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EUrOWEEKUK Capital MarKetsseptember 2013

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UK Capital Markets | September 2013 | EUROWEEK 1

Foreword by the economic Secretary to the treaSury2 Sajid Javid: The UK’s economic plan is working

macroeconomic overview4 The UK economic revival: rhythm, or blues?

bank oF england ProFile8 Communication will define Carney era at beefed up Bank

interview with Sarah breeden, bank oF england8 ‘A banking licence is a privilege — banks must remember that’

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EUrOWEEK

UK capital marKets

Foreword by the economic Secretary to the treaSury

2 EUROWEEK | September 2013 | UK Capital Markets 2013

The UK government is dedicated to increas-ing the nation’s competitiveness and maintaining London’s position as a world leader in the financial field. But we face

serious challenges. The economy is recovering from the most damaging financial crisis in generations. UK output fell by 7.2% from peak to trough. That is almost twice as deep as that experienced by the US and three times as deep as Britain’s recession in the early 1990s.

Debt was at unsustainable levels. In 2010, total pri-vate sector debt had reached 470%. The government ran rising deficits even at the peak of the boom. The UK entered the crisis with a structural deficit of more than 5% of GDP, the highest amongst the G7. Subse-quently the deficit soared and in 2010 the UK deficit was forecast to be the highest of any major economy. The historically high level of borrowing undermines fairness, growth, and economic stability.

The UK government has implemented the econom-ic strategy necessary to rectify Britain’s perilous mac-roeconomic imbalances. The combination of fiscal responsibility and monetary activism assists the rebal-ancing of the economy from debt-sustained activity towards investment and exports. Our fiscal credibility has helped keep interest rates low and allowed the UK authorities to pursue a strategy of monetary activism. This includes measures such as the Funding for Lend-ing Scheme that has supported a dramatic improve-ment in financial conditions.

Our unwavering commitment to deliver a sustain-able recovery is yielding results. The UK economy is turning a corner. Recent evidence suggests tentative signs of balanced, broad-based growth. The deficit has been cut by a third as a percent of GDP and the structural deficit has been cut more than any major advanced economy. Private sector debt has fallen by almost 40% of GDP since early 2010. For every pub-lic sector job lost, 3.2 have been created in the private sector. Employment is at an all-time high. Finally, the average of independent forecasts for 2013 GDP growth are now more than double the 0.6% official forecast from March. Britain is on the mend.

But the recovery is in its early stages, and we must remain vigilant. While the extreme risks in the euro area have been reduced, they do remain, and emerg-ing market economies have slowed as capital flows back to recovering advanced economies. We will not become complacent about implementing our plan to repair and strengthen the UK economy.

Financial services: stability and competitivenessThe financial services sector in the UK accounts for 10% of our GDP, 12% of our tax revenue, half of our trade surplus, and employs over 1 million people — two thirds of whom are outside of London. Financial services have a critical role in the recovery as a pro-vider of credit and financial intermediary services to businesses and consumers. We are taking ambitious actions along three strands to ensure that we have a financial sector which can make significant contribu-tion to sustainable growth: (i) reforming financial reg-

ulation to ensure we have a safe and resil-ient financial sector that can compete sus-tainably in the global market; (ii) creating the right environment for financial servic-es firms to trade and attract inward invest-ments and supporting firms to pursue high value opportunities; and, (iii) incentivising banks to lend to the real economy, supporting SMEs and employment.

We are delivering necessary reforms to strength-en the City and make it more resilient. We are implementing the recommendations of the Vick-ers review through the Banking Reform Bill and we have reformed the financial regulatory architecture in the UK through the Financial Services Act. We are also working hard in Brussels to secure the best pos-sible outcomes on a range of financial services dossi-ers, enhancing financial stability whilst protecting the competitiveness of the financial services industry.

In the Budget this year, the Government announced the creation of the Financial Services Trade and Invest-ment Board, which has been tasked to support the sec-tor in gaining market share abroad and creating the right environment to attract inward investments. The Board is now up and running and will identify trade and investment priorities within the financial services sector and provide senior level steers and directions for joined up government and industry actions.

A plan for sustainable growthA key element of our economic plan is an ambitious programme of growth-enhancing reforms to support a sustainable recovery. Our plan focuses on tax competi-tiveness, business growth, workforce skills, and rebal-ancing towards investment and exports.

Consistent with these aims, we are emphasising long-term investment in infrastructure by committing to publicly fund a pipeline of specific projects worth over £100 billion by 2020.

We have brought forward the delivery of our com-mitment that the first £10,000 of income is free from income tax. Increases already in place have saved a basic rate taxpayer £600 a year, rising to £700 next year. By April 2014, 2.7 million low income individuals under 65 will have been lifted out of income tax alto-gether.

In addition, we are boosting investment and com-petitiveness through a major programme of corpo-rate tax reform, including by reducing the main rate of corporation tax from 28% to 20% between 2010 and 2015. Companies that had left the UK are now bringing investment back home.

So whether it’s helping keep interest rates low; repairing our banks; dealing with the deficit, or last-ing structural reforms to make Britain more competi-tive — the government is backing British business and creating lasting improvements in the living standards of families. The economic plan is working and we are committed to seeing it through. s

UK: the economic plan is workingby Sajid Javid, MP, Economic Secretary to the Treasury

© 2013 Morgan Stanley. All rights reserved. This communication does not constitute an offer to sell or the solicitation of an offer to buy any securities. Morgan Stanley and/or any of its affiliates may hold proprietary interests in any of the securities referred to in this document.

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MacroeconoMic overview


The UK ChanCellor of the exchequer may have turned down an invitation to perform a duet with Jeffrey, the r&B-singer with whom he shares a surname, after President obama got his osbornes mixed up in June. But in the last few weeks, George osborne may have been tempted to sing chirpily in his bath, as one of his predeces-sors was famously reported to have done following the UK’s exit from the exchange rate Mechanism in 1992.

In an unguarded moment, Chan-cellor osborne may even have been tempted to echo the same predeces-sor and point to the emergence of some green shoots of recovery. he has, after all, had almost an embar-rassment of good news to digest recently, which began in June when the IMF revised its growth forecast for 2013 from 0.7% to 0.9%.

The flow of good news acceler-ated in august, when the office of national Statistics (onS), announced that second quarter growth came in at 0.7% rather than the 0.6% it estimated in July. In the same period, employment rose by 80,000, with the private sector creat-ing three times as many jobs as were lost in the public sector, accord-ing to the Confederation of British Industry (CBI). Construction orders jumped by 20% between april and June. activity and orders in the manufacturing sector are rising at their fastest clip for 19 years. retail sales are up. So are exports.

It amounts to a cocktail of good news that seems to have caught most forecasters on the hop. “I’m not aware of anyone who foresaw the speed with which the economy seems to be recovering,” says Jamie Dannhauser, director in the research group at lombard Street research in london.

others agree. “The main theme

has been the surprising strength of the incoming data,” says Mela-nie Baker, UK economist at Mor-gan Stanley. That data, she adds, has recently led Morgan Stanley to revise its forecast for GDP growth in 2014 from 1.4% to 2.4%, leapfrog-ging the CBI’s forecast for next year, which has recently been lifted from 2.1% to 2.3%.

rBC is also forecasting growth of 2.4% in 2014. “The economy has turned the corner, and I expect the recovery to be sustainable,” says Jens larsen, chief european econo-mist at rBC Capital Markets in lon-don. “But the growth rate will still not reach the levels we would have regarded as sustainable before the crisis, which would have been in the range of 2.5%-3%.”

Stanley’s Baker foresees sustain-able growth underpinned by rising productivity without stoking much in the way of inflationary pressures. “We see a virtuous circle developing in the economy with a simultaneous pick-up in demand, supply and cred-it conditions,” she says, arguing that as it is largely a cyclical rather than a structural phenomenon, productiv-ity growth should accelerate as the economic recovery gathers pace.

“This suggests that there is less need to worry about the risks of underlying inflationary pressures building in a recovery, compared with our previous concerns,” says a

recent Morgan Stanley analysis of productivity in the UK. If the Mor-gan Stanley prognosis is correct, it should have significant implications for the sustainability of the UK’s equity market, given that will sup-port rising corporate profits. Tell-ingly, Morgan Stanley has recent-ly lifted its year-end target for the FTSe 100 from 7,000 to 7,170 — suggesting there is scope for a rise of almost 10% over the next three months.

Productivity problemBaker’s qualification about the pro-ductivity outlook is an important point, because Bank of england gov-ernor, Mark Carney gave a muted assessment of the outlook for pro-ductivity growth in august, forecast-ing annual growth of 1.8% for the next three years, which is still below its pre-crisis trend of 2.2%. “While even that modest productivity is not assured, it is hardly an aggressive forecast,” said Carney. “It implies that productivity reaches its 2008 level only in 2015. and it means that productivity doesn’t catch up any of its current 15% shortfall relative to its pre-crisis trend.”

“our outlook is certainly not with-out risks,” says Baker at Morgan Stanley. “If we’re wrong on the pro-ductivity story, it changes the whole complexion of the UK recovery.”

For the time being, however, the consensus among economists is more upbeat than it has been for many years. Indeed, the marked turnaround in the fortunes of the UK economy has given the Bank of england sufficient confidence to stick at £375bn of quantitative eas-ing (Qe), rather than to twist for an additional £25bn.

The revival of the economy, how-ever, has also given rise to increas-ingly vocal misgivings about some of the policies that were originally

The UK economy seemed to shift into gear over the summer with improved data suggesting a recovery is underway. But, as Philip Moore discovers, the path back to boom times may prove anything but smooth.

The UK economic revival: rhythm, or blues?

“I’m not aware of anyone who

foresaw the speed with which the

economy seems to be recovering”

Jamie Dannhauser, Lombard Street

Research


UK Capital Markets 2013 | September 2013 | EUROWEEK 5

designed for a patient in intensive care.

Some of these stimulants, it is argued, are looking less and less appropriate now that the patient is out of bed and threatening to start cart-wheeling down the corridor.

The fiercest criticism has been reserved for the government’s help to Buy scheme announced in the March 2013 budget. Designed to kick-start demand in the housing market, this three year scheme is divided into two parts: an equity loan component and a rather more controversial initiative that will pro-vide some £130bn of guarantees for up to 15% of loans for purchas-es of homes worth a maximum of £600,000.

one of the reasons the scheme is regarded by many as hare-brained is because it doesn’t appear to take into account wild differences in affordability across the UK’s wonky property market. Most residents in the posh parts of london like Kens-ington and Chelsea don’t need help to buy property or anything else. But if they did, the government’s

scheme wouldn’t get them very far, given a median house price in the borough of £965,000, accord-ing to the This is Money website. In the northern towns of Burnley and Stoke, by contrast, it is a little under £64,000.

More broadly, however, the help to Buy idea has been lambasted by those — even within the UK’s govern-ing coalition — who argue that it is likely to engender an unsustainable house price boom and even a minia-ture US-style sub-prime crisis.

Housing helpBut Baker says that Morgan Stan-ley is positive on the help to Buy scheme. “We think there will be a supply response that will be big-ger than the market expects, and we also believe it could ultimately act as a powerful macro-prudential defence against future bubbles,” she says.

Morgan Stanley has estimat-ed that, encouraged by the initia-tive, the UK could see a 30%-40% increase in new housing starts by 2015 on 2012’s levels.

Trevor Williams, chief economist, lloyds Bank Commercial Bank-ing, is also relaxed about the impact that the scheme may have on house prices. “house price inflation in real terms is still significantly below its peak, and in some parts of the coun-try it is even declining,” he says. “The national average is distorted by the high prices in london, but the picture is more mixed than the headlines suggest.”

opinion about another stimulant,

the Funding for lending scheme (FlS) introduced in august 2012 to boost lending to households and companies, is mixed. according to the Bank of england’s latest num-bers on the FlS, in the second quar-ter of this year 18 participants made drawdowns of £2bn, bringing the total of outstanding drawdowns under the scheme to £17.6bn from 28 lenders. That is a far cry from the £70bn that was originally set as the upper limit when the scheme was announced, and perhaps explains why the programme was modified to incentivise banks to increase their lending to SMes.

In its most recent update on FlS, the Bank reports that “there is evi-dence that the price and availabil-ity of lending to businesses has improved since the scheme began and this trend has continued in recent months.” lending still has some way to go, however, before it comes close to pre-crisis levels. hav-ing risen by 16.8% in 2007 and 18% in 2008, lending to UK businesses slipped back by 1.8% in 2009, 7.1% in 2010, 3.3% in 2011 and 3.1% in 2012. “although there are tentative signs that the pace of bank balance sheet restructuring may be lessening, credit flows remain moribund,” Bar-clays cautioned in a recent note.

It may not have generated the volumes that its most enthusias-tic advocates were hoping for at its launch, but economists say the FlS has had a beneficial effect on credit conditions in Britain.

“one of the reasons that bank funding costs are so low is that they have had access to FlS,” says larsen at rBC. “The reason banks are going through such an extensive peri-od of balance sheet restructuring is not shortage of liquidity. Capital requirements and pressures on prof-itability have been the main con-straints on bank lending.”

The recent rise in Gilt yields is a reflection of a range of influences, led by the global response to taper-ing in the US. But economists say longer term rates in the UK may also reflect a view that monetary tighten-ing may be required sooner than had been expected earlier this year.

