing ten by Goldman Sachs, Highbridge This gives firms a steady source of uncertainty is still creating cautiousness Principal Strategies and Castle Hill Asset working capital that is lower risk to the within the market,” he says. “Compa- Management. bank than an ordinary loan, because it nies are reluctant to invest heavily while SuchUK loans midcap may bondnot be issuance cheap, but is secured. Lloyds Bank’s losses on its the situation remains fragile.” sometimes what matters to the borrow- £3.8bn asset-based book are less than Nevertheless, Lloyds is expanding er is being able to obtain finance and 0.5% a year. That means firms can get the complex deal team, which advises midmarket companies on financing UK midcap bond issuance activity like takeovers, management buyouts or restructurings — because it 20 believes activity is soon to quicken. bn 18 “We are having a lot more conversa- tions with clients about potential deals,” 16 says Palmer. “Due diligence is picking 14 up and people are beginning to call the 12 bottom of the market.” 10 When confidence swings back, demand for debt and equity fund- 8 ing will rise, putting the UK’s finan- 6 cial system to the test. But the signs are 4 that — apart from a few foreign banks 2 — the established lenders and investors 0 are still present and want to do more. 2007 2008 2009 2010 2011 2012 to And around them are new channels of Sept 17 finance, from retail bonds to corporate All UK non-financial corporate bond issuance, excluding utilities and current FTSE 100 companies finance funds, which could give mid- caps a wider choice than many of them Source: Dealogic/EuroWeek have experienced before.

58Source: Euro DealogWeekic/EuroW UK Capitaleek Markets 2012 Small and Medium-Sized Enterprises

SMEs: not drowning, but saving Policymakers are convinced the UK’s SMEs are not growing because they’re starved of capital. Some may be, but most are still funded by the banks, have been hoarding cash and could borrow more if they wanted to. As Jon Hay reports, subsidised loans and a growing diversity of lenders can only help — but growth will return when confidence does.

ngland is a nation of shop- of 2012 the seven biggest banks had “We are still keepers,” scoffed Napo- £39bn of debt outstanding to the small- saying yes to “Eleon, dismissing Britons as est tier of businesses, £1bn more than eight out of 10 small-minded cowards. Typically, he was in July 2011. The total facilities avail- businesses that wrong — what distinguished the coun- able to those customers had stayed flat ask for loans, as try then was . at £45bn, while the companies’ own always” But the phrase points to a truth. A deposits had swelled from £51bn to staggering 45% of UK jobs today are in £55bn. These figures hardly suggest companies with less than 250 employ- SMEs are starved of money. ees. If the country’s flat-lining growth Perhaps these are the lucky ones, is to take off, small and medium sized and there are legions out in the cold, Stephen Pegge, enterprises will have to start investing without loans? “We are still saying yes Lloyds TSB and hiring. to eight out of 10 businesses that ask for “What most small firms are showing loans, as always,” insists Stephen Pegge, keep credit flowing to the economy. A is resilience,” says Mike Cherry, policy director of SME markets at Lloyds TSB bank CEO caught dodging this responsi- chairman of the Federation of Small Commercial. bility would be pilloried. Businesses, which has 200,000 mem- “More questions are asked now, Furthermore, it is cheaper for the bers among the UK’s 4.5m SMEs. “Many there is more challenge on cashflow banks to comply. Alan Turner, head of them still have an aspiration to grow, forecasts,” says Peter Ibbotson, chairman of debt finance at Barclays Corporate, which is brilliant. However, confidence of small businesses at RBS. “It’s the right points out that Barclays has a huge remains very low, as is trust in the finan- thing to make sure businesses can repay. investment in the fabric of its SME and cial sector, which is not good news. But the same number of credit applica- mid-cap lending business. “We’ve got Most small businesspeople will keep tions are getting approved — we’re still more than 1,000 branches, an IT net- their heads down and get on with it, but approving about 90%, as before.” work and operational infrastructure that we probably think it’s 2014 at the earli- It may be impossible to discover for supports this business. It’s an absolute est before real growth kicks in.” sure if the banks are being completely nonsense to think that a bank that was In September, the Federation’s confi- straight about their record during the under capital pressure would single this dence index slipped into negative terri- financial crisis, now five years old. Data activity out to shrink it. If you make tory — though nowhere near as badly such as the security required for loans, fewer loans, you’ve still got the same as at the end of 2011. interest rates charged to different bor- costs. Volume businesses like this are the More depressingly, its quarterly sur- rowers and lending criteria are private. last places you try to effect change.” vey of members found that of the 22% “There was a very short period at the Lending to hedge funds or private of firms that had applied for credit, 42% end of 2008 when liquidity was tight equity funds consumes a lot of capital were unsuccessful, almost as many as for all the banks and it was harder for but might require only a few dozen the 43% that did get finance. them to lend,” admits Ibbotson. But the bankers, whose jobs could be cut —and The survey only had 240 respond- banks are adamant that from 2009 on, later restored — much more easily. ents, and the disgruntled may be more they have been supporting SMEs as hard “There is more capital required now vocal than the satisfied. But the trend has as they can, and have not tightened their for loans, but in the grand scheme of been worsening. lending criteria. things our SME loan book is £30bn,” Surveys like this are driving the UK’s Lloyds, for example, has increased says Pegge. “Lloyds’ group balance sheet public debate about how to help SMEs its main SME loan book every quarter is £1tr. So if you are looking to econo- grow and create jobs. through the crisis. mise on capital you don’t do it through The popular perception is that small The bank’s Commercial Finance unit, SMEs.” business’s biggest problem is “the banks which provides invoice finance and A third reason for banks to keep are not lending”, in a slump of risk- other secured lending, never lowered its backing small business is that credit aversion after the credit crunch. Govern- advance rates — equivalent to a loan-to- quality has remained remarkably good. ment policy revolves around this view. value ratio — and has recently offered At the worst point of the 2008-9 reces- two swathes of clients more leverage. sion, the insolvency rate for UK com- Loans steady panies did not even reach 1%. Before But this is far from the whole picture. No mileage in cuts 2003, the rate was never below 1%, at Figures from the British Bankers’ Asso- One reason is public pressure. Politicians least since 1985, and in the 1993 reces- ciation show that in the first quarter and media call relentlessly on banks to sion it peaked at 2.5%. UK Capital Markets 2012 EuroWeek 59 Small and Medium-Sized Enterprises

Low interest rates are the biggest rea- to businesses, totalling £2.5bn. ing to set up a national small business son for this. “The overall cost of debt for That programme has now been bank, along the lines of Germany’s KfW our clients would substantially be in the replaced by the much bigger Funding or the US Small Business Administration. 4%-5% range today, including margins for Lending scheme, which will subsi- The plan appears to be for the state and reference rates,” says Karl Nolson, dise 5% of banks’ existing UK corporate and private sectors to put in £1bn of head of debt syndicate at Barclays Cor- and personal mortgage books, estimated capital each, supporting £10bn of SME porate. “In 2007, it was 7%-8%.” at about £80bn, as well as any increase loans via commercial lenders. The FSB’s survey suggests many in lending. customers pay more than that, but the Lloyds has just drawn the first £1bn Loans from the laptop point stands. Yet even with the Bank of from the scheme, and will pass on the At the other end of the scale is a new England cutting rates almost to zero, benefit as a discount to homebuyers, breed of peer-to-peer lenders, which companies could not have survived if especially first time buyers, SMEs and use the internet to enable private inves- the banks were pushing them away. mid-market businesses. tors to make corporate loans or equity “The big question about Funding investments. Diversity needed for Lending,” asks Ruth Lea, economic Andrew Hilton of the Centre for Bankers readily agree, though, that adviser to Arbuthnot Banking Group, the Study of Financial Innovation has not everything is easy for SMEs. “Back “is whether it will actually produce predicted that “one or two will have in 2006-7 more than eight out of 10 new lending. The loans will be cheaper, become so mainstream in a few years’ applicants would have managed to get no one’s saying that’s a bad thing, but time that we will be unable to compre- finance somewhere, maybe from Irish because they are so constrained by the hend how we did without them”. or Icelandic banks that have now with- capital requirements being imposed by They are certainly exciting. One of drawn,” says Pegge. “Now there prob- the FSA, banks may say they can’t really the largest, Funding Circle, offers small ably are some that will not get financed. expand lending.” business loans to investors at the click of With hindsight, some equity risk was Bankers acknowledge that Funding a mouse, with eBay-style countdowns being financed with debt, which was for Lending will not directly increase until the offer expires. The radical idea probably never sensible.” their risk appetite — though they insist is exposing senior investors to loss and Start-ups and first time borrowers are that on the SME side, they are not risk- illiquidity, unlike a bank, where a central finding it hardest to get finance. Others averse anyway. What they hope is that, capital pool is designed to give deposi- may have been put off even asking for like a shop’s special offer, it will encour- tors complete safety. loans by the barrage of publicity about age customers to take out new loans to But so far, this model remains tiny. banks not lending. make investments. In its first two years, Funding Circle All agree that a wider variety of has facilitated £50m of loans. Com- financing options would help SMEs, and Cheap as chips pare that with , with £2bn should be encouraged. “The resultant pricing after Funding for of assets, offering a back-to-basics style The government offers a wide range Lending is lower than I’ve seen in 30 of banking with managers, rather than of help, ranging from export finance to years,” says Ibbotson. “An SME can get computers, making loan decisions. Or loan guarantees to advice. But only a few a three year fixed rate loan for less than , the risk-averse Swedish of its schemes have hit the headlines. 3%, without fees. Putting finance in lender that is adding branches rapidly in One was — strong- place at a very cheap rate will be anoth- Britain and grew its UK corporate loan arming the banks to make £215bn er influencing factor for companies to portfolio by 19% last year, to £5.7bn. of new loans in 2011. Next came a invest, but it’s not going to change eve- Gradually, competition is seeping National Loan Guarantee Scheme, which ryone’s mind.” back into the UK’s SME finance market, enabled banks to borrow under the No sooner had Funding for Lending where the big clearers have held the fort Companystate’s liquidationguarantee, andpassing individual on the insolvencysaving ratesbeen in announced England & than Wale Georges Osborne, for the past five years. to companies. Barclays, Lloyds, RBS and chancellor of the exchequer, pulled What Mike Cherry at the FSB wants others made some 16,000 cheaper loans another rabbit out of his top hat, pledg- now is to see confidence in the finan- cial sector return, after the latest knocks Company liquidation and individual insolvency rates in England and from the and banks being punished for mis-selling interest rate 3.5% 0.35% swaps to SMEs. “Our members are very Individual Insolvency rate (% of adult population) population) adult of (% rate Insolvency Individual Rolling 12 month rates exercised about that,” he says. “Some of 3.0% 0.30% the stories have been horrifying — peo- ple have been put out of business.” 2.5% 0.25% The banks understand this concern

2.0% 0.20% and know they must do better. “It’s very important that we rebuild trust in the 1.5% 0.15% banks,” says Ibbotson, “partly so that businesses have the confidence that 1.0% 0.10% banks will be there to support them, so

Liquidation rate (% of active register that they start investing again.” 0.5% 0.05% Bankers say they see tentative signs

0.0% 0.00% of buoyancy returning — and further healing of the eurozone crisis would 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 strengthen that. The nation of shopkeep- Liquidation rate (% of active register) Individual Insolvency rate (% adult population) ers might just be setting up some new Source: Insolvency Service, Companies House and the Office for National Statistics stalls. 60 EuroWeek UK Capital Markets 2012

Source: Insolvency Service, Companies House and the Office for National Statistics Profile: M&G Investments

Think for yourself, and carry a big stick M&G’s profile among UK bond investors is second to none. But what lies behind the firm’s influence? As Jon Hay discovers, M&G’s open-minded approach to investing, from public to private markets, is driven by rigorous credit research that hunts for value. The success of this formula has kept retail and institutional money rolling in — sometimes even too fast.

&G is both the epitome of ment business, founded in 1931 and buy anything without having done the UK fund management acquired by Pru in 1999. significant credit work and under- Mindustry, and the exception. The Pru DNA brought a speciali- standing what we are buying. That With its huge appetite for sterling sation in fixed income, driven by the means we are sometimes comfort- bonds, as well as euro paper, M&G life assurer’s hunger for long term, able investing in securities when is the alpha male of the big goril- stable assets. M&G’s USP was market- no one else is. We don’t need the las that prowl the UK’s fixed income ing to retail investors. At that stage comfort blanket of a third party rat- market. most of its unit trusts and funds ing, or to see what others are doing The concentrated power of the were in equities — now it is the before we commit.” leading real money investors gives UK’s largest manager of retail bond This independent thinking — the the sterling market its special virtues funds. That has helped M&G to top product of M&G’s widely admired, — depth, appetite for long maturi- the Fundscape chart for UK retail 86-strong credit research team, and ties and openness to innovation — fund sales for 14 consecutive quar- of the managers of its various retail, but also its quirky, cliquey, some- ters to March 2012. institutional and internal funds, times crabby side. who all make their own decisions A widely distributed corporate Dance like a butterfly... — means the firm often has a very bond in euros might be sold to 200- Size matters, and M&G is a bigger strong view on deals, for exam- 400 investors. In sterling 80 is plen- bond buyer than BlackRock or Legal ple on covenants. And it backs its ty, and the top 10 buyers will take & General, often seen as its closest choices boldly — sometimes making the lion’s share of the deal. rivals. Sometimes bankers and issu- deals happen that otherwise would The influence of the largest fund ers find M&G’s power irksome. It has not, and even occasionally buying managers is therefore immense. been known, they say, to hang back half a new bond. Asked for his view of M&G, one from a new issue, waiting to see investment banker’s first reaction how the book develops and using Hot and cold was to chuckle warily. “They hold that knowledge to pitch its pricing “There are certain market conditions such a massive sway in the sterling — confident of getting a good allo- where the banks and borrowers are market that you’d have to be drunk cation, even if it comes in late. particularly keen to have us involved, or crazy to be honest about them,” Another complaint, from issuers and where we might be more influ- he said. “All I’d be prepared to say or other investors, can occur when ential,” says Pilcher. “There are other is that they are by far and away the M&G’s size makes it indispensa- times when they need us less and most important investor in the ster- ble to getting a deal done securely. listen to us less. We can help deals ling market, often singlehandedly Other funds may be willing to buy to get done — we think it’s a great driving entire transactions.” the bond at a lower spread or with service to the market. Many of our M&G Investments has grown to lighter covenants, but they can find competitors can’t do research, but the front rank of City fund manag- their allocations cut back to accom- they still benefit from covenants that ers from two roots: the 160 year old modate a less aggressive M&G. we ask for. They’re free riders, but Prudential life assurance company Simon Pilcher, CEO of fixed good luck to them, I’m proud of and the M&G retail fund manage- income, who has overseen the firm’s that.” growth since he joined Pru in 1998, M&G will often be wall-crossed “We are rejects some of these gripes. “That’s to discuss a transaction privately, sometimes not the way we operate,” he says, though bankers say it never reveals comfortable referring to delaying putting in an its hand entirely. Equally, M&G will investing in order. “Generally we are the first to walk away from deals it doesn’t like. securities when commit. We never puff our orders to But, apart from bestowing power no one else is” play games — we’re good for what — and responsibility — size can we commit to and trade on our be a pain. With money gushing in, reputation.” some M&G funds have grown faster Pilcher believes M&G’s role in the this year than the markets they Simon Pilcher, market is appropriate and respon- invest in, notably corporate bonds. M&G sible. “We put a huge effort into The fund managers may feel they credit research,” he says. “We never are trying to drive 20 tonne lorries UK Capital Markets 2012 EuroWeek 61 Profile: M&G Investments

down a country lane. Accepting that it could not forecast “The US In July, M&G asked independent what would happen to the euro, the bulge bracket financial advisers to discourage retail firm sought assets that would per- understood the clients for a while from investing in form, whether good or bad things role institutions its Corporate Bond Fund and Strate- happened. That meant a preference could play gic Corporate Bond Fund, managed for corporate debt in the periphery, in leveraged by Richard Woolnough, though the over sovereign or bank paper. In this, finance” funds remain open to new money. M&G is probably in the mainstream “My IFA says M&G can’t spend of European investor opinion. the money,” says one banker. He explains that, however favoured an Against the current Mark Hutchinson, investor is, there is a limit to how Yet there are clear examples of the M&G much of a typical bond issue it can firm sticking its neck out. As long buy: “If it’s a £250m deal, we won’t ago as 1997 M&G became the Euro- migrating out of weaker credits and give £80m to a single account.” pean pioneer in private placements out of ABS, into corporate paper.” Pilcher says M&G is merely (see fuller account in chapter on midcaps), Though M&G had not foreseen slowing inflows to those two retail and it remains the leader. the crisis, that switch positioned it funds, which total £11bn. “We have Less well known is its early role well. “In late 2008 and 2009 there a strong commitment to look after in leveraged finance. Mark Hutchin- was a fabulous buying opportunity the interests of our existing clients,” son joined Pru in 1997 to expand its for non-levered investors who were he explains. “We want to make sure unlisted debt activities. never going to be forced sellers,” we are not feeling under any duress Having worked as an originator says Pilcher. “You had triple-A RMBS to buy paper and can be as selective at , Hutchinson looked to and CMBS trading at 300bp over as we want.” the US to see if institutional inves- Libor.” New issues are only a small part tors could get involved in leveraged M&G hoovered up ABS for its of what M&G does — the bulk is finance. “We were supported by the broad bond portfolios — “we were secondary trading. If M&G’s retail US bulge bracket, who understood the market in 2009,” Pilcher claims funds get too big, it could be hard the role institutions could play in — and tried to find third party insti- for them to enjoy liquidity when this market,” says Hutchinson, still tutions brave enough to put money they need to sell paper — for exam- M&G’s head of alternative credit. specifically into ABS. It recently ple, to meet investor outflows. “The native European banks had no took its first dedicated mandate, for But again, Pilcher downplays experience of working with institu- £300m. liquidity worries. He points out that tional investors.” M&G is still a big fan of ABS, despite the financial crisis and Basel In 1999, leveraged loans were especially the UK and Dutch prime III rules that have made it “critically paying similar yields to high yield residential MBS that Pilcher believes expensive” for banks to hold trading bonds, yet carried covenants, making are “probably the most robust assets inventory, so that “increasingly, bro- them better risks — and they were in European fixed income” — and kers are not market makers”, M&G’s the exclusive preserve of the banks. certainly better value than unsecured trading turnover, in absolute terms, Once Pru and other early movers bank paper, which could be subject- has actually gone up year by year. like Intermediate Capital Group got ed to writedowns. “Our investment style tends in it going, a US-style institutional loan Another gutsy bet is on com- effect to be contrarian,” Pilcher market grew quickly in Europe. In mercial mortgages, where M&G has maintains. “You take risk when you the boom years, Pru issued half a recently lent £1.25bn as banks have are paid to, and sell it when you are dozen ‘Leopard’ and ‘Panther’ CLOs retreated. not.” That means often M&G is buy- and CDOs backed by its leveraged Pilcher dismisses the trendy idea ing when others are selling, or vice finance assets. that asset managers should analyse versa, making it easier to trade. It was also a securitisation inves- the whole of a company’s capital It is difficult to gauge how much tor — not unusual at the time, structure, from equity to debt, and M&G’s credit views differ from those though M&G became one of the choose where best to invest. “We of the herd. In the eurozone crisis, most influential buyers of whole have separate analyst teams, though M&G did not flee peripheral Europe business securitisations. they communicate and co-operate,” altogether, like some fund managers. Prominence in mainstream ABS he says. “The debt mindset is very came later. “In different. Equity investors are bred M&G – the vital statistics the run-up to the to look for the upside. I have no 2012 first half figures crisis in 2007, upside from a company taking risk Funds under management £204bn ABS had per- to do well.” Prudential’s own money £109bn, retail funds £48bn, funds for external institutions like pension funds and governments £46bn formed incred- But he remains fervently enthusi- Foreign-originated retail money £10.5bn ibly stably,” says astic about the investing landscape, Fixed income £124bn, equity £53bn, property £15bn, Pilcher. “Vast insisting: “There are huge opportu- cash and other £12bn amounts of high nities for investors to buy attractive Retail net inflows £4.3bn, of which £2.8bn in UK Institutional net inflows £0.7bn quality ABS were assets, if they are willing to look a Revenue £351m held in SIVs and little beyond the mainstream.” (annualised = 0.34% of assets) conduits and the M&G may be the archetypal City Cost/income ratio 53% Operating profit £199m credit spreads fund manager — but its standing in Institutional UK Corporate Bond Fund (£4.1bn) has outperformed ground in very the bond market comes from leaving benchmark by 1.5%/year since July 2007 tight, so we were the crowd and going it alone. 62 EuroWeek UK Capital Markets 2012 UK Borrowers’ Roundtable

Can top UK borrowers’ elite market access be extended?

The UK was hit hard in the early stages of the financial crisis, but tough measures to clean up balance sheets have left issuers in good shape. UK state agency borrowers, banks and investment grade companies all enjoy a keen following in international markets and favourable borrowing costs. In EuroWeek’s roundtable, held at the beginning of September, leading borrowers and investment bankers warn against the pitfalls of these benign conditions — such as carelessly extending maturities when the curve remains steep. But the most pressing issue for the UK’s debt markets is how to finance growth in the economy, through small and medium-sized enterprises, infrastructure investment and quasi-public sectors like the housing associations. As banks face pressure in lending long term, the panel explores how the capital markets can fill the gap. Participants in the roundtable were: Front row: Back row: Neil Garrod, group treasury director, Myles Clarke, co-head of global syndicate, RBS Vodafone Andrew Géczy, CEO, Lloyds Bank Wholesale Samantha Pitt, group treasurer, Network Rail Banking & Markets Simon Kilonback, group treasurer, Oliver Sedgwick, co-head of EMEA syndicate, Transport for London Goldman Sachs Barry Donlon, head of corporate and capital Jon Hay, corporate finance editor, DCM syndicate, UBS EuroWeek (moderator)

EUROWEEK: How does it feel in the bond market to CDS levels are versus Germany. be a UK issuer at the moment? But you can’t be complacent because the UK’s got its own issues and still has a negative outlook with two of Samantha Pitt, Network Rail: As a UK government the rating agencies. guaranteed issuer we are seeing the benefits of the UK being perceived as a safe haven. Most of our nominal Simon Kilonback, TfL: In our two recent deals we had issuance this year has been in US dollars, because of the participation from Far Eastern accounts that we had demand for our name in that market. Most of it gets met, and also from large European players that you placed outside the UK, so it helps us achieve investor wouldn’t necessarily expect to see in a sterling deal and funding diversification. from a UK issuer. So we’ve been very pleased by the Our spreads have tightened over the last six months support internationally for the credit. or so. We’ve always viewed KfW, a German govern- In the current market conditions some large, real ment guaranteed issuer, as a natural peer of ours. We money accounts are looking to the UK as somewhere used to trade and price new issues wide of them. We to invest, as it’s perceived as outside the European sov- now trade inside them and place new issues inside ereign debt crisis. But as Samantha says, that could all them in dollars, and I think that’s a result of where UK change if the UK were to be downgraded.

UK Capital Markets 2012 EuroWeek 63 UK Borrowers’ Roundtable

EUROWEEK: Is TfL seen, like Network Rail, as a kind Myles Clarke, RBS: It’s also the role of the currency. A of proxy for the government? variety of investors outside the UK have increased their sterling holdings, whether it’s real money, central banks Kilonback, TfL: Yes, in a similar way. It’s not quite so or private banks. They’re making a credit decision and clear cut as Network Rail’s credit: we don’t have an saying the UK is relatively better than the euro, for explicit guarantee, but we are part of the UK public example. But they’re also saying ‘I like the currency sector. diversification’. And there’s a whole series of statutory requirements So when Network Rail’s issuing in dollars they see the and legislation that protects us and investors, as we are benefit of being from the UK. But in sterling, UK issuers part of the UK government structure. are also getting an extra kicker because a lot of foreign So over the last few months we’ve certainly seen peo- investors are upping their allocations in sterling. ple begin to treat us as a government entity rather than a large corporate. Pitt, Network Rail: We certainly saw that in January Much like Network Rail, we have seen the European when we reopened the sterling markets with a £1.5bn Investment Bank as a comparable and currently the three year issue. About 40% went outside the UK pricing we’ve managed to achieve in sterling has been because international investors had demand for sterling. significantly through the EIB. Clarke, RBS: That’s also why foreign issuers are doing sterling deals, like some of the German auto companies. The amount of cash that’s available in sterling is just not getting fed with enough issuance.

Oliver Sedgwick, Goldman Sachs: A lot of investors just look very simplistically at country risk. They will close the door to certain countries. Italy and Spain’s corporate issuers, sovereigns and banks are struggling. But when you’ve had a crisis that has run as long as this, every flight-to-quality asset, whether it’s gold, Treasuries or foreign currencies, is at its all-time tight. So if you’re non-peripheral there’s just a strong tech- nical bid from all investors. And then if you’re UK and you’ve got a central bank that can set its own policy and backstop the sovereign, that’s an attractive proposition. Simon Kilonback, TfL EUROWEEK: Yes, the UK’s credit metrics are not that amazing, on their own, are they? Neil Garrod, Vodafone: Well, Vodafone is not a UK cred- it. Most of our cash flow is generated in Europe. The Sedgwick, Goldman Sachs: It’s the same with the US. thing that’s been interesting for us is the stability of our The credit fundamentals are worse than the average of share price and CDS, even though we’ve got significant Europe, but it’s the ability to set your own policy and exposure to Europe. do it dynamically and in a timely way, without having When you investigate us, for example if you run to set it to anyone else’s agenda. In a market that’s look- some aggressive numbers for the scenario of a eurozone ing for flexibility from central banks, that counts for a collapse, you realise that we’ve got huge amounts of huge amount. cash coming from the US, Germany and the Netherlands which should appreciate in sterling terms under a euro- EUROWEEK: The quasi-government sector is going zone collapse scenario and offset the reduced sterling- through some interesting change, with initiatives equivalent cashflow being generated by the likes of that could broaden bond issuance. Housing associa- Greece, Portugal, Spain etc. tions have been very active, De Montfort University I think that explains why we’ve got stability, even has done a deal, there’s great interest in potential though you might think that as Greek and Portuguese local authority funding. A lot depends on how willing and Spanish markets wax and wane, our CDS should be the government is to support these entities direct- waxing and waning with them. ly, through the Public Works Loans Board. Is all this The correct way to look at Vodafone is as very inter- being sensibly handled? nationally diversified, with some upside because of our India and South Africa exposures in particular. Kilonback, TfL: The PWLB is there to facilitate lending to local authorities and other sub-central government Barry Donlon, UBS: I don’t think it’s a coincidence that authorities. A handful of larger ones have got bigger the UK entered the crisis early and is now benefiting borrowing requirements and the in-house expertise to from remedial measures that were taken early on. run a borrowing programme. UK corporates have probably got the most conserva- Our original deals were £100m or £200m, pretty tive cash positions they’ve run in the last two decades. much private placements to people buying on asset That’s a very strong positive for investors. swap. Most of our funding came from the PWLB or EIB. The banks are similar. Lloyds, for example, has been Now, as our capital programme has grown, we’ve got at the forefront of contingent capital issuance, of liabili- a much greater funding requirement, so we can set up ty management, of shoring up the balance sheet through and sustain a programme of capital markets borrowing difficult times. And they’re now seeing the benefit of like Network Rail. that. Entities that need to borrow more can justify the cost

64 EuroWeek UK Capital Markets 2012 UK Borrowers’ Roundtable

of setting up credit ratings and legal programmes to through the firepower they have in committed bank issue. It’s a question of value for money and both gov- funding and then the question will be how the politi- ernment and many members of the public sector will cians decide they will be funded in the longer term, question whether it’s worth borrowing away from the either accessing the public markets or going through PWLB. some kind of bond vehicle. If there’s an easy alternative to continue to go to the EUROWEEK: At one point the government did try government and ask for the money I know which alter- to push local authorities away from borrowing from native they’ll take — better value for money. the PWLB, by putting up the cost. Sedgwick, Goldman Sachs: There’s a similar issue in the Kilonback, TfL: There seemed to be a conscious decision corporate world, whereby the average corporate in the to generate a kind of muni market in the UK, but it was US does most of its funding through the bond market, difficult to see anybody being swift on the uptake. while in Europe corporates have historically relied on Most of the feedback I’ve heard from other treasurers loans that come at a lower cost. around the public sector is that a handful were happy The jump in cost of funds for a bond is a deterrent, to set up programmes and get credit ratings, but the even though corporate spreads and yields have tightened. majority found it very difficult, very expensive and At the same time, the political soundbite is that banks are didn’t really believe they had reason to do it. no longer lending. In fact, it’s more like the names that the banks want to lend to don’t need the cash. Andrew Géczy, Lloyds Bank: Yes, you can understand public sector treasurers’ reaction — they could see that the alternatives looked difficult to execute, so asked why they should put in all the energy to do it when it didn’t look like good value for money.

Kilonback, TfL: Obviously the DMO can issue much more cheaply than lots of small entities can issue on their own. For TfL, the size of our borrowing require- ment and the benefits of improving efficiency and financial management driven by the external oversight that ratings and investors bring justifies running our own programme.