This is why some are even ques-tioning the suitability of the new governor’s signature tune, forward guidance, given the apparent volte-

“We see a virtuous circle developing in the economy with

a simultaneous pick-up in demand,

supply and credit conditions”

Melanie Baker, Morgan Stanley

2012 2013 2014 2015 (Estimated) (Estimated) (Estimated)Real GDP (%Y) 0.2 1.4 2.4 2.1

Private consumption 1.1 1.5 1.6 1.8

Government consumption 2.8 1.6 -0.6 -1.5

Gross fixed investment 0.5 -2.7 5.6 5

Contribution to GDP (pp)

Final domestic demand 1.4 1 1.7 1.5

Net exports -0.6 0.8 0.4 0.5

Inventories -0.6 -0.3 0.3 0

Unemployment rate (% labour force) 7.9 7.7 7.5 7.3

Current account (% GDP) -3.8 -2.7 -2.5 -1.9

CPI (%Y) 2.8 2.7 2.7 2.3

Policy rate (eop, %) 0.5 0.5 0.5 1

General government balance (% GDP) 5.5 6.1 5.2 4.4

General government debt (% GDP) 90.1 93.5 96.2 97.8

UK forecast summary

Source: ONS, Bank of England, Morgan Stanley research estimates



face in the UK’s economic fortunes. Forward guidance, or ‘conditional commitment’, refers to the com-mitment of the Bank of england’s Monetary Policy Committee (MPC) to holding policy rates at 0.5% until GDP growth accelerates to the point where it brings the UK unemploy-ment rate below 7%.

It’s a knockoutThere are, however, three knockout clauses that would trigger a tighten-ing in monetary policy before the 7% target is reached. all bets would be off if the MPC reckons inflation looks like reaching 0.5% above tar-get over a 10-24 month period, or if medium term inflationary expecta-tions become dislodged.

Monetary tightening could also be brought forward if the Bank of eng-land’s Financial Policy judges that low rates pose a threat to financial stability by fuelling asset bubbles or excessive leverage.

For now, none of these knockouts look imminent, but some say that the credibility of forward guidance is already coming into question. “recently markets haven’t been buy-ing into the guidance story, which is a worry,” says Dannhauser at lom-bard Street research. “My hunch is that over the next few months the MPC will try hard to talk down rates and the pound and contain the upward move in yields.”

Certainly, in his first speech as governor, delivered at the end of august, Carney gave three reasons why he still believes it will be a while before unemployment reaches the 7% threshold which will trigger a rise in rates. The first, he said, is that the Bank’s projections for growth are “solid not stellar”.

The second is that although a fall from the current level of around 7.7% to 7% may look achievably

modest, it would mean that well over 750,000 new jobs would need to be created, with the responsibility for doing so falling squarely on the shoulders of the private sector. That will be a tall order.

The third, Carney warned, is that a recovery in growth does not nec-essarily filter through to faster job creation. That may be a legitimate caution. Witness concerns over what some have called the jobless recov-ery in the US.

economists appear to agree with Carney that a rapid decline in unem-ployment towards the 7% level looks unlikely. “Unemployment has been roughly unchanged for the last four years now,” says Williams at lloyds Bank. “one of the reasons for believ-ing unemployment is unlikely to fall to 7% is that one of the conse-quences of having stable or growing employment at a time of falling or stagnant output is that labour pro-ductivity plummets. as output picks up, firms will aim to generate more productivity from their existing staff before they start thinking about adding to their labour force.”

one extreme manifestation of this pursuit of productivity gains from companies’ existing labour resources has been the increase in the number of employees working on zero-hour contracts, which the office of national Statistics (onS) puts at 250,000.

There are several reasons that Carney is right to be cautious about growth and employment, say economists, particularly when it comes to the UK’s main trading partners. another dip in european economic performance could be especially damaging.

UK’s ‘lost year’another is that although the govern-ment has made considerable politi-cal capital out of the recent encour-aging data, the recovery is a fragile one which comes from a very low base, following what the Institute for Fiscal Studies (IFS) describes as a “lost year” for the UK economy in 2012.

“The marked improvement in recent economic performance is no reason for George osborne to declare victory,” says Dannhauser at lombard Street research. “one or two quarters of strong data does not

make a recovery.”The strong performance of the

last few months has only succeeded in clawing back some of the losses of recent years, making for unflat-tering comparisons between the UK and its main trading partners. “Con-struction activity is still 16% below its pre-crisis peak and production is 10% below its peak, while ser-vices have just got back to where they were in 2008,” says Williams at lloyds Bank. “as for the economy as a whole, it is still about 3% below its 2008 peak, compared with 5% above the 2008 level in the US and 4% higher in Germany.”

one explanation for the weakness of the UK’s recovery, Williams adds, has been the deleveraging of house-holds in recent years.

“at its peak, UK household debt was approaching 180% of GDP,” he says. “It has now come down to about 140%, which is a sharp-er fall than in any other industri-alised nation. There is now scope for households to start spending again, which is partly why recovery is underway, although some would argue that debt is still uncomfort-ably high.”

The weakness of the recovery to date comes in spite of the fact that government spending has risen, meaning that the economy would have been weaker without it. That does not bode well for cuts set to take effect in the near future.

“We shouldn’t underestimate how material the public sector cuts that still have to kick in will be,” says Dannhauser. “Putting the debt ratio on a sustainable course is going to require very large fiscal tightening. So the big picture is that the public finances still have years and years of austerity to go through before they are back into shape.” s

“The growth rate will still not reach

the levels we would have regarded as

sustainable before the crisis, which

would have been 2.5%-3%”

Jens Larsen, RBC Capital

Markets

“The economy is still 3% below its 2008

peak, compared with 5% above the

2008 level in the US and 4% higher in

Germany”

Trevor Williams, Lloyds Bank

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Bank of England ProfilE


Search for Mervyn King in you-Tube and you are presented with a choice between a speech by the former governor of the Bank of england and highlights of a darts match between his namesake and an opponent named Dean Winstanley. Search for Mark carney and you are offered a string of interviews and speeches broadcast on a range of television channels.

Granted, some of these date back to the new governor’s tenure at the Bank of canada. Granted, too, not all of the clips are complimentary. They include ill-tempered tirades against a mone-tary policy that some believe will con-demn UK pensioners dependent on bank savings to penury for many years.

Whether or not the British elector-ate approves of carney’s approach to monetary policy is scarcely the point. More important is that the new gover-nor has brought a refreshing openness to an institution that has historically been stereotyped — rightly or wrong-ly — as stuffy, distant and insensitive to public opinion. It is impossible to imagine his predecessor, for example, being described as “chillaxing” in a “lilac polo shirt, crumpled shorts and suede loafers”, as the Daily Mail did when it spotted carney and his wife at a musical festival in august.

“carney’s openness towards the media has surely been very helpful in getting his message about the rela-tionship between interest rates and unemployment across to companies and households,” says Melanie Baker, UK economist at Morgan Stanley.

critically, carney appears to have chosen his words to reinforce the mes-sage that monetary policy should be used to nurture growth. “The Bank of england’s task now is to secure the fledgling recovery, to allow it to develop into a period of sustained and robust growth,” he said in august. “We aim to get there in part by reducing the uncertainty that has held back growth.”

at the same time, he reminded

his audience that the Bank’s man-date of maintain-ing a 2% inflation target, remained unchanged and had been recon-firmed by chan-cellor osborne in March.

The message seems to be perco-lating through. In the august edition of the Bank of eng-land/GfK Inflation expectations sur-vey, carried out just after the release of the Bank’s inflation report, only 29% of households said they expected rates to rise in the next 12 months, which is down from 34% in May and is the lowest since november 2008, at the height of the crisis.

Regulatory shake-upWhile carney’s forward guidance may have been unfortunately timed, it has been impeccably managed and clearly delivered. “It may have made more sense if it had been implemented after the first round of quantitative easing in 2010,” says Jens Larsen, chief europe-an economist at rBc capital Markets in London. “The strong macro data and rising long term bond yields may make monetary policy difficult at the moment, but let’s reserve judgement until there is more clarity on how suc-cessful it has been in influencing inter-est rates.”

If it is too early to digest the impact of carney’s arrival on the UK econ-omy, it is also probably too soon to assess the effects of the shake-up in the regulatory environment that came into force in april. “The Bank of england is experiencing its most important institutional and function-al changes in a generation,” it said in

its 2013 Q1 Quarterly Bulletin. “fail-ings in pre-crisis arrangements have prompted the government to intro-duce wholesale changes to the UK reg-ulatory landscape.”

This reform has given the Bank new regulatory powers, with responsibil-ity for supervision from a prudential and conduct perspective passing from the now defunct financial Services authority (fSa) to the new Prudential regulation authority (Pra) and finan-cial conduct authority (fca). The Pra was quick to bare its fangs, identifying a capital shortfall of £12.8bn at Bar-clays when it imposed a 3% minimum leverage ratio on Britain’s eight largest banks and building societies. The fca, then slapped a £138m fine on JP Mor-gan in September.

The Pra’s zealousness on leverage, the Bank insists, is in no way incon-sistent with supporting economic recovery. as carney said in august, “some argue that the repair of banks’ balance sheets holds back economic recovery because it causes banks to cut back their lending. The reality is the opposite: where capital has been rebuilt and balance sheets repaired, banking systems and economies have prospered.” s

The Bank of England has been shaken up. A new governor with new targets, a new monetary policy focus, and a new means of communicating them is now in charge of a central bank with new powers. Philip Moore assesses Governor Carney’s first few months in charge and the Bank’s prospects of success.

Communication will define Carney era at beefed up Bank

Move over Mervyn: The Bank of England’s new governor Mark Carney relaxes at a music festival earlier this year © Chris Eades / Daily Mail

IntervIew wIth Sarah Breeden, Bank of england


EUROWEEK: It’s five years — almost to the day — since the Lehman collapse. What has been done since then to make the banking industry systemically safer?

Breeden: It’s been a busy five years, and I would highlight four international developments in that time that have played a key role.

The first is too-big-to-fail and resolution frameworks. Compared to where we were five years ago, there has been a step-change in the authorities’ willingness and com-mitment to ensuring that institutions that operate in the financial system are able to fail in a way that doesn’t bring the system down with them.

That’s a big change. If you go back to 2008, when we were dealing with Bradford & Bingley in the UK, we had no resolution regime for banks. Now we do, and plenty of work is still being done to ensure that our most systemi-cally important institutions are able to fail in a safe man-ner.

The second theme is re-regulating banks based on international standards established by the Basel III capi-tal regime to ensure that they are better capitalised, with better measured risk on their balance sheets, that are therefore less likely to fail. There are many dimensions to that. These include changing the definition of capital and focusing on going-concern capital that is there to absorb losses while firms are still operating. But as well as chang-ing the composition of capital, and increasing the quanti-ty that is available, we are also trying to make sure that we are smarter in the way we think about the risks that are on banks’ balance sheets.

We’ve had some good news in this area recently with the Capital Requirements Regulation (CRR) coming in at the end of this year in Europe and in the US. So not only do we have a framework, we are also well on the way to making that framework an implemented reality.

The third theme I’d highlight is the significant inroads that have been made in regulating the OTC derivatives market. We’ve mandated that there should be central clearing for some derivatives products. This means that margins will be determined by the central clearing house and that there will be effective oversight of the risks embedded in those products.

In addition, we’ve started to introduce minimum stand-

ards for those bilaterally-undertaken transactions that will remain in the OTC derivatives space. The working group on margin requirements has set out minimum standards that will apply to all derivatives transactions.

Since derivatives can be a source of leverage and a potential means of propagating shocks throughout the system, when these reforms have been implemented over the next couple of years the market will be a much safer place. Some aspects of this reform programme will come in sooner than others, with the implementation of man-dated central clearing in the US now imminent. But even on a two year horizon, the market will be much safer.

The final theme to highlight internationally is shad-ow banking. It is likely or perhaps even inevitable that as we re-regulate banks, activities that had previously taken place on banks’ balance sheets will migrate to other parts of the financial system. That’s not necessarily a bad thing. But as authorities, we need to ensure that the regulation of those entities is appropriate to their risk profile.

A lot of work is being undertaken under the banner of the Financial Stability Board (FSB) setting out a variety of measures for dealing with things that we currently know to be shadow banking, defined as credit intermediation outside the banking system with leverage and maturity transformation. Money market funds is one example of where this happens. Securitisation vehicles and struc-

Sarah Breeden is head of the Market Sectors and Interlinkages Division in the Financial Stability Directorate at the Bank of England. The division is responsible for assessing and identifying ways of reducing risks to the stability of the UK financial system that arise in financial markets and the real economy.

Having led the Bank’s work to support the transition of prudential regulation of banks and insurance companies from the Financial Services Authority (FSA) to the Bank of England, Breeden is well positioned to discuss the impact of regulatory change on the UK financial services sector. In this interview, she shares her thoughts with Philip Moore.

BofE’s Breeden: ‘A banking licence is a privilege — banks must remember that’

Sarah Breeden: “We need to make sure we remain vigilant to the emergence of new sources of risk”



tured finance conduits is another. So we’re making sure that regulation deals with these known issues appropri-ately.

But we also need to make sure there are regimes in place to ensure that we remain vigilant to the emergence of new sources of risk. We may be able to point to money market funds as a potential source of risk now. But what will be the issue in two years’ time? Will it be real estate investment trusts in the US, for example? We need to keep an eye on any area where we see credit being intermediat-ed outside the banking system with leverage and maturity transformation.

A lot has been done to design frameworks to ensure that authorities such as the Financial Policy Committee (FPC) in the UK and other systemic risk regulators look at all activities within the financial system to identify where systemic risk might arise.

These are the international areas where I think we’ve made very considerable progress. But we’d be fooling our-selves if we didn’t recognise that there was still plenty more to do.

EUROWEEK: All those areas are predicated on a degree of international co-operation. What are the main UK-specific measures that have been taken?

Breeden: The main measures specific to the UK are the legislative changes that were introduced in April 2013, when we did two things.

First, we created the Financial Policy Committee (FPC) as our macro-prudential authority, which is charged with identifying, monitoring and taking action to remove or reduce systemic risks to enhance the stability of the financial system.

The new legislation also took the old Financial Servic-es Authority (FSA) and chopped it in two, with the intro-duction of a Twin Peaks regulatory regime. The Financial Conduct Authority (FCA) is responsible for ensuring the integrity of financial services, while the Prudential Regu-lation Authority (PRA) is responsible for prudential regu-lation and supervision of all deposit-takers and insurance companies in the UK.

Both these institutional changes are very impor-tant in ensuring that the international framework that I described earlier is applied rigorously in a domestic con-text. It is clear, for example, that the PRA together with the Special Resolutions Unit at the Bank will be absolutely focused on ensuring that systemically important financial institutions in the UK are able to fail in a way that is safe for the rest of the system.

And following on from what we were saying about the importance of being vigilant to risks from outside the banking system, the FPC will be charged with monitoring the regulatory perimeter in the UK so that those risks are monitored and identified, and that regulation is capable of addressing those risks.

EUROWEEK: April 1 was only just over five months ago. Is it too early to assess what the impact of Twin Peaks has been in that short time?

Breeden: In that period, we have already had some examples of occasions on which these new bodies have worked together very effectively. When you look at the public recommendations that the FPC has made to the PRA about banks’ capital and liquidity, and to the PRA and the FCA about the risks that might arise in the event of interest rates normalising, you’ll see evidence of the three working effectively together.

The very first weekend after the PRA and the FCA came into existence, we had the Cyprus crisis. Both institutions had to work together to ensure a satisfactory resolution of those Cypriot banks that operate in the UK.

Within days we had a true test of how effectively the two organisations could work together in an important, high profile case. So the experience we’ve had to date has been encouraging.

EUROWEEK: Do we now have absolute clarity on UK banks’ capital and leverage requirements going for-ward?

Breeden: The Basel framework has set the internation-al standards. So the international benchmarks to which banks are being held are clear, and have been supported by the FPC’s own recommendations that were published in March.

There is of course still some international debate on the details of the leverage ratio, with the Basel Commit-tee’s recently circulated consultative document looking at the detail of how to calculate it.

EUROWEEK: In the UK is there a specific timetable on observance of the 3% leverage ratio?

Breeden: The FPC recommended in March that the PRA should have regard to high levels of leverage as well as to risk-adjusted measures of capital adequacy. And the PRA has said that six of the eight banks and building societies will already meet the 3% leverage ratio as part of meeting the broader 7% capital adequacy ratio by the end of this year.

For Barclays and Nationwide, a time frame has been agreed within which they will reach 3%. In each case the time line is different and that reflects the individual nature of their business. Barclays expects to reach 3% by the middle of next year while Nationwide has until the end of 2015. I think that underlines that we are imple-menting these targets in a reasonable manner.

EUROWEEK: How do you respond to the stability of the graveyard argument, which says that too much regulation may stifle growth?

Breeden: I think we’d all agree that well capitalised banks are in a better position to lend to the economy. It’s common sense that if you have confidence in your own solvency you’ll be more comfortable with taking more risk on to your balance sheet.

Our aim is to ensure that our banks are well capitalised and so able to lend to the economy, which is the best way



to make certain that we don’t create the stability of the graveyard. More generally, the objective to achieve finan-cial stability while supporting the government’s growth and employment objectives is recognised in the remit that the FPC has been given by the Treasury and in the statu-tory framework under which the PRA operates.

But the important point is that the right conditions for growth could not possibly be created with an unstable financial system — as any company and any household that has lived through the last five years would recognise.

EUROWEEK: Where does a regulator draw the line between regulating banks and seeking to influence their commercial strategy?

Breeden: The PRA has a clear objective, which is to pro-mote the safety and the soundness of the firms it regulates. That necessarily requires it to understand the business of those firms and to make a judgement on the risks that those businesses entail. It needs to do this not by looking at what’s happening today or what happened in the past, but by taking a forward-looking approach to assessing what risks might arise and by ensuring that a firm is well prepared to deal with those risks.

As soon as we’re in a judgement-based, forward-looking world, reasonable people will differ in their views of risk. I think it is inevitable that the banks will sometimes disa-gree with the judgements that their prudential regulator makes. In that context, the prudential regulator’s respon-sibility is to its statutory objective. This is to promote the safety and soundness of the banks it authorises to take deposits from members of the public. Having a banking licence and the ability to take deposits should be regard-

ed as a privilege, not as a right. I think it’s impor-tant for banks to remem-ber that.

EUROWEEK: What tools does the FPC and the PRA have at its disposal to address some of the broader concerns about financial stability? For example, would the FPC and the PRA be able to act early to head off an unsustainable housing boom?

Breeden: This comes back to the statutory objectives of the PRA and the FPC. Understanding and moni-toring the risks that are on banks’ balance sheet is an integral part of those objec-tives.

If the FPC were to be concerned about the risks

to financial stability that were arising in the housing mar-ket, it would respond in just the same way as it would if it were concerned about risks to stability arising from the commercial property market or from dealings with hedge funds or Reits. We begin by thinking about banks’ under-writing standards, and the terms on which they do busi-ness, to try to ensure that they are appropriate. We also communicate our views of the risks, as we already have in the Financial Stability Report and in the record of the FPC meetings.

The FPC has wide-ranging powers to make recommen-dations to the PRA in respect of the prudential regime for the housing market, and to the FCA in respect of conduct rules for mortgage lenders. The FCA is in the process of implementing a new code of conduct for mortgage lenders.

Finally, the FPC has a power of direction over sectoral capital requirements which might mean that if all the other tools have failed to reduce the risks in the system arising from the housing market, higher capital requirements can if necessary be imposed on residential mortgage lending. So there is a very broad range of tools available to the FPC.

EUROWEEK: Finally, do you have the impression that public confidence in banks is now being restored?

Breeden: The financial crisis highlighted the importance of having a safe and well-functioning banking system to maintain the flow of credit to the economy. Banks them-selves have gone a long way to address the misdeeds of the past. However, there is still much to be done, and the main objective of the new regulatory framework will be to ensure that the financial system as a whole is safer and more resil-ient to any future shocks. s

Breeden: “Banks themselves have gone a long way to address the misdeeds of the past. However, there is still much to be done, and the main objective of the new regulatory framework will be to ensure that the financial system as a whole is safer and more resil-ient to any future shocks”

London as a FinanciaL centre


For the City of London, until mid-September no news over the last year or so had been probably been good news. the chorus of public disapprov-al about the City, which reached a dis-cordant crescendo at the height of the Libor scandal, had gone reassuringly diminuendo over the last 12 months.

it remains to be seen if the fine lev-ied on JP Morgan in September pro-vokes a fresh wave of vilification of the banking industry, and by extension of the City of London, which is where the dodgy derivatives dealings that prompted the $920m settlement took place.

But prime time media coverage of Jamie Dimon describing a $6.2bn loss as a “tempest in a teacup” is unlikely to have gone down well with the Brit-ish public, many sections of which continue to attach frequently ill-informed blame to bankers for the wider economic downturn.

it would be a pity if the so-called London Whale shenanigans are allowed to reverse the progress that has been made in rehabilitating the image of financial services, which is an important pillar of the UK economy.

According to theCityUK, finan-cial services posted a trade surplus of £46.3bn in 2012, down slightly on 2011’s total but “still by far the biggest net contributor to the UK balance of payments.”

“restoring confidence among politi-cians and the general public is critical, not just to the financial services sec-tor but also to the wider UK econo-my,” says Leo ringer, head of financial services and corporate governance at the CBi. “the regulatory response has already gone some way towards bol-stering public trust through, for exam-ple, the establishment of a profession-al body on banking standards.”

this new entity, headed by former CBi head Sir richard Lambert, was one of the recommendations made by the cross-party Commission on Bank-ing Standards, which in June released

a devastating excoriation of the con-duct of UK banks.

the opening paragraph of its sum-mary set the tone for the indigesti-ble volume, saying: “Banks in the UK have failed in many respects.” they have failed taxpayers, it added, they have failed retail customers, they have failed their own sharehold-ers, and “they have failed in their basic function to finance econom-ic growth, with businesses unable to obtain the loans they need at an acceptable price.”

Criminal actsit included the dire warning that “a risk of a criminal conviction and a prison sentence would give pause for thought to the senior officers of UK banks.”

the City strongly endorses this threat. “our stance on the Libor scan-dal is very clear,” says Alderman roger Gifford, Lord Mayor of the City of Lon-don and UK head of SeB. “if there was criminality involved, the guilty par-ties should be brought to court and be prosecuted. that would help to show that it was a criminal act, not something that was symptomatic of a broader market malaise.”

Gifford insists, however, that the mood is upbeat. “London is feeling much better about itself than it did a year ago,” he says. “the economy has picked up, the equity market is per-forming well and job numbers in the City are back to their 2007 levels, so there is plenty of quiet optimism.”

Perhaps. But there have been some unsettling recent signals about the degree to which the UK financial ser-vices sector has recaptured the con-fidence of the young people upon whom its future depends. A Lloyds Bank survey in May found that 28% of students would be “embarrassed” to tell their friends if they worked in a bank, 41% distrusted banks, while 56% trusted them less than five years ago.

in a speech to at oxford University’s

Said Business School shortly after this survey, Lloyds Bank’ chief executive, Antonio horta-osorio, was frank about the need for the industry to rebuild its reputation to attract good people. “the next generation should see banking as an industry that helps to build eco-nomic wealth and is playing its part as a useful member of our local commu-nities,” he said. “We want the best and the brightest to see banking as a cred-ible career choice. this is vital for the industry’s long-term viability.”

it will be important for London to maintain its vigilance against compla-cency and hubris, because it still faces a number of formidable challenges and no shortage of competitors and antagonists only too eager to take the City down a peg or two. As the CBi’s ringer says, one of these is the Finan-cial transactions tax, proposed by 11 eU member states, including France and Germany, but fiercely opposed by the financial centres with the most to lose from the tax, most notably the UK and Luxembourg.

“our main concern about the finan-cial transactions tax is that it under-estimates its impact on basic services provided by financial institutions such as risk and cash management that are fundamental for businesses,” says ringer. “our argument is that the tax will not achieve what it sets out to do, which is to reduce risk. instead, it will hamper the financial services’ support of economic growth.”

Although the UK has the right to

With the equity market performing strongly and job numbers in the City back to pre-crisis levels, the mood in London is at its most upbeat since 2007. But is this optimism misplaced? As Philip Moore reports, the threats to its status as the world’s premier financial centre are greater than ever.

City faces taxing future despite fading crisis

“London is feeling much better about

itself than it did a year ago”

Roger Gifford, Lord Mayor of the City

of London and UK head of SEB

London as a FinanciaL centre


remain outside the so-called 11 mem-ber Ftt zone, the potential impact of the tax on London’s leadership in the european capital market would be devastating. this is because the archi-tects of the tax propose that it should extend to any transactions involving counterparties headquartered in the Ftt zone, including overseas branch-es of firms with their hQs in the zone. in other words, a transaction between the London offices of, say, Deutsche Bank and BNP Paribas, would be sub-ject to the tax.

that, however, is only the half of it. Consider, for example, its poten-tial impact on the european govern-ment bond market. Although primary issuance by debt management offices would be exempt from the tax, a pres-entation prepared earlier this year by iCAP cautions that “the Ftt will sig-nificantly increase funding costs for governments and corporates in the Ftt zone, and to a lesser extent those outside the zone, with consequences for the real economy.”

this, says iCAP, is because the pro-posal does not safeguard secondary market trading in public debt, which is an essential component of the effective operation of public financ-es. “this would result in an increased cost of funding and capital burden for governments,” says iCAP. “Bank of America Merrill Lynch estimates the Ftt will result in an increased annual cost of €6.5bn-€8.5bn for Germany, italy and France in the first year.” the implications for London are obvious enough, given that it is the fulcrum of

international bond trading, account-ing for an estimated 70% of second-ary market turnover in 2012, accord-ing to theCityUK.