EUROWEEK: Centralising the borrowing at the DMO does seem the obvious answer. Is that where it’s Oliver Sedgwick, going to stay? Goldman Sachs

Clarke, RBS: Part of the push [for public sector entities to But in the bond market there’s a lot of appetite. borrow in the capital markets] is also coming from the Every deal recently is oversubscribed. The market con- banks, which are not able to fund so easily or cheaply as tinues to grind tighter and we expect it to continue for they used to, particularly on a long term basis. a while. There are other initiatives going on, like the advent of the retail bond, that could support these borrowers Géczy, Lloyds Bank: The challenge we face isn’t the top being able to do smaller trades. Or they could pool end corporate borrower; in the UK they are borrowing their borrowing through a vehicle. at rates that they won’t see again for a long time. I imagine the direction of travel will still be to try The challenge is to entice SMEs and mid-sized corpo- to encourage them into more independent funding. rates to borrow. Lending for those companies is going It’s partly up to us to try to get them to execute in the down, as those companies don’t want to take on more bond market or the private market. But it’s not easy. borrowing. Who’s lent to those companies? It’s been the banks. Géczy, Lloyds Bank: We still have a long way to run And because we’re squeezed on how much capital is with bank lending — for example, Lloyds Bank and RBS attached to those loans, the lending for those compa- have already committed undrawn capacity for housing nies is going down, or those companies don’t want to associations that stretches out for another five or seven use it. years. But the banks are not making the same levels of new, EUROWEEK: When I talk to the small business side long dated commitments to housing associations as of the UK banks they don’t say their lending is con- they did in the past, primarily due to regulatory chang- strained by the banks’ capital issues at all. They say es which they face and their own cost of borrowing. ‘we are lending as much as we can to small business, That is one of the reasons that there’s a great uncer- there just isn’t the demand to borrow’. tainty about how the housing associations will be funded longer term. Géczy, Lloyds Bank: That’s right, there’s not the demand There are much bigger and smaller players, and a lot for borrowing that we have seen in the past. of swapping of portfolios is going on as they try to get critical mass, and have their properties adjacent so they Kilonback, TfL: There’s a more fundamental problem can cut costs. with SMEs in the UK where, if you compare it with But, fundamentally, we have a housing shortage in the States, it’s not as easy to set up a small business. Britain. The housing associations will eventually burn Countries that have had high levels of small business

UK Capital Markets 2012 EuroWeek 65 UK Borrowers’ Roundtable

entrepreneurialism have an environment which encour- EUROWEEK: Neil, do you at Vodafone care at all, any ages SMEs to flourish, which we don’t have. Until you longer, about the pressures on banks that Andrew’s have that it’s very difficult to make companies grow by talking about? lending to them. Garrod, Vodafone: No. Our cost of borrowing is lower Géczy, Lloyds Bank: That’s the big question about what than any of our bank group, so by definition, capital the government’s been doing, with the National Loan markets are the right answer for us. I can’t see that Guarantee Scheme, the Funding for Lending scheme, changing for a long time. all of which have been designed to lower the cost of Maybe somewhere like India where we need local borrowing for banks, so they can pass that on to bor- capital and you can’t access a bond market, there are rowers. It’s a drive to entice them to borrow money to opportunities for banks to lend. invest into the economy. But at a corporate group level, the bank market — The NLGS was originally designated for very small other than backstop facilities to support commercial companies and then got expanded. Now we have paper programmes, which are insisted upon by the rat- Funding for Lending, which has opened the assistance ing agencies — is an irrelevance for us. up to corporates generally. This should be welcomed My perception of SMEs and the government’s effort and will hopefully increase demand from businesses as to encourage the banks to lend is it’s flawed, for two well as homebuyers. What will be interesting is to see reasons. the level of take-up. If you’re a triple-B credit you have The first reason is that the banks should be reluctant all the access to capital you want. It’s the companies to lend if they are negative about the prospects for the underneath that are challenged. UK, because if we see a massive deterioration in the UK economy, the banks will, with the benefit of hindsight, Donlon, UBS: This is the problem. We keep talking have made bad loans. about a wall of cash in the UK, but it’s a wall of very They will then suffer criticism from the public and inflexible cash. They’d like to continue buying long the government. Until the government is prepared to dated sterling bonds and will occasionally buy some underwrite the credit quality of loans, I can’t see any short dated sterling. incentive for banks to lend to these SMEs, until they Look at the low proportion of high yield issuance in are more confident about the economy. the UK, or the appetite for emerging markets. We’ve all been trying those trades in recent months and we’re just scratching at the surface, relative to what can be done in the US market. We have a pension system which is dealing with incredibly low rates, we have huge amounts of cash but it’s not matched with huge amounts of risk appetite; they’re incredibly selective. And until we start seeing a push for yield actually leading to the UK credit investor becoming more flex- ible — like M&G has done with its UK Companies Fund — until we see more of that across the UK investor base, then the SME problem is going to be there.

Géczy, Lloyds Bank: If you ask the regulators what’s going to fill this lending gap, they’ll say the capital Neil Garrod, markets. My challenge is that in Europe, whether it’s Vodafone French funds, Dutch funds, UK ones, I don’t see any real money investors who want to buy non-investment The second flaw is that there is uncertainty as to how grade credit. long government support for banks lending to SMEs will continue. If a bank lends to an SME for three years Donlon, UBS: You’re right about France, Spain but in using cheap financing from the government, and then Germany and Austria it is happening. You’ve got unrat- in three years that cheap financing is not around, the ed companies, the German Mittelstand moving away loan is then back on the bank’s balance sheet. And from the Landesbanks and issuing euro unrated deals. every bank is trying to shrink its balance sheet, particu- That has taken place in the last two or three years in a larly repeat SME loan business. way that the UK has failed to do, I think. Banks don’t want that. That loan business is there for life if it’s getting refinanced. Debt is permanent capital Géczy, Lloyds Bank: But it’s still very small relative to and people forget that. You run with debt forever, you the overall. don’t pay it back; this is not a mortgage. Until you address those two flaws, in my opinion Sedgwick, Goldman Sachs: And then there’s the large you are not going to encourage SME lending from number of European corporates that have accessed the banks. US high yield market. Even in euros we’re seeing more unrated issues, Géczy, Lloyds Bank: I agree with some of what you said, debut names, rarer issuers. The growth of the corporate but I would add that the statistics are pretty clear. SMEs market this year hasn’t been the frequent borrowers, in the UK and other European countries are deleverag- it’s been new names who’ve gone to banks, found the ing — they are repaying our debts and not wanting to cost of financing prohibitive or similar to a bond and borrow more. gone down the bond route. SME lending linked to real estate is somewhat differ-

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ent, but we have seen this conservatism, this apprehen- liquidity in the system. Then growth turns off and we sion — ‘do I really want to make an investment today had this correction in Q2. Now we’re stuck with too because of my uncertainties about where the economy’s much liquidity. RBS has bought its bonds back and going?’ other banks are doing liquidity management. Until we We can offer them relatively cheap financing, espe- get some growth, people will not want to put that risk cially when governments offer things like Funding for appetite into the market. Lending schemes, but the reality is they have anxiety about borrowing and making investments. Géczy, Lloyds Bank: When you think that cleaning up banks’ balance sheets is a way to re-stimulate econo- Clarke, RBS: What would make a lot of this go away, mies after financial crises, the UK banks took the lead whether in Europe or the UK, is growth, right? That’s in cleaning up their balance sheets, but the LTRO actu- ultimately what you need. People don’t want to borrow ally prevented a lot of it. because they’re not confident in their horizons. Some banks in continental Europe were contemplat- ing selling assets and cleaning up their balance sheets. Géczy, Lloyds Bank: The other way you could create They didn’t like the prices they were seeing but last growth is by the government spending on infrastruc- fall they didn’t have a choice. The LTRO bought them ture projects and making investments. another three years.

EUROWEEK: One of the big buzzwords in the UK is infrastructure. Politicians want to stimulate growth by encouraging infrastructure investment. But you can’t just wave a wand and have more infrastructure all over the country. Projects take years to plan and are usually being worked on by some company or agency already. So what are the real prospects for more investment in this area?

Pitt, Network Rail: It is a bit of a buzzword at the moment, but we only borrow to fund investment in the rail infrastructure anyway. And our investments are determined by government, which specifies what it wants us to borrow for. Over the last couple of years we’ve faced no cuts to Andrew Géczy, Lloyds bank our capital expenditure programme, in fact the oppo- site. About a month ago the government announced a The problem is, you immediately fall under Basel III. further £9bn of investment in rail infrastructure. They In the past, the traditional lender for the construction do believe investing in infrastructure will stimulate the period of infrastructure projects was a bank. Today economy, create jobs and add to GDP. banks are discouraged to lend for long periods of time by Basel III. EUROWEEK: Is that all genuine new projects?

Clarke, RBS: There are tougher decisions, though, that Pitt, Network Rail: Some of it you could argue is already could be taken. Spending more money or raising more committed, because some of these projects have a long debt, that’s easier. But deregulate, make it easier for lifecycle. But the majority of that £9bn is new projects people to start up businesses? That’s a tougher choice. that will come to fruition over the next few years. And it’s just been announced in the reshuffle there’s However, we borrow the money to invest but ulti- going to be a new growth committee to try to address mately it’s going to have to be paid back, or refinanced. this. We get sufficient revenue from the government to cover our day-to-day costs and interest bill, but obvi- Donlon, UBS: I think that’s the issue. The government ously how much we get depends on how the govern- can provide liquidity but they can’t provide risk appe- ment manages its finances and whether it collects more tite, whether that’s at the SME level, at the banks, or in from the taxpayer. the bond market. There’s a very big difference between Then recently the government announced this liquidity and risk, and that’s the gap we haven’t yet scheme where it was going to give guarantees for infra- bridged. structure projects. But when you look at the criteria, they’re pretty stringent. I’ve not seen any evidence yet Sedgwick, Goldman Sachs: Yes, if you roll back to of any projects having met those criteria and it will be December when the LTRO was announced, no one interesting to see whether there is any take-up. really paid attention to the significance of all the liquid- ity until you suddenly saw non-farm payrolls go off the Garrod, Vodafone: I share your scepticism. If you’ve got records versus expectations, Chinese growth pick up GDP growth of 2% and 45% of the UK economy is in and they suddenly realised there’s all this cheap money the public sector, do we really believe that the private around. sector and the government sector are both growing at 2%? Or is the private sector growing at 4% and the gov- Clarke, RBS: And they were short… ernment sector much less? If you put in better transport systems there’s no Sedgwick, Goldman Sachs: Correct. And everyone doubt there’s a real benefit to productivity, but is that piled in and you get to a stage where there’s too much benefit as high as if you were getting a load of entre-

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preneurs starting up, say, a business around Beazley, Primary Health Properties. So they serve a microbiology? different kind of issuer. The answer is it can’t be. You really need the private sector to lead, and the public sector being 45% of the Sedgwick, Goldman Sachs: But how do you create scale? economy is unhealthily large. Géczy, Lloyds Bank: That’s right. Perhaps there needs Donlon, UBS: Alternatively, you can see infrastructure to be some tax incentive, to create a muni-type bond initiatives not as establishing a larger public sector, but market. as facilitating large corporates to come to the UK, build roads, build railways, build Severn Estuary barrages, Sedgwick, Goldman Sachs: You’ve got that in Asia. Most employ British people, make money and create real banks that want to raise tier one capital are going to GDP growth. Asia because income tax is close to zero and there’s It comes down to how that borrowing is facilitated. very little capital gains tax. Leverage is as cheap as ever If we were talking to UK investors today or Dutch or and investors are getting equity-like returns for tier one French investors, the easiest asset for me to sell is prob- instruments. When equity returns are 2% or 4%, they’re ably secured infrastructure debt. getting mid to high teens and not paying any tax on it. So the question is, how can we put something in place where the capital markets provide a solution that Garrod, Vodafone: If the government is giving Lloyds triggers further growth? and RBS access to money at cheap levels there should be a cost booked to the government for those guaran- Sedgwick, Goldman Sachs: You’ve also got a tax issue. tees. Because that cost isn’t visible, nor a cash cost, it Who’s going to buy those bonds? There are obviously slips off the radar. the funds and pension funds, but for Joe Public on the But you could think about a tax incentive on retail street there’s no tax incentive to buy bonds. bonds as an equivalent cost to the government. You You’re charged income tax which is, by global stand- could remove the funding incentives for the banks to ards, relatively high. In all the other countries where support SMEs and instead add a tax incentive for the there’s relief on this sort of product you have a very retail bond market. Economically, the costs of govern- healthy retail market. ment guarantees and tax incentives could be pretty similar, I guess.

Kilonback, TfL: The other problem is that the UK public are deleveraging, just like our companies and banks, so there isn’t the depth of market you have in Asia and other places.

Garrod, Vodafone: Yes, and the tax break will also be going to the wealthier sectors of UK society and they would just use that money to save. If you can distribute more income to the less wealthy sectors they’ll use that to increase their spending.

Clarke, RBS: I guess the whole retail idea is not going to solve the situation we find ourselves in. But there is definitely scope to develop the product and the Barry Donlon, technology. UBS We have been, as an issuer, very active in Italy Donlon, UBS: At UBS we’re pretty focused on the retail because the investor can go into a branch and the bond market. In Switzerland we can consistently fund domes- is quoted in front of you. It’s like buying a deposit. tic corporates at incredible levels simply because that It could come back to bite issuers if they don’t pro- market allows us, there are structures that facilitate it. tect the retail investor, and there’s a lot of work going Infrastructure projects are ideally suited to UK ster- on around conduct and treating customers fairly. But if ling investors. They’re long dated, corporate, secure — you get it right it seems to be worthwhile. they’re everything an investor wants at the moment. Even for banks, which want shorter dated, senior EUROWEEK: It’s interesting that in Portugal, where unsecured funding, it’s the ideal retail product. As the the capital markets have been stressed, they’ve government stands to benefit from this, the incentive managed to bring an active retail corporate bond should be there to develop a retail market in the short market out of almost nothing in the past year. end for UK banks, SMEs and corporates. Donlon, UBS: This rate environment is conducive to it. Géczy, Lloyds Bank: The retail bond market is picking If you think of what your pension fund has returned in up, but as a percentage of the total issuance volume it’s the last year, and then someone offers you a 5% or 6% still very small. bond… Maybe it’s not rated, but you recognise the busi- EUROWEEK: In size, yes. But the great power of ness, you think maybe it’s an implied double-B and retail bonds is that they can be small. In Germany you get a tax break on it. Net at the end of the year you’re starting to see Mittelstand bonds of only you’re going to get a 6% fixed income instrument for €10m to €50m, and this is starting to happen in the the next five years. That to me would be a very attrac- UK, with issuers like Intermediate Capital Group, tive proposition.

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EUROWEEK: With all the financing sources, both matching assets, to go out on the curve and issue for 30 private and official, that are now available to finan- years as opposed to a five or 10 year bond, you’re pay- cial institutions in the UK, is funding stress over for ing very high forward rates. them? EUROWEEK: Some of your telecoms competitors Sedgwick, Goldman Sachs: Going into Q4 last year, have gone long, haven’t they? liquidity was a key concern, and there were anxieties about French banks’ funding. That’s no longer the case. Garrod, Vodafone: Yes, but I would argue they’re not The issues now are about capitalisation and profit- looking at the shape of the curve properly. In dollars, ability. Everyone expects there’ll be a lot of bank issu- we could probably do a five year at 1.375%, we could ance this quarter and next. I think they’re going to be do a 10 year at 2.625%. The implied five year dollar disappointed. rate in 10 years’ time is very high, close to 4%. Banks are deleveraging at the quickest rate they ever Do I think rates will stay low for a long time? Yes. have done. And given that the average life of a bank Do I think I will be able to access the credit market asset is about five years, and we’re five years into this in future at a low credit spread? Yes, because my cash crisis, a lot of the assets are rolling off — and that gen- flows are so significant that Vodafone bonds should erates a lot of cash. deserve good demand. So why should I go long? So most banks don’t have liquidity issues, albeit some are stressed. They are thinking about business Pitt, Network Rail: I totally agree. There’s a big differ- models, RoE, profitability, capitalisation. And that’s ence between five year Gilt rates and 30 year Gilt rates. exactly why, coming out of the summer, the busiest We do a lot of analysis internally, looking at whether market for bank capital was this week. And there’s we’re better off borrowing 30 years now or five years more to come. and then refinancing in five years’ time, considering those forward rates. Obviously in theory you’re neutral Clarke, RBS: It’s a bit like after the LTRO when inves- but you have also got to look at it in the short term, at tors got caught short. They have got caught short in the value for money for the UK government. the financial sector again because it’s rallied 100bp or If I borrow at 3% versus 0.5%, that’s an extra 2.5% 200bp in the last three months. They’ve got redemp- I’m adding to my interest bill. And when I’m borrow- tions coming through, and a very heavy cash position. ing £5bn a year, that’s a big difference. Ultimately, Yet the number of products available to investors some of the revenue to pay that interest bill is going to has dwindled. Part of the ABS market’s gone, CLOs are come from the UK government. So I’m very mindful of gone, and the financial sector, which was supposed to that. be the stressed one, as a source of issuance has gone as well. All that drives a lot of investor demand into the Kilonback, TfL: We implemented a commercial paper corporate market, which does not need any more programme about 18 months ago, and it has generated support. a significant saving on our interest bill. It’s happened so quickly. 2012 was going to be a In March we did a one year FRN for the same reason: year of stress for banks, and it absolutely hasn’t been, we got very attractive rates, we’re not worried about because of LTRO and other sources of liquidity. refinancing risk and we’re looking to reduce our cost But to be fair as well, I think the UK banks have been of carry. We do carry high cash balances because that’s ahead of the curve, in shedding assets and managing what happens when you run a big capital programme. our loan-to-deposit ratios better and not needing the One of the ways we can cope with the low interest funding. rates is to shorten the duration of our debt.