Although the european Coun-cil’s legal services commission has recently questioned the legality of the planned tax, the CBi — for one — remains wary of the threat it poses to the UK. “the tax would have an impact on centres such as New york and Singapore, but we feel it would hit London disproportionally,” says ringer. “the proposal remains on the table, and we see it as very much a live issue.”

the bickering over the Ftt is one of several examples of europe’s frag-mented approach to regulation that some bankers see as a menace to Lon-don. “i worry that London may have seen the zenith of its importance as a financial centre and that its leading position is potentially under threat for a number of reasons,” says Colm Kelle-her, president of institutional securi-ties at Morgan Stanley in London.

his concern is that a side-effect of competing regulations are going to hand a competitive advantage to cen-tres such as New york — and possi-bly Chicago — where the regulatory reform agenda is at a more advanced stage. “For example, we all oper-ate under Basel ii or Basel iii,” says Kelleher. “But risk weightings are still applied on a national basis, and 87% of rWA models in europe are self-certified. that risks creating regula-tory arbitrage, which will lead to more pressures from the regulator.”

London’s to loseA more distant, but very dangerous, threat to London’s future comes from those whose hostility to europe extends to a desire to pull the UK out of the eU altogether. Kelle-her says that although he regards this as a tail risk, it would be very damaging for Lon-don. Gifford agrees. “A substantial number of US and Asian com-panies have located themselves in London because of the access it gives them to the euro-pean market,” he says.

Japan, for one, has made it clear that its investment into the UK would be jeopardised if it were to withdraw from the eU.

the prize is London’s to lose, because by a host of qualitative and quantitative yardsticks, the figura-tive Square Mile continues to be the world’s premier financial centre. it was ranked first among 79 cities by GFCi in March 2013, scoring 807 points to New york’s 787.

theCityUK says London accounts for 37% of global foreign exchange trading and 19% of international bank lending. there are 251 overseas banks in London (more than in New york or Frankfurt) and 588 foreign list-ings on the London Stock exchange (compared with 524 on the NySe and 290 on Nasdaq). the UK is also home to more than 800 hedge funds, with about 85% of the industry’s total euro-pean assets.

Areas such as foreign exchange and equities trading, cross-border lend-ing and investment management are all long-standing fortés for London. Perhaps more significant, however, is the UK’s commitment to ensuring that it captures new opportunities. When Gifford spoke to EuroWeek, he was in China, between meetings with the mayors of Shanghai and Beijing, and few new business opportunities for the global financial services industry are as exciting as those in the rapid-ly internationalising renminbi (rMB) market.

in 2012 alone, spot rMB trading volumes in London rose by 240% to $2.5bn a day. rMB bond origination rose by 36%, although disappointing-ly dim sum bond trading fell sharply. Nevertheless, London has clearly posi-tioned itself to play a pivotal role in the inexorable growth of the rMB market, which is another positive signal for the UK and its much maligned financial services industry. s

“I worry that London may have seen the

zenith of its importance as a

financial centre and that its leading

position is under threat for a number

of reasons”

Colm Kelleher, Morgan Stanley

Employment in financial and professional services in London

Source: ONS, TheCityUK London Employment Survey

Source: ONS, TheCityUK London Employment Survey

Thousands

0

100

200

300

400

500

600

700

201 2201 12010200920082007

Employment in financial & professional services in London

Infrastructure fInancIng


Measured by press coverage alone, it has been a busy 12 months for the uK infrastructure sector. The pro-posed high-speed rail link from Lon-don to birmingham (Hs2) has proved a reliable headline generator, as has the announcement of a stream of infra-structure initiatives and programmes by the coalition government.

Meanwhile the opposition Labour party has done its bit to keep the sub-ject in the public eye with the publi-cation in september of the results of a review by sir John armitt that recom-mended the establishment of an inde-pendent infrastructure commission to take the politics out of infrastructure planning.

despite all the noise, however, actual dealflow — particularly on the greenfield side — has been mostly notable by its absence.

Transportation, in particular, saw an almost complete dearth of progress on new build projects until this summer, when contracts were finally awarded on a pair of road concessions and the next stage in the overdue upgrade to the Thameslink rail network.

The latter — a £1.6bn contract to provide new carriages and depots — was won by a consortium led by sie-mens. It was financed by an innova-tive hybrid private finance initiative (pFI) and public private partnership (ppp), which included a debt facility provided by a syndicate group of 19 banks led by Lloyds bank, sumitomo Mitsui, KfW and bank of Tokyo Mit-subishi uFJ.

Meanwhile, a pair of spanish-led consortia were named as preferred bidders for the road concessions — a £415m project to complete the M8 motorway between Glasgow and edin-burgh and the £2bn Mersey Gateway toll bridge.

elsewhere, the social infrastruc-ture sector saw a handful of small-er projects get underway in the stu-dent accommodation, social housing

and waste sectors, as well as the announcement of a further round of funding for school refurbishment.

activity in the greenfield sector remained decidedly muted howev-er, and the picture was only slight-ly more positive on the operating assets side.

There, the majority of interest centred around the airports sector, where Heathrow airport Holdings — formerly baa — finally caved in to pressure from the Competition Com-mission and sold stansted to Man-chester airports Group for £1.5bn.

That was followed in august by the €502m transfer of the Luton airport concession from a consortium led by abertis to one comprised of fellow spanish player aena, and axa’s private equity arm.

The sector also saw the sale last October by Copenhagen airports of its 49% stake in Newcastle airport to australian fund manager aMp Capital Investors, as well as a successful refi-nancing by London City airport own-ers Global Infrastructure partners and Highstar, which secured £465m of five year funding from a 12 strong group of lenders.

according to Giles Tucker, manag-ing director and head of infrastruc-ture at royal bank of Canada, which acted on both the Luton and Newcas-tle deals, the airport sector is likely to remain one of the most active in infra-structure over the next 12 months.

He points to the possibility of fur-ther disposals by Heathrow parent Ferrovial from its uK airport portfolio — comprising aberdeen, Glasgow and southampton — as well as the antici-pated potential disposals of whole or part stakes in London City, bristol and Leeds-bradford.

For emmanuel Goldstein, co-head of transportation and infrastructure for eMea at Morgan stanley, however, the tentative nature of the uK recovery to date suggests asset holders will like-

ly sit on their hands for at least anoth-er 12 months.

“sellers want to optimise the con-ditions of their exit so if they have a choice they will prefer to wait for the wider economic recovery to translate into operational figures,” he says.

Finance not a problemWhat most bankers do agree on, per-haps surprisingly, is that the recent muted levels of activity — and the thin pipeline across nearly all sectors — has little or nothing to do with the avail-ability of finance.

This is slightly at odds with received wisdom in the post-crisis era, which holds that infrastructure funding is facing near insurmountable chal-lenges as looming capital restrictions force banks to pull back from long term lending and refuse to leave them-selves open to refinancing risks, while the anticipated wave of institutional money coming into the sector refuses to take construction risk on its balance sheet.

partly, the answer to the conundrum lies in the current very low — by his-torical standards — levels of activity in the sector.

The big contraction in the long term bank lending market has been matched, for the most part, by the lack of projects, while the handful of banks that have remained active — primarily from Germany and Japan — have suf-ficient capacity to mop up most of the

The disappointing levels of activity in the UK infrastructure sector — and the thin pipeline across nearly all sub-sectors — has, surprisingly little or nothing to do with the availability of finance. Lucy Fitzgeorge-Parker finds out where the blockages are.

Financing UK infrastructure: all together now… and lift

“Many of the construction

companies are actually re-gearing outside of the UK

due to the lack of a sufficiently strong

pipeline”

Giles Tucker, Royal Bank of

Canada

Infrastructure fInancIng


smaller deals that have emerged.There has also been a trend for

increasing innovation by market par-ticipants to explain the continuing availability of funding. as an exam-ple, Tucker picks out a pair of student accommodation deals undertaken by rbC this year, both of which ended up in the bond market.

a £190m project for university of Hertfordshire, which closed in May, was sold as an unwrapped instrument, the first unwrapped uK project bond for around 15 years, while a similar £62m 35 year bond for university of edinburgh, launched in July, featured a rare wrap from monoline insurer assured Guaranty.

Innovation aheadsimon allocca, head of loan markets at Lloyds bank, agrees that innovation will likely be the key theme in infra-structure financing for the next 12-18 months. “Indeed,” he adds, “I strongly believe that, because of the challenges we’re facing, we’ll see more innovation on financing in this space than in any other.”

This conviction stems partly from the view, shared by most infrastruc-ture market participants, that the appetite for uK assets among institu-tional investors is strong.

as Lloyds bank’s head of infra-structure and energy Guillaume Fleuti notes, uK infrastructure assets are as popular with interna-tional investors as with domestic pension funds and insurers.

“Non-european based investors and sponsors are comfortable with investing in the uK, both in infra-structure and in other asset classes,” he says. “They see it as a very stable investment destination and they see the recovery coming up faster here than in the rest of europe.”

Goldstein at Morgan stanley agrees. “International investors love the uK, which they see as a very safe and sound investment destination,” he says. “If they were offered the right opportunities they would be very happy to increase their exposure to the country.”

However, the lack of dealflow in the uK — and particularly the shortage of the type of investment grade assets required by institutional accounts — is currently forcing many investors to look instead to continental europe for places to put their money to work.

similarly, sponsors are look beyond the uK for opportunities. “Many of the construction compa-nies are actually re-gearing outside of the uK due to the lack of a suffi-ciently strong pipeline,” says Tucker.

Breaking the deadlockas to what could get the uK infra-structure market moving again, mar-ket participants are less certain.

The coalition government, which has outlined plans for more than £300bn of spending by the end of the decade, is hoping that new initia-tives in the pFI sector and a high pro-file guarantee scheme — as well as the appointment of the man responsible for the successful delivery of London’s Olympic Games, Lord deighton, to oversee them both — can break the deadlock.

The new pF2 format for public pri-vate partnerships, which allows the government to take an equity stake in new infrastructure projects and also to aggregate debt for financing, is being trialled in the next £150m tranche of the priority schools project and has received a positive response from the private sector.

Meanwhile, in June, Treasury secre-tary danny alexander announced that

the £10bn Hinkley nuclear plant pro-ject and the Mersey Gateway would be the first to receive a guarantee under the government’s new scheme to accelerate infrastructure construction.

as he admits in an exclusive inter-view with EuroWeek (see page 16). how-ever, Lord deighton is in agreement with other sector participants that the availability of finance is not the main barrier to uK infrastructure develop-ment.

Indeed, he notes that a key aspect of his new role involves “pulling togeth-er projects and getting them in the right shape to take them to market” —

including assisting with the uK’s noto-riously laborious planning processes.

according to bankers, this remains a stumbling block for both investors and construction companies.

“all investors want to map out their pipeline in terms of future invest-ment,” says allocca, “and equally sponsors looking to build projects need to get investment approval and capital allocation approval — and clearly both parties will prioritise in those jurisdictions where the speed of planning permissions and licences is quicker.”

He agrees with Lord deighton, how-ever, that this alone would not be suf-ficient to deter investors, given the strength of demand for uK assets.

“There is no doubt that between the various market participants — the banks, the insurance companies and the pension funds — all the infra-structure requirements of this country can be met,” he says. “There is suffi-cient liquidity through construction and post-construction to meet all the requirements, but at the moment the missing piece is just bringing everyone together.”

Tucker also notes that, when the pipeline does start to build, the mis-match between the risk requirements of investors and sponsors may start to become more apparent.

“unlike the banks, which used to provide the long term funding for infrastructure, institutional investors need projects to be investment grade,” he says. “The government is aware of that but they haven’t necessarily had to confront it as they might have done if the pipeline had been as strong as it was historically.”

Much clearly depends on whether the government and Lord deighton can deliver the pipeline it has prom-ised over the next 12 months. Inves-tors both at home and abroad will be watching closely. s

“Non-European based investors

and sponsors are comfortable with

investing in the UK, both in

infrastructure and in other

asset classes”

Guillaume Fleuti, Lloyds Bank

“I strongly believe that, because of the

challenges we’re facing, we’ll see

more innovation on financing in this

space than in any other”

Simon Allocca, Lloyds Bank

IntervIew wIth Lord deIghton, CommerCIaL seCretary to the treasury


EUROWEEK: How positive has the response from the private sector been to the infrastruc-ture programmes and initiatives announced by the government this year, including the new PF2 format for PPP projects?

Deighton: The PF2 format was devel-oped from a very extensive engage-ment process with the private sector. We received more than 150 writ-ten responses and conducted a large number of roundtables and events, so what came out of the process really reflected what the industry at large — not just the finance sector but also the people who build and operate these projects — wanted to see in an improved and amended PFI approach.

On the financing side, the most rel-evant change is of course the govern-ment’s decision to become an equity partner in these projects, and so far people seem to be very happy with this approach. The first new pro-gramme that is being developed that way is a schools building programme, which in fact incorporates two inter-esting innovations. One involves the government co-investing as an equity partner and the second one is a con-cept that we call an aggregator, which allows us to collect up the debt that we effectively need school by school so we can then finance it as a bulk loan. This really gives us the flexibility to go to whichever market is the most effi-cient, which brings the bond market in as a possibility for financing. So we are seeing quite a bit of innovation there and the response from the mar-ket has been very positive in terms of

interest in participation. It is still rela-tively early days but so far so good on that front.

Even more significant from our point of view is the UK infrastruc-ture guarantees scheme. I always refer to it as the Treasury rolling out the heavy artillery, partly because of its sheer scale — we have a facility of up to £40bn. We have just extended the scheme through to 2016 because of the level of interest and also because infrastructure projects, as you would expect, have very long gestation peri-ods and it does take a while to get these things up and running. Howev-er, we have had around 140 enquiries relating to the scheme and, as we set out in our Investing in Britain’s Future report published, there were already

around 20 prequalified projects at the time of publication in June, adding up to about £13bn in total. In addition to that, there is almost the same amount again — or perhaps slightly less, in terms of the guarantee amount — for the Hinkley nuclear power project. This shows that the scheme is devel-oping real momentum.

Interestingly, the challenge initially for us with the guarantee scheme was that people thought it was just too good to be true, and we had to go out and explain in detail that this really was what we were prepared to do to help get these important infrastruc-ture projects off the ground. So to the extent that financing was the major obstacle, this programme is a very important part of our armoury.

If anyone knows about delivering big projects on time, it is Paul Deighton. As CEO of Locog for six years, the former senior Goldman Sachs executive played a pivotal role in ensuring the smooth running of the London Olympics.

His success unsurprisingly caught the eye of politicians and in the wake of the Games he was tapped to undertake an even bigger challenge. Appointed as Commercial Secretary to the Treasury, Deighton — now a life peer — has been charged with the responsibility of delivering on the coalition government’s ambitious infrastructure project.

Nine months into his new job, Lord Deighton talks to Lucy Fitzgeorge-Parker about how the government is working to attract new investment into the infrastructure sector, why the controversial High Speed 2 rail project is essential for UK growth and what he hopes to achieve over the coming year.

Focus on delivery: putting policy into practice

Deighton: “The challenge initially for us with the guarantee scheme was that people thought it was just too good to be true”

IntervIew wIth lord deIghton, CommerCIal seCretary to the treasury


EUROWEEK: How important is developing new investor bases for UK infrastructure (e.g. pension funds, foreign sovereign wealth funds), what are the hurdles to bringing in new investors and what can the government do to promote this?

Deighton: The most recent nation-al infrastructure plan published last December alongside the Autumn Statement identified a pipeline of just above £300bn over the next 15-20 years, and clearly when you have an investment programme of that scale diversifying your potential sources of finance is very important strategically.

First of all, it is important to note that the £300bn is expected to com-prise funding from both the private and public sectors. Indeed, the vast majority — over two-thirds — is going to be financed in the private markets. That’s why we want to make sure that the private markets understand these projects and that structures are being developed which accommodate their inclusion.

On a practical level I would say that, generally speaking, finance is not usu-ally an obstacle to these projects get-ting done. When we have a financea-ble proposition the markets are highly creative about finding solutions, so a fair amount of my time is actually spent on pulling projects together and getting them into the right shape to take them to market, which includes getting through challenges around planning permission and making sure that the right technical solutions are in place.

Putting that to one side, however, what we are obviously trying to do is to make sure that banks continue to have the opportunity to participate, in the way that we saw recently with the Thameslink rolling stock deal, which involved a big bank syndicate. We also want to make sure the capital markets can participate, whether that is under the UK guarantee scheme, whether it is under the wrap of a monoline insur-er — and we’ve seen something of a resurgence of that market — or wheth-er it is under the aggregator structure of the new PF2 format.

We have done a lot of work with the domestic pension fund industry, working with key players in develop-ing the Pensions Infrastructure Plat-form for investment. That already has

commitments of around £1bn and we expect considerably more commit-ments as pension funds develop the credit analysis skills to understand infrastructure projects, which is some-thing they are currently very focused on.

I also spend quite a lot of time in discussions with big overseas inves-tors, for example the sovereign wealth funds, which are extremely attracted to investing in the UK. They regard our rule of law and general environ-ment as easily as attractive as any-where else in the world. What is more, in a world where government bond markets are not yielding very highly, the notion of investing in an infrastructure project with long term secure cashflows that tend to be infla-tion adjusted is a very attractive alter-native, so they are very keen to be part of it.

Generally speaking, investors are very interested in owning and invest-ing in mature operating assets, as you would expect, and any time you see an airport or a water company there is usually a very competitive reaction to trying to be part of the capital struc-ture that owns it. Unsurprisingly, the more difficult issue is people’s appe-tite to be involved during the con-struction phase. However, there is a lot of work being done on that, and it is where the sponsors of these projects themselves come in and where poten-tially our own government infrastruc-ture guarantees can play a part. It is also where, over time, one or two of these institutional and international investors may find their understand-ing of the projects will allow them to participate at the earlier stage of development where of course the returns are commensurately higher.

Overall, I would say that the financ-ing picture is developing well on all fronts and at the moment it is definite-ly not a major barrier to the inaugura-tion of most infrastructure projects.

EUROWEEK: One issue that has been cited regularly as a barrier to investment, particularly for over-seas institutions, is the very long approvals process in the UK. What can be done to overcome that prob-lem?

Deighton: The UK planning system is something that we have contin-ued to reform. If I look at the different

parts of the process, this is clearly one part where — certainly from a project development point of view — there may be aspects where we are not quite internationally competitive. That is why we introduced the National Plan-ning Policy Framework last year to simplify the planning process, under which nationally significant pro-jects have a special unit to see them through.

However, I wouldn’t say that the current planning situation acts as a deterrent to investors. Where it has been a problem it just means that it takes longer for a project to get to the stage where investors and lend-ers have a proposition which they can look at. The extreme example would be that, for plenty of very cogent rea-sons, it is clearly taking us some time to decide where we might like to build additional airport capacity in southeast England. We are now going through the process with the Davies commission, which presented its report in August and out of which we will come up with some final recom-mendations in 2015. There are clearly good, democratic reasons why we have to be very careful about where we site a new runway, but when we have made a decision to proceed I am sure that the financing interest in being part of that airport increase will be very strong. British airports gener-ate a lot of cashflow and are extremely financeable. So yes, it does take time for us to decide what to do, because we go about these things extraordinar-ily carefully, but I wouldn’t say that it deters the investors, it just means they maybe have to wait longer than they would like to be part of what is a very attractive opportunity.

On the other hand, in the UK we are clearly pioneers in terms of privati-sation. Our utility industries are pri-vately owned in the main, particular-ly the energy industry and the water industries, but also the airport sector. They are governed by an independent regulator whose job it is to make sure that the pricing settlements give a fair deal to the consumer but also create an environment in which the compa-nies can privately finance the capital development they need. For exam-ple, Heathrow will shortly be opening the new Terminal 2 building, which was simply financed by the corporate entity based on the cashflow from the existing business. The situation is the

IntervIew wIth Lord deIghton, CommerCIaL seCretary to the treasury


same with our water industry, where the pricing settlement allows the con-stant refurbishment and development of the capital that is necessary to keep the water supply in good shape. So there is an enormous amount of infra-structure development that effective-ly takes place through the corporate form within the privatised utility sec-tor, which works incredibly efficiently.

EUROWEEK: The major infrastruc-ture project that has dominat-ed headlines recently is the high-speed rail link HS2. Some industry participants have suggested that a focus on such high profile, contro-versial infrastructure projects can divert interest and investment from smaller projects. Is that a valid criti-cism?

Deighton: I don’t really understand the logic of that — I think you have to look at each one of these big projects and its impact individually. HS2 is an absolutely fundamental investment in the capacity of our railway sys-tem, which would grind to a halt if we didn’t make it. You could chop it up into lots of little projects if you like — into the phases of the railway, the sta-tion developments etc — but the fact is we need to create another transpor-tation spine. We haven’t built a railway north of London for more than 120 years and we’ve underinvested in the railways overall for the past 40 or 50 years, and this is what we have to do to give us the capacity we need. It will free up capacity on the existing line to allow for much better services on the commuter side and on the freight side, and that in turn will have a consider-able stimulating effect on economic growth. It’s as simple as that.

I don’t think that the fact that we are doing HS2 makes any difference to the financial attractiveness of smaller or medium sized projects. Indeed, it gives people a context within which they can understand the logic behind the other things we do on the railway and the road system, because it fits into an overall strategy. And from a governmental point of view we con-tinue to invest in the other projects alongside it to make sure that the overall performance of the road and rail network makes sense.

Similarly, in the energy sector we are very focused at the moment on the Hinkley project, which represents

the first potential power station in the new nuclear build out. That is a very significant project, but I don’t think a focus on that makes it any more dif-ficult to look at smaller wind farms or other renewable projects. On the con-trary, I think it helps people under-stand the broader context of the gov-ernment’s energy strategy, and I think the fact the government is such a pro-active participant in ensuring that important deals get done leaves a lot of capacity for the private markets — assuming we’ve got the policy envi-ronment right — to take care of the small and medium sized deals.

EUROWEEK: What do you expect to achieve over the next 12 months?

Deighton: The principal focus of the government now is really on delivery, getting things done. We have done a lot of work in putting in place the vari-ous financing schemes and we have done a lot of work on defining and pushing ahead very big symbolic pro-jects such as HS2 and Hinkley, as well as the Thames Tideway Tunnel that will upgrade London’s sewers from the current Victorian system. We have underinvested chronically in infra-structure for a very long time in the UK, so we need to demonstrate that this type of symbolic project, where government involvement is really nec-essary, is getting done.

We also need to follow through on the plan we have announced for a spending round with a big investment programme in roads and in the rest of

the rail system. It is incredibly impor-tant that we make sure that that is get-ting delivered and that we will have the transportation capacity we need in future.

Energy is equally important. Around two-thirds of the investment envisaged under the National Infra-structure Plan is in this sector, and we need to ensure that our energy policy and the market reforms that we work through from a policy point of view are finally passed through parliament. We also have to ensure, in turn, that the regime we have translates into a set of contracts for developers to undertake the building programme we need across a range of sectors to replace our coal fired power stations and to achieve a blend of renewa-bles and nuclear that will secure our energy supply for the future with the right mix of decarbonisation. That is an area where translating issues from policy into practice is hugely impor-tant, so we will be extremely focused on that.

Overall, I am very focused on mak-ing sure that people here in govern-ment are equipped with the skills to be able to deliver with urgency and focus the projects that are on the table. With the economy in its recovery stage and with confidence improving it is really important that we do the work on our productive capacity which infrastructure allows us to do to make that growth sustainable. I would say we are in a very sweet spot to get on and deliver the projects that will help us modernise the economy. s

Deighton: “We haven’t built a railway north of London for more than 120 years and we’ve underinvested in the railways overall for the past 40 or 50 years, and HS2 is what we have to do to give us the capacity we need”

The GilT MarkeT


The UK DebT Management Office (DMO), as this report went to press, was set for what was shaping up to be another spectacular syndication. having already extended its conven-tional Gilt curve with a blowout £5bn 3.5% 2068 bond, the DMO is set to extend its linker curve to the same maturity point. but away from the UK’s headline grabbing syndications, there are other reasons to be positive about the market.

At roughly the halfway point through the UK’s financial year, gov-ernment borrowing is just under 40% of the total fiscal year forecast of £120bn, excluding Qe cashflows, according to research by Sam hill, RbC Capital Markets’ UK fixed income strategist.

That compares well to the previ-ous three years when the UK has been over 40% at the same stage, he says. And that bodes well for the prospect of the government not having to borrow its full forecast amount by year-end, especially given the recent spate of better eco-nomic data.

The IMF in June revised upwards its growth forecast for the UK from 0.7% to 0.9%, while second quarter growth was revised up by the Office for National Statistics from 0.6% to 0.7%.

There have also been improve-ments in employment numbers, construction starts, manufacturing orders, retail sales and export num-bers.

but there has also been a rise in yields, as there has been globally, since the beginning of May when investors started to react to the potential tapering of quantitative easing in the US. The 10 year Gilt has risen from yielding 1.62% to around 2.90% in that time.

And so it is hardly any surprise that international investors have added to their Gilt holdings. International

participation in the fabled Gilt syn-dications typically runs at around 10%. but the DMO most often runs long-dated syndications, which inter-national investors — often central banks — do not want to buy. Instead they buy maturities of 10 years and below and so it is the secondary mar-ket where the effect can be seen.

“When looking at the statistics that we’ve published, it really is also worth looking at the nominal fig-ures,” says Robert Stheeman, chief executive of the DMO. “At the end of Q1 2013, 31.2% of the overall Gilt port-folio was held overseas, versus 30.7% a year previously. That doesn’t sound

like a big change, but when you look at numbers such as, it was £380bn at the end of Q1 2012 versus £432bn at the end of Q1 2013 — that is a pretty sizeable increase.”

Although the improved UK data hardly smacks of a booming mac-roeconomic recovery, the UK has enjoyed a sustained safe haven bid throughout the era of financial crisis. but Stheeman thinks there is more than that behind the increase in international interest.

“It is in the nature of any safe haven bid that it can and probably will be unwound, because at one point the assessments of the respec-tive strength of sovereign issuers will change,” he says.

“but I would like to think that the

Gilt market will continue to benefit from the participation of major over-seas investors, because people have a positive view on the Gilt market or the currency.”

Domestically, there has been lit-tle change to the investor base, says Christophe Coutte, head of rates at Lloyds bank. but there have been shifts in the levels of demand from domestic players, prompted by great-er financial regulation.

“Some of our LDI buyers — pen-sion funds and life insurers — are buying bigger sizes than before,” he says. “We’re also seeing more buy-ing from bank treasury desks. The increase in the Gilt issuance pro-gramme has been met with grow-ing appetite from investors looking to meet their new capital require-ments.”