Géczy, Lloyds Bank: The Bank of England also imposed Sedgwick, Goldman Sachs: The environment at the greater liquidity constraints upon UK banks than moment incentivises every corporate or non-financial European central banks placed on their own banks. In institution to go shorter. Banks should go longer the fall of last year that felt pretty good, when there because they need more funding and they’ve got to go was a lot of anxiety about some of the others. for the diversity of investors and tenors. I don’t think you’re going see to issuance from banks for a while because their balance sheets are decreasing. Donlon, UBS: Some of it comes down to cultural But to be really clear, while there is focus upon decreas- approach as well. There was a very interesting week ing the size of the balance sheet that relates to my non- in May when British Telecom did a short dated dollar core book, the business that I’ve decided that’s not part issue and AT&T came to the UK and issued a 32 year of my core franchise, I am also trying to grow my core fixed rate sterling trade. It seems contradictory that two balance sheet. borrowers in similar sectors chose completely different The challenge is that these core book companies say transactions. they don’t need finance — even if we keep driving But it’s simply down to the fact that companies down the price. in the US typically keep a lot of their debt fixed rate and have capacity for longer dated issuance — paying EUROWEEK: As we’ve touched on rates, I’m inter- higher spreads but locking in long term funding. In ested in the treasurers’ views on what you should be Europe most corporates have a high proportion of float- doing to maximise the benefit of the present excep- ing rate debt and a culture of issuing more cheaply but tionally low rates. for shorter terms.

Garrod, Vodafone: Rates are low, but curves are very, Géczy, Lloyds Bank: That cultural difference is also about very steep because they’re keeping the base rates so your economic outlook. If you travel around the US and low. If you’re indifferent to maturity and you’re not talk to customers, there’s a sense of optimism about the

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economy now that didn’t exist nine months ago. EUROWEEK: Does that mean secured issuance could When you as UK issuers look at the forward rates make a comeback in the UK? as you do, and say no they’re too high, that’s because you’ve got a more pessimistic view on the economy Sedgwick, Goldman Sachs: Well, we’re at a stage where and where the rate curve should be, right? the bond market doesn’t give you a huge amount of value for security. Garrod, Vodafone: Yes, exactly right. There’s an interesting case study in the Tesco sale and leaseback deals. They are Tesco’s senior unsecured debt, Géczy, Lloyds Bank: That optimism in the US means that plus the investor has security over some properties and US issuers come here and say, this is looking pretty the rental income from them. And they trade north of cheap right now. Tesco’s standard bonds. It’s partly a liquidity premium because they are a bit more bespoke. Garrod, Vodafone: But actually the key point for me Investors got burnt on some of the asset-backed is that if rates do materialise as the forward rates are programmes and they’re just not ready to invest in the predicting, you won’t have an economy. They cannot analysis to understand these deals. go up. All the syndicate desks have been round trying to You’ve got an economy where rates are this low. You do secured bonds for financials. It’s been a non-starter start putting short rates up to 4%, which are implied because there just isn’t the investor intelligence to several years out — the growth’s gone. The global econ- properly analyse the collateral to give the issuer value omy cannot tolerate a rate increase. inside a senior unsecured. So why give away assets We saw one rate increase from Japan going from an when you can get senior unsecured for the same levels eighth to a quarter, and it’s gone back again. This is a or better? generation of low interest rates.

Kilonback, TfL: People have got to get back to the under- standing that you’ve got to build long term. Both busi- nesses and business investment have got to be long term, relationships between banks and their clients have got to be long term. We’ve got into a short-termist culture. We’re in a dig- ital age and everybody’s expecting a magic fix, and it’s just not going to happen.

Garrod, Vodafone: That’s right. We keep talking about a three or five year recovery. Why do people not look at Japan? It’s been going on 20 years. The economists are now starting to say it’s seven years. Keep going, guys. You’ve got lots of years to go yet. This is a Japan situation. And Japan was the only one Samantha Pitt, in trouble when it happened there. This is global, not- Network Rail withstanding the little bits of optimism here or there. You put rates up to 4%, that optimism’s just gone. Pitt, Network Rail: There’s a point I want to add on the regulatory reforms and banks’ cost of funding increas- EUROWEEK: One way the UK government is trying ing. Obviously they have to pass those costs on when to lower rates for borrowers, both individuals and they lend, which does dis-incentivise people from companies, is the £80bn-plus Funding for Lend- borrowing from banks. But it also impacts on the cost ing scheme. But is there a risk that it just depresses of derivatives. If you’re a major user of derivatives, other capital markets, like covered bonds or secu- it is pushing up your cost of executing derivatives, ritisation, because banks don’t need them for the particularly if you have one-way CSAs [credit support moment? annexes].

Sedgwick, Goldman Sachs: All of those products are EUROWEEK: Even for such a highly rated issuer as diminishing anyway. Everyone is frustrated by the Network Rail? shortage of covered bond supply, though it’s partly because the banks are not generating the collateral. But Pitt, Network Rail: Oh yes. It’s not been material enough at the same time, you’ve also had a lot of banks put to change our behaviour significantly, but it will do in that collateral to the ECB. It’s purely an economic deci- the future. That’s why a lot of our peer group, the sov- sion as to whether the bond market is more efficient. ereigns, supranationals and agencies, and the Bank of England, are moving to two-way CSAs. EUROWEEK: So official funding sources are taking We’ve got approval to do it, too. I think it’s a smart over? thing to do because it doesn’t just reduce your cost of hedging, it also increases your capacity to hedge. At the Sedgwick, Goldman Sachs: To some degree, but then moment we’re finding our hedging is getting concen- you’re also seeing the return of the German Pfandbrief trated with a small number of counterparties, which is because the bond market is now pricing through the not healthy. ECB equivalent. Banks are just being opportunistic as to where they can get the best access or cost of debt. That EUROWEEK: Are they counterparties that are taking is such a big driver now of their RoE. a different interpretation of Basel III from others?

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Pitt, Network Rail: In the past there were different inter- Donlon, UBS: No, banks should be brokers. We pretations of Basel III and every bank had its own little should be providing liquidity and duration but not black box, but things are changing. More and more on a proprietary basis. We should be acting as agent banks are conforming. Obviously there will be differ- between lender and borrower. ent costs of hedging because it depends on what your existing portfolio is with a specific bank, but I think the Garrod, Vodafone: Not at 15% return on equity you variation is settling down. But this is a big issue for cor- shouldn’t be! You should be taking some risk for that, porates and for my peer group. I tell you.

Kilonback, TfL: We also use derivatives, and the cost and Donlon, UBS: No, but we as banks should be advisers the regulation to make everything exchange-traded are and we should facilitate duration extension. We should difficult. be facilitating ways for the retail banks to provide Most corporates don’t want exchange-traded con- mortgages and borrow on a wholesale basis in a way tracts. It doesn’t work for us from an accounting per- that’s attractive. And Solvency II really won’t do that. spective. There’s the variation margin, but also if you I mean, the interesting point of Solvency II in the cov- have an exchange-traded contract that you can’t get ered bond space is it will foster direct lending from the hedge accounting for, you’re causing a lot of P&L vola- insurers into pools of mortgages, because that’s become tility and corporates will just stop hedging. very efficient. But again, that’s helping a very healthy I also think, when it comes to a lot of hedging prod- sector. ucts, banks are going to have to get used to lower returns on equity. EUROWEEK: Solvency II just seems so distortive and random in the things that it favours. As you said, it EUROWEEK: One issue that could affect risk appe- helps public sector issuers and covered bonds, but it tite in the market quite severely is Solvency II. How almost kills investing in securitisation, doesn’t it? big a threat is that to funding? Donlon, UBS: Yes, but it’s not designed to help. This Donlon, UBS: On the side of insurers’ funding, for the is the insurance industry managing their own risk. high quality UK insurers like Prudential or Aviva, we’ve They’re not here as a public service. So we shouldn’t be no problem raising capital, even Solvency II-compliant surprised that it doesn’t facilitate other objectives. capital, and that can be done in the domestic market in the UK. It’s very expensive, but we can do it, or they EUROWEEK: Even on the corporate side, though, it can go to Asian retail. penalises longer-term lending. Where it will be interesting is on the side of the assets insurance companies are buying. If you’re a long- Clarke, RBS: Well, it reinforces the problem. It’s like dated funder like Network Rail or TfL, suddenly your the old problem in the Gilt market. Trying to make government guarantee becomes extremely valuable, pension funds safer by making them buy Gilts forces suddenly having a double-A rating becomes extremely yields down and can increase the mismatch for the pen- valuable. sion fund. What do you do? You buy more. That’s why But, back to the SMEs, it really discourages UK insur- you’ve got real yields in the UK of 0% in an inflationary ance companies from buying unrated debt. We’re all market. So all these issues of Solvency II are incredibly talking about wanting to have a private capital market distortive. solution for the middle ground of the UK corporate economy, and Solvency II will clearly work against that. Garrod, Vodafone: In our own defined benefit pension scheme, I was one of the people saying, we shouldn’t Géczy, Lloyds Bank: That’s the frustrating thing. People buy triple-A long-dated paper because we don’t get want the insurance companies to lend to SMEs, but paid for it — and there is only one way the rating can every regulatory reform is pushing that away. go. And if it’s very highly rated corporate paper, like I also wonder, do the insurance companies even have AA+, over time the propensity to increase leverage to the teams and the skill sets to evaluate the risk of, let’s add value to the business increases substantially. say, a pool of non-investment grade SME loans? If you buy single-A rated paper there are, at least, two ways the rating can go. So it is quite strange to Donlon, UBS: One or two UK investors do. M&G for insist that an insurance company can only buy strongly example has a very strong private placement team and rated bonds. the risk appetite to do independent credit work and take a contrarian view on a pool of assets. That’s great, Géczy, Lloyds Bank: It’s one example of a wider prob- but it’s like the local authority question, it needs to be lem: as government continues to have an increasing scalable. role in the economy, how can regulatory reform and It crosses so many UK issuers at the moment. governments kickstart economies? Whether it’s the public/private infrastructure projects One of the great challenges we face, between the or SME lending, you need an investor base to take up banks and the capital markets, is a disconnect which that product. Now, retail’s very nice to talk about, but the UK government’s trying to address, but hasn’t quite it might take 5% or 10% of the market. You have to addressed yet. incentivise the pension and insurance base to step in. It’s the problem that, as we look to invest in greater infrastructure, the banks don’t want the long-dated risk, EUROWEEK: Isn’t that what a bank is for? You buy because the regulatory reforms and our cost of fund- the bonds of a bank or put your money in a bank ing make it unattractive for banks. Banks are willing to and the bank does the credit work and lends to hold it for a short period of time. companies. We’ve got to really work on that question because

UK Capital Markets 2012 EuroWeek 71 UK Borrowers’ Roundtable

if we don’t, and the Japanese banks and the regional they going to be used to facilitate growth? German banks go away, you won’t have enough capac- We need an approach that focuses on behaviours as ity to do what’s needed for UK infrastructure. opposed to just metrics and rules. Once you put rules The answer has to be about who takes the refi risk in in place, people play to them. the construction period until it turns to operating. The Fed’s approach has been more, ‘What’s your cul- ture like? How do you motivate your people? How are EUROWEEK: What about the idea that the chancel- they behaving?’ Which is more important in the long lor is now pushing of a KfW for the UK? run than, ‘here are a load of rules and you have to stick to them’. Pitt, Network Rail: It would be interesting if it does Remember, too, that these conversations aren’t tak- come about. Given there are so many initiatives going ing place in a lot of countries in Europe. There’s still a on, it could be a simpler way of coordinating every- lot of denial out there. You can’t fix the world econo- thing under one body. my, but certainly I think what’s going on in the UK is as constructive as possible. It’s going to be really a test Kilonback, TfL: I think a UK KfW could add value if it of political leadership. We’ll look back and see if the solves the infrastructure conundrum, of who steps in right decisions were made. where the banks’ project finance used to be, manages projects during the construction phase, takes the con- EUROWEEK: Oliver, do you think we’re getting the struction risk and helps bridge to the longer term UK right leadership? investor base. It needs an entity that can provide, dare I say it, a Sedgwick, Goldman Sachs: The jury’s still out. But I form of credit assessment, particularly for SMEs and think the regulatory question is the difficult one, par- companies that are not rated, a bit like the National ticularly on the banking side. When it comes to CRD Association of Insurance Commissioners for private IV or Basel, every country’s got their own bugbear, and placements in the States. That would be incredibly valu- trying to get harmonisation is near-impossible. That’s able and would give the pension fund industry some- why you end up with CRD IV, where basically every- thing to base their assessment on. thing’s thrown in. That in many ways is the problem with Europe as a whole. Donlon, UBS: That’s a good point. But it’s worth men- But the market is getting used to the muddle-along tioning too, that when it comes to investment grade, approach. It’s buying into the belief that the euro is corporate and financial borrowing, the UK’s in a very going to be preserved. Even if there are more shocks, healthy place because the private sector has taken steps I don’t think it really changes the game in the UK — in some cases very expensive and in other cases because this is one of the flight-to-quality jurisdic- clever — to recognise the crisis earlier than some, work tions. through it and protect balance sheets. One thing to look out for, though, is growth return- The UK banks didn’t have liquidity issues like the ing. With rates so low and spreads so tight, the impact French ones because they paid up a huge amount of of growth on debt markets could actually be fairly money to ensure that they had liquidity over the course negative, since fixed rate borrowing costs could sud- of this year. And they are not losing deposits like the denly rocket, and central banks, the UK included, have Spanish ones. not got many tools to contain that. UK corporates are also running very high cash bal- ances, which is very expensive and a drag on earnings. Garrod, Vodafone: Barry’s phrase was ‘liquidity is not But their bonds are trading hundreds of basis points risk appetite’. Actually liquidity is, in my view, now get- tighter than their European peers. So I don’t think it’s ting detrimental. accidental that the private sector in the UK is in a much With the Dow at 13,000, credit spreads as tight better place today than it is in some other countries. as they are and rates as low as they are, it does not help risk appetite. Things feel artificially high, and it’s Clarke, RBS: That’s right. It’s also very important that because of the colossal liquidity that’s being pumped the regulatory response in the coming years is not over- into the system. We’ve got to keep trying to test and done. The Bank of England’s new powers — how are remove some of that liquidity and see asset prices fall slightly to encourage risk appetite.

EUROWEEK: Like in the UK, a quarter of the Gilt market is now owned by the Bank of England.

Garrod, Vodafone: Exactly, it’s all artificial. The one sav- ing grace is that the Bank of England has as good a grip on these aberrations as any central bank out there. I think they’re very, very good. But globally, we are saturated in liquidity and it’s counterproductive. We are taking asset prices far too high, just like we did before the crisis. The liquidity has got to be withdrawn in stages, because we’re just going to become liquidity junkies. Then if we ever get through this, we’ve got a demo- graphic time bomb and the cost of global warming, Myles Clarke, where we’re now past a point of no return in terms of RBS temperature rise. Everything is still just so precarious.