Curve extensionWhether the macroeconomic scene continues to improve in the UK or not however, and what affect that might have on Gilt supply, there are still notable supply events this fiscal year through the DMO’s syndication pro-gramme.

The 2068 inflation linker is just such a bond and the choice of deal exemplifies the uncommon amount of work that the DMO puts into bring-ing a deal its investors want. After all, when there are just a handful of domestic liability-driven investment (LDI) buyers that dominate your order books at the riskiest end of the curve, it pays to listen when you have a large borrowing requirement.

The DMO first consults with its primary dealers — called Gilt edged Market Makers (GeMMs), and key investors. In the case of the 2068 link-er and the conventional 2068 Gilt that preceded it, there was a clear investor interest to extend the UK’s curve.

“In choosing these maturities we don’t have any fixed approach,” says

The UK Debt Management Office’s pragmatic approach to raising money has won it plaudits from fellow borrowers and bankers alike. Its syndications continue to attract heavy interest from an admittedly somewhat captive domestic investor base, but there is a growing overseas bid also supporting the market. Ralph Sinclair reports.

Pragmatism helps DMO to extend Gilt appeal

“We try and do what we think is

best for the programme and

best for the market, and those

two usually go hand-in-hand”

Robert Stheeman, DMO

The GilT MarkeT


Stheeman. “We’ve got an open mind. Once we’ve set the parameters, we try and seek feedback from the mar-ket and try and do what we think is best for the programme and best for the market, and those two usually go hand-in-hand.”

The desire on the part of investors — pension funds and life insurers — is to have a hedging instrument to buy to cover their long-dated liabilities. Rarely, unlike other markets, do inves-tors extend along the curve to pick up extra yield.

“In the case of our ultra-long or super-long issuance, it is very much driven by the specific need of the UK pension fund industry to match assets and liabilities, rather than just a vague sense of desiring yield pick-up,” says Stheeman. “Not that yield pick-up isn’t occasionally present, but the yield curve, from 30 years upwards is very flat, if not slightly inverted, and the further along it you go, it’s not obvious that you’re going to see much in the way of extra yield pick-up.”

For the DMO the syndication pro-gramme, expected to raise £21bn this fiscal year, offers greater quality and quantity of dialogue with investors than it could achieve through auc-tions alone.

“The information that we gather, as a result of the whole process, is vastly in excess of what we would gather just through the auction process alone,” says Stheeman. “Our knowledge of the market over the last four years now as a result of the syndication programme has increased hugely. The quantity and quality of the dialogue with the

investor base has increased. That’s ultimately to the benefit of the Treasury and to the exchequer as well.”

FRN idea sinksAside from curve extending con-ventional and inflation-linked Gilts, however, investors can expect pre-cious little innovation in terms of new products from the DMO, and investors should not expect one of this year’s big investment trends — floating rate notes — any time soon.

Although the DMO has monitored the trend in the dollar market, it has structural reasons not to want to offer its own product. “The driver towards the USA’s issuance of floating rate notes is fundamentally to do with the average maturity of their debt, which is a little over five years,” says Sthee-man. “Ours is a little under 15 years so the impetus is a different one here.

“Our job is to minimise the cost of borrowing rather than fix the mar-ket’s structural problems. That doesn’t mean that we don’t have a potential interest in it, but it will be interesting to see if the sort of scenario that you’ve just painted leads to specific demand for collateral, which would potential-ly translate into better financing costs for us at the other end.”

It is an issue that GeMMs have wrangled with recently in determin-ing what advice to give the DMO. “We looked at whether there was a cred-ible story for floating rate Gilts — who would they appeal to?” says Coutte at Lloyds bank. “It could be economi-cally attractive for bank treasuries

currently buying fixed rate Gilts and asset swapping them to directly buy floating rate Gilts. It could also be of interest to retail investors who want to enjoy the potential back up in yields.We tried to assess the potential vol-ume and it would only have been a small portion of Gilt issuance but it may be of greater interest when we are in a rate hiking environment.”

“The vast majority of FRN buy-ers are able to buy fixed rate notes on an asset swapped basis,” says Dan Shane, head of SSA syndicate at Mor-gan Stanley. “So while we have seen an increasing trend in FRN issuance, a large majority of that is simply a shift of buyers who would otherwise have bought fixed rate securities and asset swapped them, saving themselves paying the bid/offer in terms of exe-cuting the derivative.

“There are very few accounts that I can think of that have demand for floating rate instruments that are not in a position to buy an asset swapped fixed rate bond.”

Supply sideThere are several factors that could affect Gilt supply but the DMO aims to provide as consistent as possible an approach, even in the face of poten-tial windfall events such as the sale of the government’s stake in Lloyds bank. “Revisions in our remit are not depend-ent on individual transactions such as the possible sale of Lloyds,” says Stheeman. “We try and accommodate any sudden intra-year changes to the financing requirements through our cash management operations.

“We place a lot of emphasis on trying to make sure that the Gilt programme, within reason, is protected unless there’s a very, very significant move-ment in government finances, which tend to be announced at fixed times — one being the budget, the other being the Autumn Statement.” s

“The increase in the Gilt issuance

programme has been met with

growing appetite from investors

looking to meet their new capital

requirements”

Christophe Coutte, Lloyds Bank

Overseas holdings of Gilts

Source: DMO

0

5

10

15

20

25

30

35

40

0

50

100

150

200

250

300

350

400

450

500

200

7 Q

3

200

7 Q

4

200

8 Q

1

200

8 Q

2

200

8 Q

3

200

8 Q

4

200

9 Q

1

200

9 Q

2

200

9 Q

3

200

9 Q

4

2010

Q1

2010

Q2

2010

Q3

2010

Q4

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q3

2012

Q4

2013

Q1

Overseas holdings, £bn (LHS)

Overseas holdings,% of total Gilt stock (RHS)

Overseas holdings of Gilts

Source: DMO

UK Capital Markets 2013 EuroWeek 21

United Kingdom Debt Management Office Roundtable — 2013

EUROWEEK: What progress has the DMO made so far this year with its borrowing remit and where are you up to with your syndication programme in particular?

Robert Stheeman, DMO: This year, we have a Gilt sales programme of around £155bn. Our financial year runs from April 1, 2013 to the end of March, 2014, so we are very close to being halfway through and we are also on target to reach the halfway point in our programme

Although our pace of borrowing does vary a little bit at times — that is to say we’ll take our foot off the accelerator at quiet times, such as the summer break or over Christmas — we’re in a particularly busy period now in terms of what we’ve got to raise from the markets.

The syndication target itself — £21bn — is

somewhat flexible. It falls within the overall pot of what we call supplementary issuance.

We announced on September 6 that we will be looking to launch a new index-linked bond with a March 2068 maturity in the week beginning September 23, subject to market conditions. The market is expecting that transaction following the previous announcements we’ve made about the quarterly issuance calendar.

Notwithstanding the fact that markets can be very volatile, things are looking quite positive for that particular syndication.

We’ve also announced that we plan to hold a syndication in the fourth quarter of the calendar year — a re-opening in October of the conventional 3½% 2068.

We will be making further announcements about that in due course.

Participants in the roundtable were:

Charlie Diebel, head of strategy, research, Lloyds Bank

Sam Hill, UK fixed income strategist, RBC Capital Markets

Anthony O’Brien, co-head of European rates strategy, Morgan Stanley

David Parkinson, head of UK rates sales, RBC Capital Markets

Dominic Pearson, director, Gilt sales, Lloyds Bank

Daniel Shane, head of SSA, Morgan Stanley

Robert Stheeman, chief executive, UK Debt Management Office

Ralph Sinclair, SSA markets editor, EuroWeek

Open-minded DMO aims to do right by the market

The UK economy appears to have perked up of late if recent data is anything to go by. Add to that a rise in Gilt yields, and you could be forgiven for thinking that the Debt Management Office, which sells sovereign debt on behalf of the UK, could start to relax about its vast funding programme — especially as it maintains something of a safe haven status among sovereign credits.

But the economic recovery needs to be maintained and while international investors appear to be buying an increasing amount of Gilts, the DMO must still navigate the domestic market, which dominates Gilt buying at the long end of the curve. EuroWeek met with DMO chief, Robert Stheeman and a number of key bankers from the Gilt market in London in

early September, ahead of the UK’s pioneering 2068 inflation-linked Gilt coming to market, to discuss the outlook for UK sovereign debt.

22 EuroWeek UK Capital Markets 2013


EUROWEEK: The planned 2068 linker follows on directly from the 2068 conventional Gilt syndication that you did earlier in the year. Did that first syndication lay the groundwork for this?

Stheeman, DMO: We had earlier signalled our intention to introduce what we call super-long issuance, meaning anything longer than 50 years — I apologise repeatedly and profusely for the epithet super-long, it’s just that we ran out of superlatives having used ultra-long already and we couldn’t think of anything else to call it — showing that we were looking to extend, moderately, the maturity spectrum.

This was the result of last year’s consultation on potential super-long issuance. We chose the 2068 maturity a few months ago now, as a result of feedback we received from the market.

There was no automatic assumption that it should be a 55 year bond. One or two people, at the time, suggested that we might even want to consider going further along the curve, although we got the distinct impression that the universe of investors tends to shrink the further out you go. That applies to the linker market as well.

Again, there was no hard rule to say just because we’ve issued a 2068 conventional, therefore we had to issue a 2068 linker. But the market feedback pointed overwhelmingly to a 2068 maturity. The presence of the conventional there will help with the hedging for the linker.

But in choosing these maturities we don’t have any fixed approach. We’ve got an open mind. Once we’ve set the parameters, we try and seek feedback from the market and try and do what we think is best for the programme and best for the market, and those two usually go hand-in-hand.

EUROWEEK: Is there scope to extend the Gilt curve even further than 2068? Is that of benefit to investors?

David Parkinson, RBC Capital Markets: Nobody would rule out a longer-dated issue in the future, but, for the time being, the expectation is that 2068 will be the focus of further issuance, both in conventionals and linkers.

There’s a finite amount of demand for this very long-dated paper and that might well be satisfied with a few more tranches of 2068 paper.

Pension fund liabilities go all the way out to 80 years or possibly further, but the size of those liabilities diminishes substantially beyond 50 years.

So, in picking a date to extend the maturity of the yield curve to, the aim is to find a date that will be meaningful in terms of adding an extra hedging instrument for some of those very long liabilities, but without going so far out into the tail that demand is so thin that you would never get to the point where you can build up a liquid issue.

Daniel Shane, Morgan Stanley: The consultation paper that Robert was referring to earlier covered this point about additional interest in maturities further along the curve, including perpetual bonds.

The feedback that came back at that stage favoured this graduated approach and we’ll have another measure of market demand on the back of the 2068 linker syndication.

A priority of the DMO will be to ensure the liquidity of this new instrument, bringing it to an increased level of liquidity through re-openings, which I would expect to be a priority, near-term.

One thing that the DMO is very good at is responding to investor demand and if it becomes apparent as a result of these two syndications that there is sufficient demand for a bond beyond 2068, then it shouldn’t be ruled out. But our near-term expectations are that these two deals are going to be the key sweet spots for investors, in the long end of the curve, and therefore be upsized first.

Stheeman, DMO: Without wishing to pre-empt anything, we do not view these types of issuance strategies as one-offs. Ideally, we look to build new bonds up in size to provide liquidity to the market through re-openings

We don’t want to have any orphans out there. We like our children to remain well brought up with loving parents.

EUROWEEK: When you gather feedback from investors about curve-extending trades, how much of what they say is driven by just matching what they have on the other side of the balance sheet? And how much of it is driven by the need to earn some sort of yield given how low they are?

Stheeman, DMO: In the case of our ultra-long or super-long issuance, it is very much driven by the specific need of the UK pension fund industry to match assets and liabilities, rather than just a vague sense of desiring yield pick-up. It is not that yield pick-up isn’t occasionally present, but the yield curve from 30 years upwards is very flat, if not slightly inverted, and the further along it you go it’s not obvious that you’re going to see much in the way of extra yield pick-up.

EUROWEEK: Are Gilt investors ringing dealers up complaining about the terrible yields on offer or are they more concerned by other matters?

Parkinson, RBC Capital Markets: No, not at all. Investors are conscious that the Gilt market doesn’t exist in a vacuum — it’s a market like any other that finds a level based on supply and demand.

One of the key considerations for investors in terms of where they see value is what Gilt yields look like compared to German yields, US Treasury yields. It is the collective judgement of the market that puts yields at the level they’re at.

There may be times when those yields are at a David Parkinson, RBC CM



level which may lead to investors seeking returns elsewhere, but you don’t get people phoning up to complain about the level of yields that the market itself sets.

Dominic Pearson, Lloyds Bank: Yes, exactly — they have the choice not to buy.

EUROWEEK: If you’re buying ultra-long sterling products, though, you don’t have much of a choice of what to buy, do you?

Pearson, Lloyds Bank: In a lot of instances a choice has been exercised for decades not to buy and that is the reason that this situation exists at all. Defined benefit pension schemes have, for a long, long period of time decided to run a material asset and liability mismatch and they’re bearing the historic consequences of that.

There’s nobody they can complain to other than their forebears — it’s a fact of life. What happens in practice is that they’re caught between the need to try to reduce their deficit, so when yields go higher, then they are going to be incentivised.