72 EuroWeek UK Capital Markets 2012 Infrastructure

Projects needed to prove infrastructure promise There is no lack of talk and ideas from the government as to what might replace banks in funding the UK’s infrastructure. But project flow is needed for it to become clear just who will be the main financiers of infrastructure — and how they will do it. Oliver West reports.

he world of infrastructure should be “The days of an exciting place to be in the UK. The cheap and Tcoalition government has made clear readily available that it views the sector as a key driver of the bank originated economy, and has made commitments and debt finance are plans to back this up. over” Published in 2010 and then updated in November 2011 to provide “inves- tors, builders and operators of infrastruc- ture with the transparency and commit- ment which they lacked for a decade,” the Danny Alexander, National Infrastructure Plan would appear Chief Secretary to the Treasury to be a promising step. Chief Secretary to the Treasury, Danny funded by the government. Alexander, openly admits that UK infra- In his speech on financing capital structure has had “long standing weak- infrastructure made at the London Stock nesses,” while Chancellor Exchange Centre Forum on September 10, claims that investing in infrastructure is “a Alexander acknowledged that the govern- key part in this government’s strategy”. ment “should recognise that the days of Perhaps more impressively, the gov- cheap and readily available bank originated ernment appears to have grasped the way debt finance are over”. changing financing markets will affect the For once, government and indus- industry. With capital constraints and regu- try are in agreement: pension funds and latory requirements forcing banks to lend other institutional investors will have to get less and for shorter durations, new sources involved. of financing are required. “The natural home (for infrastructure The Treasury estimates that the infra- deals) has to be the capital markets and the structure pipeline includes over 500 banks’ role has to be increasingly to facili- projects and programmes worth over tate this financing in to that market,” says £250bn. It expects that almost two thirds James Miller, head of secured debt products of investment will be privately funded, at Royal Bank of Scotland. with the remainder either partially or fully As it attempts to entice the institutional investor base into infrastructure, the gov- ernment has teamed up with the National Association of Pension Funds and the Pen- sion Protection Fund to establish the Pen- sion Infrastructure Platform, which will be able to invest directly in UK infrastructure assets and projects. As long as the credit quality is high enough, and the instruments do not carry redemption options for the borrower, pen- sion funds should be interested in the asset class in a variety of forms, according to Georg Grodzki, head of credit research at Legal & General Investment Management. “Not everything has to come to the bond market,” Grodzki says. “Private place- ments are acceptable for pension funds and Bridging the gap: can capital markets help the UK in its drive for insurance companies, and bilateral lending infrastructure projects, such as HS2? is an option too. Pension and annuity funds are less in need of liquidity than corporate 74 EuroWeek UK Capital Markets 2012 Infrastructure

bond funds, so they can accommodate the lower liquidity of loans.” Danny Alexander said in September that he expected the platform to have raised its target of £2bn by January; seven UK pension schemes have already committed to funding start-up costs and made soft commitments for initial capital allocations. In addition, July saw the opening of a scheme through which the govern- ment can guarantee private investment in infrastructure. “By allowing high priority projects to benefit from the UK Government’s balance sheet credibility, we will be able to accelerate and bring forward up to New Alder Hey Hospital: but will the financing £40bn of major projects that are strug- match its innovative design? gling to access private finance,” said Alex- ander in September. flow generative asset class,” says Miller. projects flow quickly enough. As one So although Danny Alexander talks of banker says, there is a difference between Solving a problem they’ve “£40bn of major projects that are strug- having a wish-list of projects on a docu- failed to create gling to access private finance,” the strug- ment, and having them ready to finance. The ideas receive good reviews from gle is not yet visible to many debt market Bankers praise the Department for market participants. But there appear to participants. The large corporate infra- Transport for having made the most be few thrills in day-to-day debt market structure deals such as those mentioned progress with their projects, engaging activity. Bankers say the infrastructure above appear to be popular with the with advisors, and achieving a budget to space is dominated by a refinancing spike bond markets already, but the arguably push deals forward. But they say other caused by the five to seven year deals trickier project finance deals that might government departments have not been signed before the crisis maturing and the benefit from the new schemes are not yet nearly as enthusiastic. three year deals signed since the crisis forthcoming. began. “We should applaud the fact that the Easy option still available “New event-driven dealflow is the government recognises the importance Part of the problem is that, in general, the lightest I’ve ever seen it for some time, of infrastructure to the growth story, bank lenders still in the market are still which is a concern, although we are and have come out with the guarantee capable of financing the fairly thin deal- very busy because of the high number of scheme to help get deals over the line,” flow. Although some banks have exited deals that require refinancing,” says RBS’s says Chris Heathcote, head of project project finance lending entirely, new Miller. finance at . “But to entrants from Japan, China and Canada And so far these refi deals have gone a certain extent they are solving a prob- have given further support to the market. well, with borrowers including BAA, Gat- lem that hasn’t really hit so far: we do not Attention has turned to the rebuilding wick and Associated British Ports having have a significant number of deals out of children’s hospital Alder Hey in Liver- completed successful bond transactions. that are failing to find finance.” pool — a deal which some bidders are “There is nothing like a recession to Although the National Infrastructure understood to be proposing to finance test whether infrastructure assets live up Plan outlines several key investments (see through the institutional market. to their name of being non-volatile, cash- table on page 76), banks are not seeing the “Alder Hey is the first deal I’ve seen Community support When National Grid raised £260m for a more local market.” on a national level, or require the through a retail bond in October 2011, The report proposes what it calls guiding hand of the Treasury,” adds it highlighted yet another potential “community infrastructure bonds”, Gregory. alternative form of financing for infra- which would look to attract households, Respublica says there is growing structure companies. But with all the private businesses and the community interest from investors in the “blended headlines focussing on the National sector as investors. These bonds would returns” offered by social impact bonds Infrastructure Plan, maybe an opportu- be issued through an independent, — where financial return is sacrificed nity is being missed. not-for-profit, special purpose vehicle, for social benefit, also making funding “If banks are not seeing project which would have a remit to work for cheaper and the business more viable. flow, part of this may be because they a particular community of interest, cre- Local businesses, too, could be incen- are expecting to see national infrastruc- ated with the support of, but not owned tivised to invest in their local infrastruc- ture programmes,” says Dan Greg- by a public authority. ture, the report says. ory, author of a report by think tank Respublica believes that they could Gregory sees the bonds as potential Respublica titled Financing for Growth: find popularity — and be cheaper — if sources of financing for local projects A new model to unlock infrastructure tangibly linked to local projects. such as tram systems, schools, sports investment. “Yet there is lots of scope “Not all financing has to be done stadia or community hospitals.

UK Capital Markets 2012 EuroWeek 75 Infrastructure

for a long time where I would expect down by senior debt,” says L&G’s Grodz- “We do not have there to be several innovative financing ki. “Alternatively you could have subor- a significant options being put forward,” says Miller dinated debt that would provide credit number of deals of RBS. enhancement for the senior tranche.” out that are However, having innovative options But more equity can be expensive and failing to find on the table does not necessarily mean unattractive for the sponsor, while banks finance” innovative options will be taken, espe- are not highly rated enough to be guar- cially as the total debt financing for the antors of construction risk, according to £250m project is likely to be under Heathcote at Lloyds. £150m. Some bankers say that, although It is also not yet clear what will hap- margins on project finance loans have pen to the Public Finance Initiative (PFI) Chris Heathcote, increased significantly since before the model that has financed public infrastruc- Lloyds Banking Group crisis, they still under-price risk — and ture projects with private capital since the are hence more attractive for the bor- early 1990s. Investors are still waiting to mindsets for sponsors to make the transi- rower than the bond markets. hear what will come of the government’s tion to stronger institutional involvement, “My concern is that if Alder Hey reforms of the model, which has lost which most people would agree is inevi- just goes down the bank market route popularity as it is seen by some, includ- table in the long run, but is easier said it would be another lost opportunity in ing the Treasury Select Committee, as than done,” adds Grodzki. a [debt] market with very little project potentially expensive and inefficient for “Many sponsors, especially outside dealflow to show there are alternative the borrower. the public sector, are willing to accept funding sources.” “In principle, social infrastructure the refinancing risk associated with using A key aspect of the Alder Hey deal is is still attractive but it depends a lot on the bank market, so they would have to that it requires the financiers to take on what government will tell us about their consciously want institutional investors to construction risk — something that has plans for reforming PFI,” says Grodzki. come on board in order for that to hap- historically been very difficult for the So until there is an absolute need to pen from day one.” institutional market to accept. move away from the bank model, it will Grodzki believes the next few months While it is not yet clear what inno- be hard to see where exactly the funding could give some clues as to what extent vation the Alder Hey project might use shortfall might come and how it could sponsors are willing to go down the to entice institutional investors, market be resolved. institutional route. Until this happens, participants already have several potential It is down to sponsors, as well as the it will be difficult to tell whether the ideas. government, to enforce the change in UK is able to construct a new funding “To overcome construction risk, you funding sources. This is not always easy model for infrastructure to match George could have a guarantee from the govern- when the banks are the tried and tested Osborne’s bold claims that the UK is ment or a well rated bank, or a higher method. building infrastructure “fit for the 21st equity portion that can later be taken “It takes some resolve and innovative century”.

The UK’s priority projects

Transport Roads Highways Agency programme in construction – New Lower Thames crossing pre-2010 Spending Review Highways Agency managed motorways programme – Mersey Gateway Bridge Spending Review projects Highways Agency trunk road improvements programme – Local transport projects – funded at or before 2010 Spending Review 2010 Spending Review projects Highways Agency – Autumn Statement package Local authority major transport schemes – development pool projects Alternative approaches to resolving issues along the A14 corridor Public transport Crossrail Reading upgrade programme Thameslink High Speed Two (subject to consultation) Rail infrastructure and rolling stock enhancement Northern rail connectivity (Liverpool-Newcastle including Northern Hub) East Coast Main Line Intercity Express Programme Great Western Electrification London Underground investment programme Kings Cross Station improvements Northern Line Extension to Battersea Airports Gatwick capital investment programme Heathrow capital investment programme Ports Ports – container terminal projects Ports – renewable energy projects Local infrastructure funding programmes Growing Places Fund Regional Growth Fund Energy Electricity generation – new nuclear investment Electricity generation – wind energy investment Carbon Capture and Storage investment Electricity and gas transmission and distribution investment Electricity generation – gas investment (CCGT) Smart meters Electricity generation – biomass investment Communications 4G mobile auction and rollout Fixed broadband investment – private and public Rural mobile coverage Urban broadband fund Water and sewerage and flood risk management Thames Tideway Tunnel Flood and coastal erosion risk management programme (including Thames Estuary 2100) (Source – National Infrastructure Plan, HMT)

76 EuroWeek UK Capital Markets 2012 The Banking Sector

More capital please, we’re British If you thought bank regulation was a big topic in the eurozone you should see the UK. With so much of the economy tied up in , the authorities are desperate to get things right. Katie Llanos-Small asks how far the push for capital has to run, and how banks are keeping up.

ervyn King, the governor of It advised that: “taking into account the Bank of England, is prob- each institution’s risk profile, the Finan- Mably not a man prone to scrib- cial Services Authority works with banks bled reminders. But if he was, a Post-it to ensure they build a sufficient cush- note saying “When in doubt, add some ion of loss-absorbing capital in order more capital” would probably be stuck to help to protect against the currently to his computer screen. heightened risk of losses… Banks should The UK’s banks have been frantically continue to restrain cash dividends and raising their capital ratios since their compensation in order to maximise the pre-crisis lows. As a result, those ratios ability to build equity through retained are now unrecognisable compared to earnings.” just a few years ago. In mid-2008, Bar- But with the all now boast- clays held an equity tier one ratio of 5%. ing double digit core tier one ratios, Four years later, it was 10.9%. analysts and bankers are asking when Lloyds Banking Group and Royal the capital push will stop. Bank of Scotland, with 6.2% and 5.7% “UK banks are carrying consider- respectively in mid-2008, now both ably more common equity relative to have over 11% core tier one — although the size of their balance sheets, on a they are admittedly special cases, hav- gross or risk-weighted basis, than they ing been rescued by the government. have for a very long time,” says Alastair HSBC, top of the big four in 2008 with Ryan, co-head of European banks an 8.8% core tier one ratio, now holds research at UBS. 11.3%. “The amount of equity in the busi- But the improved levels are seemingly ness is high in absolute terms and his- not enough. The Financial Policy Com- torical terms. But regulators like the FPC mittee, a new arm of the Bank of Eng- haven’t been good at recognising and land, recommended after its June meet- giving credit for that. The essential truth ing that lenders form a cushion of capital is that UK banks have had very large above the Basel III transition require- amounts of equity put in and very large ments, to support increased lending. amounts of risk taken out.” The banks face a pile of new regula- UK capital20 requirements compared to EU and Swiss rules tions, designed to protect the taxpayer

High trigger cocos 18 from ever having to sink billions of pounds into the institutions again. Additional bail-inable debt - to bring PLAC to 17% 16 Besides the higher capital ratios Tier two Tier two being brought in globally as part of the

14 Basel III process, the UK’s banks will Additional tier one Additional tier one Low-trigger cocos need to structurally separate their retail Countercyclical capital

12 s t bu er - up to 2.5% Countercyclical capital and investment banking units and hold e s

s bu er - up to 2.5% A d

e primary loss-absorbing capacity equal to t h g i 10 e

W 17% of risk-weighted assets. k s

i G SIB bu er R f Additional CET1 bu er,

o At the same time, rulemakers are

% including G SIB bu er 8 Capital conservation bu er pushing them to lend more to the real (CET1) economy. In 2012 alone, the authori- 6 Capital conservation bu er Capital conservation bu er (CET1) (CET1) ties have rolled out two programmes designed to bring down the cost of 4 wholesale funds for banks, allowing

Minimum CET1 Minimum CET1 Minimum CET1 2 them to lend to customers more cheaply — the Treasury’s National Loan Guaran-

0 tee Scheme, and the Funding for Lend- UK ring-fenced G SIB, as proposed in EU's CRD IV proposals Swiss rules Treasury white paper, June 2012 ing Scheme, a joint programme between Source: EuroWeek the Treasury and the Bank of England. UK Capital Markets 2012 EuroWeek 77 The Banking Sector

“The banks have ample capital to to reduce risk-weighted assets. Lloyds “In these go out and grow their loan books, has slashed RWAs by a third since the conditions, utilising the cheap funding under end of 2009, reporting £333bn across selling assets the FLS,” says Ryan. “But because the core and non-core businesses in mid- and increasing Bank of England continues to demand 2012. capital ratios are unquantified amounts of more capital RBS has similarly cut back its assets. not necessarily in the system, the banks are not going Its £1.4tr of total assets at the mid- compatible” to be able to behave in a way they year point of 2012 was nearly a third economically should do. What should less than four years earlier. happen is that well capitalised banks But as the economy continues to would use cheap funding to go out stagnate, offloading assets is increas- Simone Verri, and lend it and grow their businesses. ingly difficult. Goldman Sachs But the FPC and the Bank of England “It is very clear that if you have continue to demand more capital.” to conserve capital — because you variable focus, however, and depends Despite the banks’ rapid recapi- have been asked to hold more capi- on which jurisdiction you are talking talisations, their reticence to increase tal — it becomes very important that about. The Independent Commission lending is frustrating policymakers. you don’t take losses when you sell on Banking and the focus on primary Mortgage lending slumped from its assets,” says Simone Verri, head of loss-absorbing capacity means that peak in 2007 and has flat-lined since European financial institutions financ- within the UK, tier two is unques- 2009, showing no sign of revival ing at Goldman Sachs. “Therefore the tionably a key element in a bank’s (see table). Gross lending in May was ability to sell assets and deleverage armoury.” £12.2bn. That was up 5% on the pre- has been curtailed by the requirement Lenders are already targeting a vious month, but a long way from the to increase their capital positions. In 17% primary loss-absorbing capacity more than £30bn a month they were these conditions, selling assets and (PLAC). Put forward by the ICB, the dishing out in the pre-crisis years. increasing capital ratios are not neces- metric means ring-fenced banks will Hopes grew that the Funding for sarily compatible.” have to hold equity and long term Lending Scheme, which kicked off in debt equal to 17% of risk-weighted August, would make a real difference Sub debt has its day assets. to lending rates. Indeed, expectations Common equity ratios came sharply Banks will soon start exploring were that the programme would have into focus after the crisis, but hybrid again the conventional forms of non- more success than its predecessor, capital and subordinated debt remain equity capital — tier one and tier two the National Loan Guarantee Scheme, important to banks — perhaps even securities. Indeed, because banks’ funding would get more in the UK than elsewhere in has sold two dollar tier two deals this cheaper, the more they increased their Europe. year. But for the most part, regulatory lending. “Common equity is undoubtedly hurdles are slowing the process down. But banks have a capital dilemma. the key focus for all regulators across “With regulation still in flux and Increasing loans eats into capital. But the EU,” says David Carmalt, head of a number of key structural aspects yet replenishing that capital is difficult financial institutions debt capital mar- to be pinned down, few borrowers in an environment of low economic kets for the UK and Ireland at Lloyds can even consider moving ahead with growth and depressed asset prices. Bank Wholesale Banking & Markets. additional tier one issuance,” says Car- Lloyds Bank and RBS have made “The importance of tier two within malt. “The cost and risk of executing strong progress since their bail-outs banks’ capital structures is a source of a transaction which proves to be non-

Intense agenda of change

The UK’s gruelling series of public investigations into the banks new organ of the Bank of England, is and the financial system led to satirical website, The Daily Mash, also keeping an eye on things. Its remit to label the UK an inquiry-based economy. Joking aside, keeping is to take a systemic perspective, moni- up with the flood of regulatory changes facing banks, particularly toring and acting to make the financial sector more resilient. those in the UK, can sometimes seem like a full time job. The plans have their detractors. Some worry that the reshuffle, particu- Royal Bank of Scotland described 2013 to oversee the banks. larly the split of the PRA and the FCA, the agenda for regulatory change as The PRA will sit within the Bank of will double the reporting workload for “intense” in its 2012 interim report. England. It will oversee deposit-takers, banks. Others would surely agree. insurers and some investors and is But not everyone is opposed. One At the domestic level, there are charged with promoting the soundness benefit of the Bank of England taking several new elements to deal with. The of such institutions. The FCA will be an the reins on regulations is that it will Financial Services Authority is being independent institution with a remit to have a deeper understanding of how phased out as the main bank regula- make sure financial services markets markets work, says a banker. tor. In its place, the Prudential Regula- operate properly, regulating conduct “When you’re regulated by the tory Authority and Financial Conduct and supervising trading infrastructures. people with the cheque book, the level Authority will start operating in early The Financial Policy Committee, a Continued on 79

78 EuroWeek UK Capital Markets 2012 The Banking Sector

compliant in the new world sits New instruments Gross and changes in net secured lending with the issuing bank. Gross and changes in net secured lending A new type of tier three capital “In the main, most mar- may also be on the horizon for ket counterparts are comfort- 40,000 all UK lenders. Introduction able enough that current form of such an instrument would tier two can be executed into the 30,000 be an evolving process over year-end with limited risk, so for the coming years as banks test borrowers with significant refi- 20,000 investor appetite and evalu- nancing requirements, or who are ate the benefit to their senior seeking to increase their tier two £m unsecured funding costs. 10,000 transition cap ahead of January 1, In keeping with UK regula- 2013, we should continue to see tors’ perspective that banks’ 0

11 12 primary issuance into December.” 10 total loss-absorbing capacity 07 03 02 Jul Jul Jul Jul 01 Jul Jul Jul Jul 05 Jul 04 Jul 08 Jul 09 Jul For hybrid tier one instru- Jul 06 should be high, they are under- ments, structuring teams are -10,000 stood to be giving more official waiting for the final UK rules on Gross secured lending Changes in net secured lending support to such an asset class tax treatment for new-style secu- than their continental peers. rities. The final decision will be Source: Bank of England and UBS One capital solutions spe- a political one, they say — one cialist says the UK’s regulators banker expects new-style tier two to In the meantime, one way the are more interested in banks using a be classified as debt for tax purposes. builders could boost their ratios is form of bail-in buffer than those on Whether new-style additional tier one to move to internal ratings-based the continent, for example. instruments do too is fifty-fifty, he approaches to calculating their risk- Regulators in Europe are not fussed reckons. weighted assets. about how banks assuage the con- Coventry Building Society moved cerns of senior unsecured investors Building capital to the IRB approach for its mortgages about the threat of bail-in, he says. The question of hybrid capital for in 2008, and Nationwide started roll- In contrast, those in the UK are more building societies is even more com- ing out the method at the same time. interested in seeing banks issue new plicated. With no equity capital, the The IRB approach is already com- securities that do not conform to reg- mutuals cannot consider issuing secu- mon among the larger banks. ulatory capital rules, but which would rities with share conversion features. “Not many builders are under the serve as a buffer for senior unsecured At least one building society is IRB approach,” says one FIG origina- investors against bail-in. understood to be working with struc- tor. “There are potentially huge ben- “Europe to me seems pretty agnos- turing teams to produce a mutual- efits in adopting it. They could get tic on how the bail-in requirement specific additional tier one instrument. a large reduction in the capital held is met, as long as there’s enough of But that will also depend on final against their mortgage book. There [a buffer],” says the banker. “The UK regulations on how securities should are definitely two or three looking goes a bit further, to encourage the absorb losses through temporary or at changing to IRB or already doing creation of this new asset class. It’s a permanent principal writedowns — it. But it’s difficult for some of them nuance rather than a material differ- and the tax treatment. because they’re fairly undermanned.” ence.”

Continued from 78 from January 1, 2013. under Basel III rules. Incorporating of scrutiny and involvement is higher, Delays in EU rule-making mean that all the extra capital deductions to be as is their understanding of liquidity deadline is unlikely to be met. But the phased in over the following six years, conditions and treasury operations,” FSA in August published an open note the bank would have an estimated says a FIG origination specialist who to the banks described as a “business 8.6% ratio in January. HSBC calculates did not want to be quoted. as usual” letter by market participants. that its core tier ratio would have stood “I believe that so long as banks Its message was clear — it was incon- at around 10% in June 2012 under are supported by central banks, which ceivable that UK lenders should con- Basel III calculations. is the case universally, then bigger sider delaying their own preparations RBS expects to have a 10.3% Basel involvement of central banks is actually for the new capital framework, just III ratio at the end of next year, or positive for the sector. Central banks because of European foot-dragging. between 9% and 9.5% on a fully load- are in a position to understand liquid- “The FSA will continue to undertake ed basis. Lloyds reckons it would have ity much better than pure regulators.” all preparatory work that is possible held 7.7% core tier one capital at the At the same time, the UK’s banks in the absence of finalised legisla- mid-year point on a fully loaded basis. are closely watching regulations at the tive text, in full expectation that the At the same time, debate contin- European level. Some will hit them, EU legislation will follow the Basel III ues over whether individual countries others will not. implementation timetable,” it said. “We — the UK included — will be allowed Implementation of Basel III in the expect all firms in scope of CRD to do to require banks to hold more capital European Union is a good example. likewise.” above the CRD IV minima. Opponents The UK’s banks will be subject to the The banks’ mid-year financial argue the move would erase gains fourth Capital Requirements Direc- results suggest they are well on track to made towards a level playing field for tive and the first Capital Requirements meet the incoming requirements. Europe’s banks, while supporters say Regulation, CRD IV and CRR I. They Barclays projects a 9.2% core tier countries should be free to make their were due to start coming into effect one ratio at the beginning of next year own banks safer if they want.

UK Capital Markets 2012 EuroWeek 79 Bank Funding

UK bank debt weathers the scandal storm Even as the reputation of UK banks is shredded in the public arena and the country’s economy stagnates, the sector has garnered an impressively loyal following among debt investors. But just as demand is peaking, bankers are worried that a torrent of subsidised liquidity could cut off supply. Will Caiger-Smith asks whether their concerns are justified.

cursory glance at any UK news- “To a certain paper’s front page over the past extent the FLS A 12 months will have revealed is a temporary a plethora of banker bashing stories. phenomenon and A quick look at the bond markets, most institutions however, reveals a different story. UK will want to keep bank debt is the flavour of the year their investor base for investors looking to gain access to active” financial institutions that are protected from the euro and the European sover- eign debt crises. Robert Plehn, Banks are deleveraging quickly and Lloyds Bank balance sheets are far cleaner than they were before the crisis and even two a catastrophic IT meltdown, and Stand- years ago. But the speed of the transfor- ard Chartered broke trading sanctions mation is not without its side-effects. with Iran. In August, a well known Alastair Ryan, co-head of European investors’ almanac rated three of these bank research at UBS, says that while firms as “sell” — StanChart was the regulators have whipped the banks into only “hold”. shape, the result is that the FIG bond But a regulatory regime well in issuance pipeline is dry. advance of most eurozone jurisdictions “In 2007 and 2008 banks in the UK has given UK banks something of a generally had poor funding structures,” gold plating in the eyes of debt inves- he says. “They had large balance sheets, tors. While the big four UK banks’ share they were wholesale funded, the fund- prices have tumbled over the course of ing was generally short dated and they 2012, their senior CDS is at worst stable held relatively little liquidity against and at best around 125bp tighter. risks of market deterioration. It’s under- The same is happening in the secu- standable that when the risks embed- ritisation market, especially among US ded in that range of aggressive struc- investors. One securitisation banker says tures crystallised, the authorities would prime UK RMBS paper has tightened respond aggressively. more than 60bp on the secondary mar- “Now, the situation is reversed. ket during the last two months. Banks are overly liquid and they David Hague, head of UK & Ireland have conservative funding structures. FIG DCM at Royal Bank of Scotland, Because of constant pressure from the says the market was caught out by how regulator, the banks have over-issued quickly UK banks went from spewing for the past few years. Now they have out deals left, right and centre, to tak- £300bn of excess liquidity sat on their ing their debt back off the market. balance sheet.” “A lot of issuers are keen to get the message out that they are well funded, Bad press liquid and will be pretty rare in com- It seems almost perverse that a group ing to market, and the UK has followed of financial institutions so beset by through to the letter in terms of not controversy in the popular press should issuing,” he says. “That has caused a be so popular with investors. Barclays huge tightening in secondary spreads was battered by the Libor scandal and for UK banks. will remain bruised until its new man- “If you mirror that against con- agement team can regain the initiative. tinental Europe — the potential for HSBC admitted to accidentally laun- Greece to exit the euro, the risk that dering money for terrorists and drug other countries could exit, the destabil- dealers. Royal Bank of Scotland suffered ising effect that would have — the UK 80 EuroWeek UK Capital Markets 2012 Bank Funding

and sterling balance sheets are a natu- of sterling, euro and US dollar bonds. An extra 25bp charge will be ral hedge to that. Not only is that get- Having seen banks like Lloyds able incurred for every 1% fall in net ting a lot of attention from domestic to pull off such trades, which would lending, up to a limit of 150bp. This investors but it’s a story that carries have been impossible just a couple means participating institutions can well over to continental Europe — of years ago, it is not too much of a expect a funding cost of between we get a lot of continental investors stretch of the imagination to think roughly 0.75% and 2%, taking into looking for UK bank assets.” the UK may have been well served by account the Bank’s 0.5% base rate. hitting crisis point before Europe. Letting the air out “In terms of deleveraging, given Side-effects Lloyds and RBS are two of the best the historic size of their balance Many market participants are scep- examples of balance sheet deflation sheets, UK banks were forced to be tical about the scheme’s ability to in the UK market, both having more ahead of the curve,” says Harman boost lending. But banks are cer- or less publicly withdrawn from the Dhami, head of FIG syndicate at RBS. tainly taking an interest — after all, senior unsecured market this year. “We are now much further ahead the levels on offer are generous. But RBS has not printed a single of our continental peers, and that is while it may stave off a contraction in benchmark sized public deal in that being reflected in the credit percep- the UK economy and is undeniably a format since May 2011. It has issued tion of UK banks.” boon for the banks, some worry that covered bonds, as well as senior in it might not be such a good thing for the private market, but the scale of Mainline funding the credit markets. its deleveraging means it simply no Deleveraging is not the only fac- The sort of collateral banks would longer requires funding in the sizes tor influencing the new issue mar- normally use for securitisation — offered by the public market. ket, however. In his annual Mansion mortgages, loans, auto Lloyds, meanwhile, issued two House speech in June, Bank of Eng- loans — is perfect fodder for the FLS, public senior deals this year — a land governor Mervyn King spoke and they can get more bang for their €1.5bn five year in January, priced at of a “large black cloud of uncer- buck putting it in repo with the Bank 305bp over mid-swaps, and a £1.4bn tainty” hanging over Europe and the of England than they would packag- five year in April, priced at 55bp over UK, “dampened animal spirits” and ing it up into asset backed securities Gilts. However, having completed its households and businesses “battening and selling it to private investors. In funding programme, it announced in down the hatches to prepare for the August, Building Society issued its first quarter results presentation storms ahead”. How to get the banks an £897m RMBS deal named Albion that it would only be accessing mar- lending again? but chose to retain it to get this ben- kets on an opportunistic basis. The answer, or at least one of efit. Bankers say other building socie- All the while, both banks have them, was the Funding for Lend- ties are considering doing the same. been offloading assets. Lloyds has sold ing Scheme (FLS). The scheme offers “Given the size of these institu- several loan portfolios, building up a cheap funding to banks, not on the tions, it is much easier to put that large buffer of excess cash which it condition that they increase their packaged-up collateral into the FLS put to work with a mammoth liability lending to UK households and busi- and pass the cost saving benefit back management operation in July. nesses but simply that they reduce it to their members than sell those Lloyds bought back £4.9bn of by less than they had planned. The bonds to third party investors,” says its own senior debt, equivalent to fee starts at 25bp for banks whose Hague at RBS. 24% of the outstanding amount of sterling lending to UK households “It shows that our banking system the securities it was targeting. RBS and non-financial companies is flat is healthy and the people at the top announced a copycat deal in early to positive between the end of June are making decisions based on eco- September, targeting just over £16bn 2012 and the end of December 2013. nomic considerations. In the current The big three: UK bank CDS plummets environment where every bank CFO UK bank CDS grinds tighter is focused on net interest margin, overall profitability and what that means for share price performance, 450 HSBC Barclays Royal Bank of Scotland banks will look at all the options to 400 reduce their funding costs and thus improve the outcome for all stake- 350 holders, both customers and share- holders. But it does mean there is a 300 lack of assets for people to put their

250 money into.” Investors are sensitive souls, how- 200 ever, and banks will not want to neglect them. Robert Plehn, head 150 of asset backed solutions at Lloyds,

100 believes borrowers will do their best to keep their buyers sweet and not be 50 completely seduced by the generous, windfall wiles of Mr King. 0 01 Sep 11 30 Oct 11 28 Dec 11 25 Feb 12 24 Apr 12 22 Jun 12 20 Aug 12 “To a certain extent the FLS is a temporary phenomenon and most Source: Markit institutions will want to keep their UK Capital Markets 2012 EuroWeek 81