But when sentiment deteriorates they are then faced with a quandary of whether to bite the bitter bullet or just hope for a better time.

But that’s just the nature of risk and markets. It’s not an acute problem apart for liability-driven investment (LDI) buyers that find themselves in difficult circumstances.

Moreover, as much as it damages defined benefit pension schemes, one has to bear in mind that the quid pro quo is that the government and future taxpayers benefit from low interest rates, as do other private sector borrowers who are not encumbered by defined benefit pension schemes.

So, the question to be asked is, to what extent do we need to subsidise one community of the economic world? We just have to make sure that there are vehicles to enable them to hedge their risks, which the DMO provides, and let nature take its course.

Parkinson, RBC Capital Markets: It’s important to remember that long Gilt yields are some 80bp or so above their lows from last year and equities are, perhaps, 25% above their 10 year average levels, so quite recently, there’s been a very substantial improvement in pension fund solvency. Pension funds have been very keen to lock in some of that improved solvency and there’s been an increase in demand for long dated yields, as a result.

EUROWEEK: What about the outlook for Gilt yields, given the new methodology for setting rates at the Bank of England, the future of QE and so on?

Charlie Diebel, Lloyds Bank: We are entering a very difficult paradigm for UK and European assets because we’re at a different stage of the economic cycle.

Although the world is talking about the US tapering quantitative easing as if it is tightening policy — and we all know that it’s not, it’s just less accommodation — the changing factor is a potential lessening of support for the markets.

That is not the case in the UK or eurozone, but markets have always had the US as their prime driver.

It’s almost impossible for the Bank or any policy maker internationally, to diverge from what’s going on in the US, unless it’s a very domestically captured market.

Being 96% owned by Japanese investors, the demand and supply conditions of the JGB market can be effectively dictated by the Bank of Japan — the consequence being highly regulated banks and life assurers resulting in a closed market, not really open to international comparison.

It’s no surprise that you’ve seen such a steepening in the coupon curve there, simply because the market is looking for some insurance.

The central bank can control the front end of a yield curve, but it can’t control the long end and nor should it try to. It creates all sorts of moral hazards and risks which could make any attempt at it self-defeating.

While we’re in a world where US data remains strong enough to keep the Fed on this path of considering QE tapering, then it’s going to be very difficult to control where 10 year or longer dated yields go, but the Bank should be able to control where two-year goes.

Anthony O’Brien, Morgan Stanley: The UK economy is not doing so badly itself. We were talking about a triple-dip recession in the UK in April and we’ve moved so far from that since.

Guidance is working. It’s just not working as far out along the curve as we thought it might do.

I can say guidance is working because we put up our growth forecasts and instead of bringing forward our forecasted date for interest rate hikes, we actually pushed it back, which shows that there is some belief in what Carney’s saying.

However, you can’t take away that the UK economy’s doing exceptionally well, and as long as nothing goes wrong in Europe, the economy probably continues to do OK. And when economies do well, yields tend to rise.

Sam Hill, RBC Capital Markets: The recent change in the policy framework has accentuated the theme of yield curve segmentation. The 10 year part of the curve is still inherently exposed to international developments and because of the gradual improvement in the outlook for the US and the avoidance of some of the more serious crises we’ve seen in the euro area, there has been a rise in core market yields.

But what Governor Carney attempted to do in his speech in Nottingham on August 28 was to underline that the Bank accepts that although there’s a limited amount it can do about that, they can and will seek

Dominic Pearson, LLoyds Bank



to underpin the path of forward rates in the 0-5 year sector.

While investors will continue to be nervous about longer dated maturities, there is a limit to how much more weakness we could see in the 0-5 year sector because the Bank will likely become uncomfortable if it sees the implied path of market rates rise much further.

Shane, Morgan Stanley: The other interesting element to this, which I’m sure the Bank is going to monitor very closely, is the transfer of Gilt yields into the real economy, in terms of borrowing yields. For example, mortgage rates do not seem to have risen on the back of the sell-off in the Gilt market. If that changes then it might change the Bank’s approach.

Similarly, corporate and financial borrowers are not seeing their credit terms deteriorate so Gilt yield sell-offs are not something, per se, to be concerned about. They’re a function of an improving economic story at the moment, which has been extremely encouraging.

It’s in line with other markets and if you look at the developments in the 10 year US Treasury bond yields, the Gilt market is very much in line.

It’s ironic, because the timing of the Nottingham speech and then the sell-off would suggest that neither the speech nor the recent inflation report had an effect. But actually, we would have seen yields higher still if it hadn’t been for them.

Hill, RBC Capital Markets: Another area, where I’m surprised we haven’t seen more of a change in market prices since the inflation report is that we haven’t seen break-even inflation rates retest the wides. We’re still about 25bp off those wides.Now that the Bank is targeting a real economic variable, we’ll be spending our time looking at the unemployment rate fan chart as much, or more than, the time we will spend looking at the inflation fan chart.

EUROWEEK: Why do you think there’s been a delay?

Hill, RBC Capital Markets: I don’t know but if we continue to see a strong run of economic data and the Bank reinforces its commitment to keep rates on hold, irrespective of that, then over time, we should see that demand for inflation protection increase.

Shane, Morgan Stanley: That’s interesting because a lot has been written about the 7% unemployment

trigger. It’s the one variable that everyone’s now quoting and looking at.

Consensus forecasts are that it won’t be breached until 2016 and yet, the market is pricing in a Bank of England rate hike, probably in 2015, so there is some kind of discontinuity between the two.

But given the inflation knock-out that the Bank has referred to, it is more likely to be inflation breaching the 2.5% target that triggers a rate hike.

O’Brien, Morgan Stanley: We don’t think it will hit unemployment at 7% until 2016, however we think that there will be rate hikes in mid-2015 because we expect the inflation expectation threshold to be broken.

We can ignore inflation at the moment to a certain extent, but it will come to the forefront when wage growth starts picking up.

Nobody knows what these inflation expectations are. However, they are going to be the most important thing, and that is where it is most likely that one person will vote against the Monetary Policy Committee. As soon as one person votes against it, forward guidance is dead.

The other thing about unemployment is that it’s a function of three other factors — immigration, productivity and the participation rate.

Shane, Morgan Stanley: So is forward guidance not all it’s cracked up to be?

O’Brien, Morgan Stanley: Forward guidance works for the Fed because QE is happening at the same time. The central bank is making a commitment that it is not trying to drift. If the US has to taper QE, it has to prepare the market for that. Then it has to prepare the market for hikes and they have to hike, which all takes time.

Shane, Morgan Stanley: But I think it has helped the real economy — don’t you think that’s fair?

O’Brien, Morgan Stanley: Yes, absolutely.

Shane, Morgan Stanley: People on the street, whether it’s small corporates, whether it’s individuals, believe that rates are going to be lower for longer. That’s got to be a healthy thing for driving growth.

Hill, RBC Capital Markets: We can debate how much difference this makes to the real economy or not, but another marker would be that all sub-2016 Gilts still yield below the Bank’s base rate.

That would not be the case if the Bank had said nothing about its intentions for the path of interest rates into the future.

So while in absolute terms total returns on short dated Gilts have been negative, on a rolling quarterly basis of late the differential between those negative returns and the negative returns you see on 10-15 year Gilts has been far more extreme. Investors have been far more sheltered by being in the sub-five year sector than in the 10-15 year sector than you would normally expect during a sell off by quite some way. That’s a sign that guidance on the forward path of rates has had some effect, even if it’s been underwhelming in absolute terms.

EUROWEEK: Has the possibility of rising rates

Daniel Shane, MoRgan stanLey



sparked demand for floating rate paper in the UK as it has in the dollar market?

Stheeman, DMO: We do hear of occasional interest in the product, but it’s always worth reiterating, we are a fixed rate borrower. You could argue that a proxy for floating rate issuance is our Treasury bill stock, but that, while relatively small, is growing.

The US has expressed a growing interest in FRNs as a product but that says perhaps more about the structure and profile of its overall debt portfolio in terms of the average maturity.

Our Treasury bill stock will be up to £70m by the end of the financial year. So the need for us to term out that floating form of debt is probably less than you find elsewhere.

Also offering an attractive enough spread in the FRN market is tricky. In some of the shorter maturities especially, we would probably be somewhere well below Libor, which would probably shut out quite a large part of the potential investor base for the product.At the same time, anyone who issues a floating rate note, as always, will have to find a reference to which to attach it and Libor ain’t what it used to be.

EUROWEEK: Which is probably a good thing.

O’Brien, Morgan Stanley: Will you be watching US FRN issuance though?

Stheeman, DMO: Yes, absolutely. It’s interesting to see how they’re doing in terms of reference. But the driver towards the USA’s issuance of floating rate notes is fundamentally to do with the average maturity of their debt, which is a little over five years. Ours is a little under 15 years so the impetus is a different one here.

Also the investor interest is slightly different here. I don’t sense an overwhelming desire to buy UK floating rate note assets, notwithstanding the fact that we do seem also to be potentially entering into a rising rather than a falling rate environment.

Pearson, Lloyds Bank: Do you think that the prospect of a big increase in centrally cleared derivatives with central clearing houses requiring government collateral could see future participants requiring much larger pools of government debt that doesn’t carry much duration risk with it? And that could mean either that you see bigger demand for your

Treasury bills or because it might just be easier to manage floating rate note products.

Stheeman, DMO: From the narrow perspective of the DMO, our job is to minimise the cost of borrowing rather than fix the market’s structural problems. That doesn’t mean that we don’t have a potential interest in it, but it will be interesting to see if the sort of scenario that you’ve just painted leads to specific demand for collateral, which would potentially translate into better financing costs for us at the other end.

O’Brien, Morgan Stanley: How much are people asking syndicate desks for floating rate notes?

Shane, Morgan Stanley: From a syndicate perspective it’s a slightly different discussion, because of course DMO syndications come traditionally at the long end of the curve.

O’Brien, Morgan Stanley: But what about from corporate issuers?

Shane, Morgan Stanley: The vast majority of FRN buyers are able to buy fixed rate notes on an asset swapped basis. So while we have seen an increasing trend in FRN issuance, a large majority of that is simply a shift of buyers who would have otherwise have bought fixed rate securities and asset swapped them, saving themselves paying the bid/offer in terms of executing the derivative.

There are very few accounts that I can think of that have demand for floating rate instruments that are not in a position to buy an asset swapped fixed rate bond.

Parkinson, RBC Capital Markets: The pockets of potential demand for such instruments generally exist as an alternative to buying T-bills or short-dated conventional Gilts. The DMO would have to determine that there was a cost advantage to the tax payer to issuing in a different format.

We would also have to consider the impact on the liquidity of the existing instruments too.

Another issue that’s pertinent here is that the liquidity regime for banks has been somewhat eased over the last year, and arguably that reduces the potential demand for floating rate Gilts. Liquidity portfolios have been net sellers of Gilts rather than buyers.

Diebel, Lloyds Bank: The Gilt market is largely owned by two groups of people — the pension funds and life insurers, and central banks.

The central banks’ only interest in floating rate debt is the T-bill market, otherwise they’re in the five to 10 year sector. Pension funds and life insurers want the ultra-long dated Gilts.

The DMO is probably the most aggressive sovereign borrower globally in terms of the duration it will push into the street, so let the Federal Reserve do what it likes on the floating rates.

EUROWEEK: There were headlines recently about Lloyds Bank being sold off, and the government has a number of assets on its balance sheet which could bring a revenue windfall. Do you have to make contingencies for that in your borrowing plan, or will you worry about that when it happens?

Robert Stheeman, dMo



Stheeman, DMO: Probably more of the latter. Revisions in our remit are not dependent on individual transactions such as the possible sale of Lloyds Bank. We try and accommodate any sudden intra-year changes to the financing requirements through our cash management operations.

We place a lot of emphasis on trying to make sure that the Gilt programme, within reason, is protected unless there’s a very, very significant movement in government finances, which tend to be announced at fixed times — one being the Budget, the other being the Autumn Statement. So were something to happen then, and that’s at this stage pure speculation, it would be accommodated in our cash management operations as necessary.

O’Brien, Morgan Stanley: We talked about QE and expectations. QE under Carney is probably a far different event than QE under King, and therefore the curve will probably look quite a lot different. I suspect we’ll see more buying at the front end of the curve.

Hill, RBC Capital Markets: The new policy regime has retained some flexibility. You can’t say that QE has been ruled out, because if you look at the wording of the forward guidance, it says that the MPC stands ready to undertake further asset purchases, if warranted, while the unemployment rate is above 7%. But then at the speech in Nottingham there was quite a clear emphasis on keeping short end rates lower.

QE announcements have often led to a bounce. You get a reduction in yields, and then that fades very quickly.

It might not be very long at all before at least one member of the MPC starts to vote for QE again. There was that hint in the August minutes.

If anything there is a case for a bias towards buying the shorter sector. Probably the five year part of the curve would be where you would see the most benefit.

Pearson, Lloyds Bank: Do you think it’s more likely that we are going to get QE than not, Sam? If King was unable to get MPC members to vote with him when the economy was weaker, it is unlikely that Carney will be able to get members to vote with him for more QE when the economy is stronger.

Hill, RBC Capital Markets: It’s not RBC’s forecast that there will be an extension of QE, and also I can’t see any evidence that Mark Carney is an enthusiastic advocate of QE in a way that King was.