Source: Markit Bank Funding

investor base active,” he says. “This is ther lending. “Banks and relatively easy in respect of UK inves- “The FLS is there to kickstart building societies tors but new overseas investors — that process,” says Hauser. “Also, the are keen to use particularly in the US and Asia — have wholesale market can actually be the FLS but also spent time educating themselves on cheaper than retail funding for some recognise that the UK markets, the assets and struc- lenders, given the very competitive they need to keep tures that back the securitisations, conditions in retail deposit markets. a foothold in asset performance, etc. Even existing So some banks and building societies funding markets, overseas investors need to spend time may adjust their retail funding rather so will ensure they keeping this knowledge fresh. than their wholesale funding.” have a continuing “If there is no supply of product Andrew Hauser, issuance for an extensive period of time then Stable doors slam... Bank of England programme” this knowledge base could disappear It is clear that the FLS is a big thing making it more difficult, and prob- for the Bank — a macroeconomic accessing at least the securitisation or ably more expensive, for issuers to tool in the same league as quantita- covered bond markets. raise funding in these markets in the tive easing. Despite the positive rhet- UBS’s Ryan believes the end aim future. Most issuers are aware of this oric, however, some feel the scheme of ringfencing is to force investment and so I expect to see some regular, is the Bank’s way of remedying a banks to shrink by making it more albeit reduced, securitisation issuance disease it caused through regulation difficult for them to access markets. out of most of the larger UK issuers, overload. “Ringfencing is not designed to notwithstanding the FLS.” “The FLS is a belated but welcome make UK banks safer,” he says. “It response to elevated funding costs is designed to make UK banks have A marathon, not a sprint which were themselves driven by smaller wholesale operations. How For its part, the Bank of England is regulatory changes, bail-in, too-big- that works is that the investment keen to emphasise that the scheme to-fail, and ringfencing,” says UBS’s entity will have less reliable access was introduced with the aim of Ryan. “The regulator made banks’ to wholesale operations and will boosting lending and therefore, in debt lower quality. The cost of issu- therefore want to be smaller. It seems turn, borrowing. Five or six other ing went up, and the regulator made likely that unless an outside-ringfence building societies are understood to them issue a lot. The banks’ response business was significantly better capi- have a similar view to Leeds regard- was to lend less, so the regulator talised than a retail business, it would ing their use of retained securitisa- responded by making their funding be lower rated and therefore harder tion in the FLS, but the long term cheaper.” to fund.” effect on the wholesale markets “When it expires we would expect Indeed, the difference in rating should be positive, says Andrew the cost of issuing wholesale debt between retail entities and investment Hauser, head of the Bank’s sterling to have fallen again. I don’t think banks may start to bite even before markets division. you will see UK covered bonds at the regulations are enforced. At some “First, banks and building socie- these levels again. The FLS has closed point, investors will be forced to take ties are keen to use the FLS but also a chapter in which UK banks were a view on which which part of the recognise that they need to keep a required by the regulator to issue the bank will be charged with servicing foothold in funding markets, so will wrong quantity at the wrong spread.” their assets — accounts buying debt ensure they have a continuing issu- maturing in 2020, for example, will ance programme,” he says. “That will ...before fences are erected have to start thinking not just about be helped by the fact that getting While stopgap measures like the what they are buying right now, but new lending onstream takes time — FLS may affect issuance in the short where that security could be trans- we expect take-up of the FLS to be term, in the longer term, the shape ferred to in the future. smoothed over the 18 month win- of the UK banking sector is changing, “There will be a ratings gap dow, rather than coming in a big cliff and banks’ funding strategies will between a standalone investment right at the start of the scheme. have to adapt with it. The ringfenc- bank and a fully retail-funded retail “Second, the cost of issuance is ing proposals put forward earlier this bank,” says Dhami at RBS. “How- coming down quite sharply. That year by Sir John Vickers’ Independ- ever, spreads are currently attractive reflects all sorts of factors, of course ent Commission on Banking (ICB) enough for bank debt to be a com- — but the FLS is likely to have played are still being worked through, but pelling investment offer. Additionally, a part. Indeed, reducing funding costs they will arrive sooner or later, and it the extended transition period [to is one of the key objectives of the will inevitably affect the mechanics of ringfencing], coupled with the strong scheme. With yields coming down, debt issuance. regulatory and banking infrastructure the attraction of wholesale funding There is a school of thought that in the UK facilitates a positive out- should increase over time.” says ringfenced entities — the retail look for UK bank funding platforms.” The aim of the FLS is to boost part of the bank — should be funded The great British public has given lending to households and firms entirely by deposits, meaning any its banking industry a rough ride this relative to what it otherwise would operations outside the ringfence year, probably deservedly so. How- have been, he says. Some substitu- would have to be wholesale funded. ever, as hard as it may be to look past tion of wholesale funding is likely However, the amount of surplus capi- the IT failures, bonus rows and rate in the short term, but the aim is tal retail banks will have from mort- fixing scandals, the market for UK that increased lending should help gage lending and potentially corpo- bank debt is something of a success growth, in turn boosting banks’ need rate lending make it seem unlikely story. Perhaps, in time, the sector can for wholesale funding to finance fur- that they would prohibited from make its people proud again. 82 EuroWeek UK Capital Markets 2012 UK data UK Data Over the following pages we have provided a snapshot of UK economic, Gilt market and banking sector data. We have used the latest data available, from official sources including the Bank of England, HM Treasury and the the rating agencies. For more detailed information please refer to the websites of these official institutions.

Standard & Poor’s: AAA/A-1+ (stable outlook) Moody’s: Aaa (negative outlook) Fitch: AAA (negative outlook)

selected key officials

HM Treasury UK Financial Investments Financial Services Authority Rt Hon George Osborne MP Robin Budenberg Lord Adair Turner Chancellor of the Exchequer Chairman Executive Chairman

Rt Hon Danny Alexander MP Jim O’Neil Andrew Bailey Chief Secretary to the Treasury Chief Executive Head of Prudential Business Unit

Rt Hon Greg Clark MP Martin Wheatley Financial Secretary to the Treasury Bank of England Managing Director Sir Mervyn King Governor David Gauke MP Exchequer Secretary to the Treasury Charles Bean Robert Stheeman Deputy Governor, Monetary Policy Chief Executive Sajid Javid MP Economic Secretary to the Treasury Paul Tucker Deputy Governor, Financial Stability Jo Whelan Lord Sassoon Deputy Chief Executive Commercial Secretary to the Treasury Paul Fisher Joanne Perez Executive Director, Markets Head of Markets Nick Macpherson Permanent Secretary Andy Haldane Executive Director, Financial Stability Tom Scholar Second Permanent Secretary

Financial overview GDP growth estimates compared

($bn) 2011 (%) 2012 2013 2014 2015 2016 Fitch (Mar 12) 0.5 1.9 2.5 2.7 2.9 GDP 2418.7 OBR (Nov 11) 0.7 2.1 2.7 3 3 GDP per head ($ 000) 38.9 Bank of England (BOE) (Feb 12) 1.3 2.8 3.1 Population (m) 62.1 European Commission (EC) (Feb 12) 0.6 1.5 International reserves 95.0 IFS (Feb 12) 0.9 2.4 2.8 3.1 3 Net external debt (% GDP) 37.5 IMF (Jan 12) 0.6 2 2.6 2.7 2.7 Central government total debt (% GDP) 77.7 NIESR (Oct 11) 0.8 2.6 2.5 2.3 CG foreign-currency debt 2.3 OECD (Nov 11) 0.5 1.8 CG domestically issued debt (GPB£) 1171 Oxford Economics (Mar 12) 0.5 1.8 2.8 2.8 2.7 Source: Fitch Source: Fitch, OBR, BoE, EC, IFS, IMF, NIESR, OECD, OE. IMF World Economic Outlook update until 2013, with 2014-2016 estimates reflecting 2011 IMF projections

UK Capital Markets EuroWeek 83 UK data

Standard & Poor’s latest Fitch’s UK rating factors UK rating update Moody’s latest UK credit opinion

Strengths Overview Credit Strengths • The high-value added, diversified, and wealthy • We project that, despite recent weakness, the The credit strengths of the United Kingdom include: economy is one of the pillars of the UK’s AAA credit UK economy should begin to recover in the second • A large, diversified, wealthy economy rating. The broad tax base also supports the UK’s half of 2012 and steadily strengthen, and we expect credit profile. economic policy to continue focusing on closing the • Strong micro-economic flexibility (including in the labour market) • The UK has strong institutions, including respect fiscal gap. for property rights and rule of law, as well as strong • In our view, monetary flexibility remains a key • Robust institutions and pragmatic policy-making policy flexibility and responsiveness. credit strength owing to the British ’s • Social and political consensus on fiscal objectives • As the benchmark borrower in its own reserve role as a global reserve currency. • Limited debt financing risks due to the long currency, UK government bonds have “safe haven” • We are affirming our AAA/A-1+ long and short term average maturity of the debt and a large domestic status for investors, largely mitigating refinancing unsolicited sovereign credit ratings on the UK. investor base - The role of sterling as a global risks. There is also low interest rate risk, even relative • The stable outlook reflects our expectation that the reserve currency, and the presence of a supportive to other major AAA peers. UK government will implement the bulk of its fiscal national central bank • The Bank of England (BoE) provides assurance consolidation programme and that the economy against a self-fulfilling liquidity crisis, distinguishing should recover in the remainder of 2012 and Credit Challenges the UK from its eurozone peers. Although QE is strengthen thereafter. The credit challenges of the United Kingdom include: intended to offset deflationary pressures in the economy, it has also reduced the supply of UK • A considerable public sector deficit and debt government debt to the market by two-thirds, further Rating rationale (excerpt) burden, which reduces fiscal flexibility - Weaker supporting the UK‟s financing profile. Our view of the UK’s wealthy and diverse economy, macroeconomic prospects • The UK’s labour and product markets are flexible. fiscal and monetary policy flexibility, and adaptable • Risks emanating from the euro area crisis product and labour markets support our unsolicited • The UK’s track record of previous successful ratings on the sovereign. In our opinion, the UK episodes of fiscal consolidation and public debt government remains committed to implementing Rating rationale (excerpt) reduction, and strong political commitment to the its fiscal programme, and we believe it can respond The UK’s Aaa sovereign rating continues to be current consolidation programme, support the rapidly to economic challenges. We also view the UK characterised by a large, diversified and highly government’s plan to reverse fiscal imbalances. as having deep capital markets with strong demand competitive economy, a particularly flexible labour for long-dated government bonds (Gilts) by both market, and a banking sector that compares Weaknesses domestic and non-resident institutional investors. favourably to peers in the euro area. The economy The market-value weighted average maturity of generally benefits from the significant structural • The UK has one of the largest fiscal deficit and debt UK government debt is more than 14 years, which reforms undertaken in the past. As a result of these positions among “AAA‟ rated helps contain the government’s annual public gross strong structural features, Moody’s expects the sovereigns, leaving little room for the borrowing needs compared with those of peers. UK to eventually return to its trend growth rate of accommodation of additional fiscal shocks. Public We also expect that the Bank of England (BoE)’s around 2.5%, although the return to trend growth debt in 2012 is projected to be the fifth largest in the monetary policy, which we view as highly is expected to be slower than originally expected, G20 in 2012, having registered one of the steepest accommodative, will help keep the government’s reflecting the nature and depth of the financial crisis. increases of all Fitch-rated sovereigns since the borrowing costs in check. The BoE’s monetary policy While the negative outlook in part reflects concerns 2008-2009 crisis. includes its Asset Purchases Facility, under which about the UK’s macro-economic outlook for the next • The large banking sector represents a significant a total of £375bn in Gilts will have been purchased few years, the country’s Aaa rating is supported contingent fiscal liability on the sovereign. With between March 2009 and November 2012. by several factors. The current fiscal consolidation a significant proportion of the banking system‟s programme remains intact and the government assets outside the UK, the sector is exposed to risks has demonstrated its willingness and ability to Outlook arising outside the UK‟s control, including eurozone take action to address shortfalls. The UK has been crisis spill-over effects. However, Fitch considers The stable outlook reflects our expectation that proactive in pushing banks to hold more capital and that UK banks are relatively well placed to absorb the government will continue to consolidate public in taking steps to reduce the probability and impact future episodes of financial market turmoil, having finances, enabling net general government debt as a of the sovereign having to use its own balance strengthened their capital positions and reduced percentage of GDP to stabilize by 2014 (and remain sheet to support British banks. Furthermore, the their exposures to the weaker eurozone economies at a similar level in 2015 before declining), and that outstanding debt stock has important structural over the years. an economic recovery will begin to gain traction. It features that give the UK government a very high • As with many peers, there is still uncertainty also reflects our view that governance issues with shock-absorption capacity. about the scale of the loss of potential output and specific institutions, changes in EU-wide bank or tax the implications for medium-term trend growth as a policy, or greater financial stress in the eurozone Rating Outlook (excerpt) result of the global financial crisis. will not affect London’s position as a preeminent financial center. The outlook on the UK’s Aaa ratings was changed to • The highly indebted balance sheet of the household negative on 13 February 2012. The rating action for sector exerts deleveraging pressure on the economy. We could lower the ratings in particular if the pace the UK was part of a broader exercise reassessing EU This is expected to continue into the medium term. and extent of fiscal consolidation slows beyond what we currently expect. This could stem from a sovereign debt ratings, which Moody’s announced in Source: Fitch Ratings, March 2012 reappraisal of our view of the government’s ability a report published last November. to implement its fiscal strategy or from significantly The primary driver underlying Moody’s decision weaker economic growth than we currently to change the outlook on the UK’s Aaa rating anticipate. to negative was the weaker macroeconomic environment, which will challenge the government’s Source: Standard & Poor’s, July 2012 efforts to place its debt burden on a downward trajectory over the coming years.

Source Moody’s Investors Services, July 30, 2012

84 EuroWeek UK Capital Markets UK data

August 2012 CPI Fan Chart August 2012 GDP Fan Chart UK goods exports to EU and non-EU countries(a) Chart 2.9 UK goods exports to EU and non-EU countries(a)

Percentage increase in prices on a year earlier Percentage increase in output on a year earlier £ billions 7 8 38 Bank estimates of past growth Projection 7 6 36 6 EU 34 5 5 4 32 4 3 30 2 3 1 28 + 0 2 - 26 1 Non-EU 24 1 2 + 3 22 0 4 - 20 5 0 1 ONS data 2007 08 09 10 11 12 6 7 2 Source: HM Treasury 2008 09 10 11 12 13 14 15 8 2008 09 10 11 12 13 14 15 Source: Bank of England (a) Chained-volume measures (reference year 2009). Data do not exclude the estimated impact of MTIC fraud. The diamonds are the averages of Source: Bank of England data for April and May 2012.

Net debt and net borrowing: Public sector net borrowing, Survey measures of output growth in time series 1993/1994 to 2011/12 selected euro-area countries Net debt and net borrowing: time series (a) Chart 2.7 GDP in selected countries and regions Public sector net borrowing, 1993/1994 to 2011/12 Public sector net debt as a percentage of GDP, 1976/77 TO 2011/12

Indices Percentage changes on a year earlier £billion 70 16 160 (b) China (3%) 14 140 60 12 120 10 100 50 India (2%)(b) 8 6 80 40 Brazil (1%) 4 60 2 40 30 United States (16%) + 0 – 20 2 + 20 Euro area (42%) 0 4 – 20 10 6 2005 06 07 08 09 10 11 12 40 0 60 1976/77 1981/81 1986/87 1991/92 1996/97 2001/02 2006/07 2011/12 Sources: Eurostat, Indian Central Statistical Organisation, Instituto Brasileiro de 1993/94 1996/97 1999/00 2002/03 2005/06 2008/09 2011/12 Geografia e Estatística, National Bureau of Statistics of China, Thomson Reuters Source: O‚ice for National Statistics Datastream and US Bureau of Economic Analysis. Source: Oice for National Statistics (a) Real GDP measures. Figures in parentheses are shares in UK goods and services exports in 2011 from the 2012 Pink Book. The latest observations for China and the United States are 2012 Q2 and for India, Brazil and the euro area are 2012 Q1. (b) Non seasonally adjusted.

market-implied default Credit ratings of selected sovereigns selected European probabilities over the ext five years government bond spreads(a) Chart 1.1 Market-implied default probabilities over the Chart 1.4 Credit ratings of selected sovereig(a) next fivef yearsor sele for selectedcted soversovereigeign debn(a) deBT Chart 5.1 elected European government bond spreads(a)

Portugal (right-hand scale) Italy (right-hand scale) Per cent Credit rating 80 Greece (left-hand scale) France (right-hand scale) Portugal (b) Aaa Ireland (right-hand scale) Austria (right-hand scale) Spain (right-hand scale) Ireland 70 Aa1 United Kingdom (right-hand scale) Spain Aa2 Basis points Basis points Japan 5,000 1,600 Italy 60 Aa3 France A1 (b) Germany Italy 1,400 50 A2 United Kingdom 4,000 A3 1,200 United Kingdom, Baa1 40 United States, Baa2 1,000 Germany Spain 3,000 30 and France Baa3 Ba1 800 20 Ba2 Portugal Ba3 2,000 600 Caa1 10 Greece Caa2 400 Caa3 1,000 0 Ca 200 2008 09 10 11 12 C 2007 08 09 10 11 12 0 0 June Aug. Oct. Dec. Feb. Apr. June Sources: Markit Group Limited and Bank calculations. 2011 12 Source: Moody’s (a) Probability of default, derived from CDS premia, from the perspective of a Sources: Thomson Reuters Datastream and Bank calculations. so-called ‘risk-neutral’ investor that is indi’erent between a pay-o’ with (a) All data points are at year-end, except for 2012 which is at 21 June 2012. certainty and an uncertain pay-o’ with the same expected value. If market (a) Yield to maturity of benchmark ten-year government bond less participants are risk-averse, these measures may overstate actual yield to maturity of benchmark ten-year German government bond. probabilities of default. A loss given default of 60% is assumed. (b) December 2011 Report (b) December 2011 Report

UK Capital Markets EuroWeek 85 UK data

Unemployment rates(a) GDP in selected countries Survey measures of output growth in and regions(a) selected euro-area countries(a) (a) Chart 2.8 Survey measures of output growth in selected Chart 3.11 Unemployment rates (a) Chart 2.7 GDP in selected countries and regions euro-area countries(a)

Recessions(b) Indices Unemployment rate Percentage changes on a year earlier 70 Long-term unemployment rate(c) 16 Per cent (b) 14 China (3%) 14 65 France 12 Germany 60 12 10 55 India (2%)(b) 8 10 6 50 Brazil (1%) 8 4 45 Italy 2 40 United States (16%) + 6 0 – 35 Euro area (42%) 2 Spain 4 4 30 6 25 2 2007 08 09 10 11 12 2005 06 07 08 09 10 11 12

0 Sources: ADACI and Markit Economics. 1978 86 94 2002 10 Sources: Eurostat, Indian Central Statistical Organisation, Instituto Brasileiro de Geografia e Estatística, National Bureau of Statistics of China, Thomson Reuters (a) Published composite indices of manufacturing and services sectors. A figure over Datastream and US Bureau of Economic Analysis. 50 indicates rising output compared with the previous month, and a figure below Source: ONS (including the Labour Force Survey). 50 indicates falling output. Includes flash estimates for July 2012 for France and (a) Real GDP measures. Figures in parentheses are shares in UK goods and services Germany; data for Italy and Spain are to June 2012. (a) Rolling three-month measures unless otherwise stated. exports in 2011 from the 2012 Pink Book. The latest observations for China and (b) Recessions are defined as in Chart 3.8 the United States are 2012 Q2 and for India, Brazil and the euro area are 2012 Q1. (c) Defined as those people who have been unemployed for more than (b) Non seasonally adjusted. twelve months divided by the economically active population. Data prior to 1992 are based on non seasonally adjusted, annual LFS microdata. These annual observations correspond to the March-May quarter.

Average foR independent forcasts Average of independent forecasts Average of medium-term forcasts for for 2013; PSNB (2013–14) for 2012; GDP growth CPI inflation Average for independent forcasts for 2013; PSNB (2013–14) Average of medium-term forcasts for CPI inflation Average of independent forecasts for 2012; GDP growth

112. 5 2.2 2.6 Current account (£billion) 2.0 110. GDP growth (per cent) CPI inflation (annual average, per cent) 1.8 0 1.6 2.2 107. 1.4 1.2 5 1.0 105. 0.8 1.8 0 0.6 102. 0.4 0.2 1.4 5 + 0.0 – 100. 0.2 0 0.4 1.0 Jul Jul Jan Oct Jun Jun Apr Apr Sep Feb Feb Mar Apr May Jun Jul Aug Feb Dec Mar Nov May May Mar

Aug Aug 2012 2013 2014 2015 2016 2012 2011 2012 Source: HM Treasury Source: HM Treasury Source: HM Treasury

Average of medium-term forcasts Average of medium-term Dispersion around the independent for GDP growth forcasts for PSNB consensus for 2013: Average of medium-term forcasts for GDP growth Average of medium-term forcasts for PSNB DispersionPubli aroundc sec torthe independent net borrowi consensusng for 2013: Public sector net borrowing

3.5 140 140 GDP growth (per cent) PSNB (£billion) PSNB (2013-14, £billion) NIESR CG F

120 CEBR 130 MS BE 2.5 CapE CBI N 100 120 SG EIU 1.5 OEF S BC

GS 110

80 G LS EP IN S C v Sb DB RB SCB EE

0.5 BC Li FC 60 GI 100

Independent Consensus

-0.5 40 90 2012 2013 2014 2015 2016 2012 – 13 2013 – 14 2014 – 15 2015 – 16 Source: HM Treasury Source: HM Treasury Source: HM Treasury

86 EuroWeek UK Capital Markets UK data

Gilt Holdings Data International 10 year spot Selected 10 year government government bond yeilds(a) bond yield(a) Chart 1.8 International ten-year spot government Chart 3 Selected ten-year government bond yield(a) bond yeilds(a) Percentage points 6 Overseas holdings (%) Banks & B Socs (%) Spain Belgium United States United Kingdom Insurance & Pension sector BoE (%) Ireland(b) France United Kingdom Italy Austria Germany Per cent Per cent 5 10 70 Previous Bulletin 60 9 4 50 Germany 8 40 7 3 30 6 20 United States 2 5 10 + 4 0 – 1 3 2 Japan 4 2 0 6 2007 08 09 10 11 12 1 1995 97 99 01 03 05 07 09 11 12 0 Sep. Nov. Jan. Mar. May July Source: Thomson Reuters Datastream. 2011 2012

Sources: O€ice of National Statistics (ONS) and the Bank of England (a) Yields to maturity. Source: Bloomberg. (a) Yields to maturity on ten-year benchmark government bonds. (b) Yield to maturity on eight-year government bond.

Change in gilt holdings by Selected European 10 year UK gilt yields relative to yields (a) (a) sector since 2008 Q1(a) Chart 1.2gover Selectedn meEuropeannt bo ten-yearnd yields government on German and US government debt (a) Chart 1.3 UK gilt yields relative to yields on German and bond yields US government debt(a) Chart 2 Change in gilt holdings by sector since 2008 Q1(a)

Non-bank private sector Bank of England(b) Per cent Percentage points 8 0.8 Non-residents Net official sales May Report Banking sector UK-German spread Cumulative change since 2008 Q1 (£ bn) Italy 7 600 0.6 Asset purchases begin 6 500 Spain 5 0.4 400 United Kingdom 4

300 3 0.2 UK-US spread Germany 2 + 200 0.0 1 – 100 0 Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July 0.2 Jan. Apr. July Oct. Jan. Apr. July 0 2010 11 12 Q2 Q4 Q2 Q4 Q2 Q4 Q2 2011 12 2008 09 10 11 Source: Bloomberg. Sources: Bloomberg and Bank calculations. Source: Bank of England (a) Yields to maturity on ten-year benchmark government bonds. (a) Purchases by the non-bank private sector exclude repos. (a) Spread between ten-year spot zero-coupon yields. (b) Gilts acquired through asset purchases are held by the Asset Purchase Facility, a subsidiary of the Bank of England.

UK five year and 10 year Cumulative gilt purchase(a) UK five year and 10 year Chart 1.4nomi UKn five-yearal spot and gilt ten-year yields nominal and spot gilt by maturity(b) nominal spot gilt yields and Chart A Cumulative gilt purchase(a) by maturity(b) yields and five-year yields, five years forward(a) (a) Chart 1.9 UK banks’ indicative longer-term funding (a) five year yields, five years forward spreadsfive year yields, five years forward

Percentage points 15+ years 3.5 Per cent 7–15 years May Report 7 3–7 years 3.0 Five-year yields, May Report £ billions (b) 375 Spread on five years forward 6 three-year 2.5 (a) 350 Five-year retail bonds (b) 325 CDS premia 2.0 5 300 1.5 275 4 250 1.0 Covered bond 225 (c) 3 spread 0.5 200 175 0.0 Five-year spot gilt yields 2 150 2007 08 09 10 11 12 Ten-year spot gilt yields 125 1 Sources: Bank of England, JPMorgan Chase & Co., Markit Group Limited and 100 Bank calculations. 75 0 (a) Sterling only. Spread over the three-year swap rate. The three-year retail bond rate 2007 08 09 10 11 12 50 is a weighted average of rates from banks and building societies within the Bank of 25 England’s normal quoted rate sample with products meeting the specific criteria (see www.bankofengland.co.uk/statistics/Pages/iadb/notesiadb/household_int.aspx). Sources: Bloomberg and Bank calculations. 0 (b) The data show a simple average of the five-year CDS premia of Barclays, HSBC, v v v g g g g b b b Lloyd Banking Group, Nationwide, Royal Bank of Scotland and Santander UK. Fe Fe Fe Feb Au Au Au Au No No No May May May (a) Zero-coupon yield. May (c)From January 2012 onwards, the data show a weighted average of the spread (b) Derived from the Bank’s government liability curves. 2009 10 11 12 between covered bonds of any maturity issued by UK banks and equivalent-maturity swap rates, weighted by the outstanding value of each bond. Before January 2012, the data show a simple average and include bonds with a maturity of between three Source: Bank of England and five years only.

UK Capital Markets EuroWeek 87 UK data

Selected European 10 year UK gilt yields relative to yields on Chart 1 Cumulative asset asset purchases pur byc hasestype: amounts Chart 1.2 Selected European ten-year government(a) bond Chart 1.3 UK gilt yields relative to yields on German and(a) US (a) (a) government bond yields German a(a)nd US government debt outstandingsby type: amounts outstandings yields(a) government debt

Percentage points Commercial paper — reserves Corporate bonds — reserves % 0.8 8 financed (left-hand scale) financed (left-hand scale) May Report Commercial paper — DMO Corporate bonds — DMO UK-German spread financed (left-hand scale) financed (left-hand scale) 7 Italy 0.6 Secured Commercial paper — Gilts — reserves financed DMO financed (left-hand scale) (left-hand scale) 6 £ bn Spain 350 5 0.4 300 United Kingdom 4 0.2 250 3 UK-US spread + 200 Germany 2 0.0 – 150 1

0.2 100 0 Jan. Apr. July Oct. Jan. Apr. July Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July 2011 2012 2010 2011 2012 50 Source: Bloomberg. Sources: Bloomberg and Bank calculations. 0 y y y y (a) Yields to maturity on ten-year benchmark government bonds. (a) Spread between ten-year spot zero-coupon yields. v v v b Fe b Fe b Fe b Fe No No No g Au g Au g Au Ma Ma Ma Ma 2009 2010 2011 2012

Source: Bank of England

Chart 1.17 Tier 1 capital ratios for selected international banking systems(a)(b)(c)(d) UK banks’ exposures to Chart 1.14Cost Cost o fof de defaultfault pr otectionprote cfortio selectedn Tier 1 capital ratios for selected Chartvul n2 erable UK banks’ euro-area exposures to cvulnerableountries euro-area bank systemfor sele(a) cted bank system(a) international banking systems(a)(b)(c)(d) countries

Basis points Per cent Total exposures to sovereigns and banks in vulnerable 800 14 2007 2010 euro-area countries Italy 2008 2011 Spain 700 12 Total exposures to sovereigns, banks and non-bank private France 2009 sector borrowers (net of provisions) in vulnerable euro-area United States 600 10 countries United Kingdom Germany Core Tier 1 capital 500 8

£207 billion 400 6

£169 billion 300 4

200 2

100 0 France Germany Italy Spain United United £42 billion Kingdom States 0 Jan. Apr. July Oct. Jan. Apr. Sources: SNL Financial, published accounts and Bank calculations. 2011 12

Sources: Capital IQ, Markit Group Limited, Thomson Reuters (a) Includes banks with total assets of more than US$100 billion at end-2010. Datastream and Bank calculations. (b) Aggregated Tier 1 capital divided by aggregated (risk-weighted) assets. All Sources: Bank of England, published accounts and Bank calculations figures are under local accounting conventions. (c) Data exclude 100% government-owned banks. (a) Aggregated five-year CDS premia from selected banks and (d) Tier 1 ratios are used because of di“iculties comparing core Tier 1 ratios LCFIs, weighted by assets as at 2011 Q4. across countries.

(a) Major UK banks’ exposures Fee on FLS drawings Chart 6 SelectedSelected European Euro banks’pean cr baeditnk defaults’ swap (a) (a) Chart 2.24 Major UK banks’ exposures(a) Chart A Fee on FLS drawings (CDS)credit premia default swap (CDS) premia

Italy(b) Germany(e) Other exposures Europe UK household unsecured Fee (basis points) Spain(c) United Kingdom(f) Rest of world UK CRE UK household secured 175 France(d) Basis points United States UK corporate (excluding CRE) 900 Per cent 100 150 Previous Bulletin 800

125 700 80 600 100 500 60 75 400

40 50 300 200 25 20 100

0 0 10 9 8 7 6 5 4 3 2 1– 0 + 1 2 3 4 5 Jan. Feb. Mar. Apr. May June July Aug. 0 2012 2005 06 07 08 09 10 11 Sources: Markit Group Limited and Bank calculations. Cumulative net lending over the reference period Sources: Bank of England, published accounts and Bank calculations. as a percentage of the stock of loans as at 30 June 2012 (a) Unweighted averages of five-year, senior CDS prices. (b) Average of , , Monte dei Paschi and . (a) As Virgin Money has not yet reported its end-2011 results, its 2011 Source: Bank of England (c)Average of Banco Popular Espanol, BBVA and Santander. reported half-year figures have been annualised. (d) Average of BNP Paribas, Crédit Agricole, and Société Générale. (e) Average of Commerzbank and Deutsche Bank. (f)Average of Barclays, HSBC, Lloyds Banking Group, Nationwide, Royal Bank of Scotland and Santander UK.

88 EuroWeek UK Capital Markets