But he did say that if the quasi-tightening that’s implied by higher expectations for bank rates goes further, he will act.

Pearson, Lloyds Bank: At the same time he also said he was happy with higher long dated yields, because they tell us the economy is doing better, which is exactly what we’re all after.

Hill, RBC Capital Markets: Yes, but he made a distinction between under five year and over five year maturities.

Pearson, Lloyds Bank: Yes, he did.

O’Brien, Morgan Stanley: If they don’t think they’re

going to raise rates until 2016, it’s possibly a little negligent to do nothing and hope that there will be a steady drift downwards.

The call for more QE is not our base case, but it is a possibility. We do see QE under Carney being quite a bit different.

Diebel, Lloyds Bank: Using QE in the circumstances that we’re presented with would be futile and probably counterproductive. I do hope Carney carries through with his threats to intervene with a more effective solution to just QE.

It comes back to what’s driving Gilt yields. Yet he has no control over the number one data driver, which is the US. So to sit there and go and buy a whole bunch of additional Gilts, if the US data continues to improve, is just a waste of money.

That’s quite a risk to take at this point in time, particularly when you’re leaning into an improved set of macro data.

We may be in for a bit of a data fade into year-end, but nonetheless the picture is improving. It really wouldn’t make any sense now.

O’Brien, Morgan Stanley: It seems that Gilts are the favourite short — particularly in the 10 year sector — among investors I have met with recently. The Bank is up against a few things. It could push yields up quite a bit.

Stheeman, DMO: It’s an interesting comment. I don’t know what yields are going to do, I never have, and I probably never will.

Just before I came here I printed off a graph which showed all the movements in the last three months in the yield curve and by far the largest has been in the 10 year sector as you say.

But one thing I have learnt over the years is that if there is a general view, which is widely held, it’s usually wrong. And that goes for my own view on the direction of yields as well.

EUROWEEK: What changes have there been in overseas interest in the Gilt market? Is the UK still seen as safe haven?

Shane, Morgan Stanley: Holdings of Gilts by overseas investors continues to increase at a steady rate.

In 2007 overseas investors held about 31% of the Gilt stock. In the 2012 data, it’s 30%, so at first sight it looks virtually unchanged or slightly lower. But of course this hides the effect of the Bank of

Anthony O’Brien, MoRgan stanLey



England’s Asset Purchase Finance process. The Bank owns nearly 30% of the Gilt stock, so once you’ve stripped that out, the amount of overseas investors is up at 42% of the publicly held stock of Gilts — it’s a considerable increase.

Part of the reason for this has been the view that sterling is a source of stability compared to concerns about the euro.

But it is also generally a long term trend. We’ve seen foreign exchange reserves for central banks grow, and that cash is looking to find a home and to diversify not just away from US Treasuries, but the dollar as well. Sterling has been a net beneficiary of that.

For now we’ve probably seen the increase pause. A lot of the central banks that are active in these markets are caught up in their own emerging market currency crises, which has stunted the growth of FX reserves.

Syndication distribution statistics tend to show 90% domestic and only 10% foreign sales. But they don’t give you the full flavour because syndications tend to be at the long end of the curve but overseas demand is concentrated on the one to 10 year maturities.

Stheeman, DMO: When looking at the statistics that we’ve published, it really is also worth looking at the nominal figures. At the end of Q1 2013, 31.2% of the overall Gilt portfolio was held overseas, versus 30.7% a year previously. That doesn’t sound like a big change, but when you look at numbers such, it was £380bn at the end of Q1 2012 versus £432bn at the end of Q1 2013 — that is a pretty sizeable increase.

We are often asked about this whole issue about being a safe haven. I went out of my way to sound cautious this time a year ago, and also in particular 18 months ago, at the height of the eurozone crisis. It is in the nature of any safe haven bid that it can and probably will be unwound, because at one point the assessments of the respective strength of sovereign issuers will change.

But I would like to think that the Gilt market will continue to benefit from the participation of major overseas investors, because people have a positive view on the Gilt market or the currency.

Diebel, Lloyds Bank: There’s more to it. The size of the reserves that these central banks hold these days has made them asset managers rather than reserve managers because they will willingly buy instruments that are less than perfectly liquid — and liquidity was the original rationale behind asset purchases.

The archetypal liquidity-focussed one here would be the Bank of Japan, where they have put everything in sub-three year US Treasuries — that’s $1.3tr of sub-three year paper. That’s about as liquid as you can get, but most reserve managers don’t behave that way these days.

As a result there is no reason that the Gilt market along with other G10, non-euro and non-dollar markets will continue to see support, because it’s almost inevitable that as an asset manager you’re working to typical diversification principles.

Stheeman, DMO: That diversification aspect has played a huge role in terms of purchases of sterling assets, even long before the eurozone crisis, arguably actually since the creation of the eurozone, because a number of major European currencies began to disappear at that point.

Hill, RBC Capital Markets: Safe haven demand has been most observable at a time when there’s been a crisis in Europe. If that is on the increase, then that’s also driving part of the improvement in confidence that we are seeing in the UK economy. It’s worth remembering that when the emergency Budget took place in 2010, the forecast was that this year the government cash requirement would be £65bn, but it was actually £113bn when it was announced in the Budget in March this year.

If we do see a reduction in safe haven demand, there’s a good chance that will go hand in hand with a reduction in the cash requirement forecast in future years, so alongside the sensitivity of prices to a small reduction in safe haven demand, there will be a corresponding benefit in the reduction of Gilt supply. I’m sure that overseas investors will respond accordingly and that there will be demand because of the improvement story for the underlying fundamentals of the UK economy.

O’Brien, Morgan Stanley: Robert, you issued an ultra-short Gilt a few years ago. Would you consider doing so again? There is a lot of overseas central bank investment at the very front end. They like liquidity but the outstandings are all old Gilts.

Stheeman, DMO: They are, although the way we have issued, and the way we usually issue Gilts is always that once it’s out there, we continue to re-open them, not just for the period that they might be specific benchmarks, but if necessary also at other times.

Clearly the redemption profile is changing and we have to take that into account. So while the near term redemption profile used to be very small indeed, that’s no longer the case, so we’re pretty cautious about issuing ultra-short Gilts. But there will be times when we recognise, for instance, that there are particular market stresses and we might, if we felt it absolutely necessarily, and if there was sufficient demand, want to schedule ultra-short issuance via a mini tender if trading in a particular bond might have begun to look squeezy.

Clearly the shape of the yield curve plays a role, we have a cost minimisation objective, so we have to look carefully at what is expensive and what is not. We try to balance that objective with our view on maturities and we feel that the overall reduction in refinancing risk, as a result of being able to issue as many longs as we do, is a desirable outcome, and

Sam Hill, RBC CM



we will probably focus on that. But I wouldn’t want to rule out that we would do something — that we would if necessary, address particular spots of illiquidity in the market.

Parkinson, RBC Capital Markets: RBC’s strengths are very much in the sterling and dollar block.

There have been a number of times during the euro crisis where we’ve seen waves of demand for Gilts, Canadian dollar bonds and Australian dollar bonds all at the same time at a particular maturity. So the safe haven flow is real, but the way we’ve always viewed it is as an intensification of demand, and that the net buying particularly of Gilts of up to 10 year maturities, over a longer period than the crisis, has been much more important than the periods of intensification.

EUROWEEK: Is the Gilt market a profitable primary dealership? Does Robert think it should be or not?

O’Brien, Morgan Stanley: One of the problems with the Gilt market is the liquidity that investors have is much better than the liquidity that dealers have themselves and the DMO is aware of that.

However, to solve that problem, you require dealers to widen their bid/offer spreads which is unlikely in the foreseeable future

An electronic trading screen for GEMMs might be able to get round some of this.

Shane, Morgan Stanley: The days of arbitrarily spending money on primary dealerships is one for the history books but the Gilt market remains very competitive compared to other sovereign primary dealerships — there are probably not huge margins to be made.

Banks are revenue and profit maximisers, and as a result of that, we look at market share and opportunities in light of a whole ream of ancillary benefits that may accrue from it. But the market still stands on its own legs, it’s not something that people are going to be committing huge costs to, just to achieve a market share objective because that just isn’t the environment we live in.

Parkinson, RBC Capital Markets: There are going to be ebbs and flows in profitability in any financial markets business, but I think all 18 institutional GEMMs hold their licences voluntarily.

The important thing to remember is that a successful GEMM operation is typically part of a broader and well established fixed income business. RBC has been a GEMM since 2000. We’re one of the leading players in sterling credit and one of, if not the top player in the sterling SSA market over the last three or four years and we very much see the Gilt business as an integral part of that wider sterling fixed income business.

Pearson, Lloyds Bank: It’s a fair point. A GEMM isn’t a standalone business — in many institutions it’s servicing a variety of internal businesses, which in turn make their own profits. Historically that has driven aggressive and competitive pricing. Some of that’s deteriorating now as the regulatory environment is tougher, and capital charges higher.

In addition, there’s uncertainty over the ring-fencing of investment banking from retail banking. At the moment, the significant market makers in the

Gilt market are UK banks. The probability is that the Gilt market, as indeed all market making activities, will fall outside that ring-fence, resulting in a different operating environment that will impact the institutions involved in this activity.

Stheeman, DMO: Ralph asked the question whether we thought primary dealerships should be profitable. The easy answer is to say it’s not for us to determine that, but actually the honest answer is that we have always recognised the need for primary dealerships to be commercially viable for the GEMM community.

We believe in the primary dealer system and we grant a number of privileges which go with being a primary dealer, the biggest of which is exclusive bidding rights at our auctions.

We don’t, for instance such as in the US, have a facility for direct bidding — beyond a very small retail element — by the public, institutional or overseas investors. We give something which we hope is of value to the primary dealers.

In return, we ask for certain obligations to be observed around minimum market share, but we are incredibly sensitive to applying rules around that that would make participation less commercially viable.

That’s not because we’re nice guys — we’re not, I can assure you. It’s because we realise that the longer term health of the primary market relies on good commercial self-interest.

We are under no illusions about the benefit the government gets from our GEMMs taking down our supply in an orderly fashion and if necessary, using their balance sheets to warehouse the paper until it is passed on.

We recognise the need for the Gilt market to be a commercially attractive proposition over the long term for GEMMs. We’re very cautious about anything that might impact negatively on that commercial aspect, because we sure as hell can’t force people to buy our Gilts.

EUROWEEK: Would screen-based trading help?

Stheeman, DMO: It isn’t the role of the DMO to impose a particular model on the market. We follow these things very carefully and things that make the market transparent, in general we favour.

But if you look at those instances where governments have tried to endorse specific electronic platforms, it’s not always been a uniquely happy experience.

We don’t possess any absolute wisdom in terms of market structure, to say this is exactly the sort of market that we want, not least because the regulatory environment is constantly changing. What might have worked a few years ago, may not work now. Obviously the same applies to the future.

If this is the direction in which the whole market wants to move, and if it’s in keeping with the regulatory framework, we’re very happy to see that sort of thing happen. But it isn’t the job of the DMO to be the driving force behind that sort of thing.

Diebel, Lloyds Bank: Do you think that the progress towards greater regulation that is obviously coming down the pipeline poses a threat to liquidity in the Gilt market?

Stheeman, DMO: Conceivably, yes. It’s something which we are very focussed on and we engage very



much with the Treasury on this as well. One of the positives about the UK set up is that

actually we do have authorities who are very much attuned to the needs of the market.

We are fortunate to have an extremely close and open dialogue with our colleagues in the Treasury on these sorts of things, because the law of unintended consequences, especially around some of the regulatory initiatives, seems to hold on a constant basis.

We believe that a deep, liquid, well functioning Gilt market is absolutely crucial to us being able to fulfil our mandate.

EUROWEEK: Robert, you’ve said before that there are banks waiting in the wings to take over GEMM status and, as DMOs go, you’re especially close to your investor base. In fact you were able this year to mandate a firm for a syndication that has closed its SSA business and the deal still flew out the door. Is there an argument for paying lower or no syndication fees? After all, you have already told us you’re not a nice guy.

Shane, Morgan Stanley: I suspect you’re referring to UBS, and obviously there have been some changes there. But I suspect that Robert would still argue that they have a Gilt franchise and a significant presence in the market, and therefore they were able to perform the services of a syndicate manager perfectly capably.

Other changes that might have taken place in their broader SSA franchise don’t reflect necessarily the bank’s capabilities in the Gilt market. Is that fair?

Stheeman, DMO: That’s absolutely fair. It’s not for us to pass judgement on the business model chosen by an individual GEMM. It’s much more important to see that the minimum standards that we require of GEMMs, and they’re not onerous, are observed.

As to the question of syndication fees, I trust you’ve checked the exits of this room. I would argue — and funnily enough, I imagine I would get a lot of agreement from around the table at this point — that we don’t pay much in the way of fees in any case.

But it’s worth asking what we are actually paying fees for. It’s not just hiring a selling group. We are paying fees because the whole process of de-risking our issuance is such that on balance, in our view, it makes sense in terms of not just our ability to sell, but for the wider market infrastructure, for us to be able to support something that allows us to deliver our programme. That’s a very important point, and we mustn’t lose sight of it.

Another thing we mustn’t lose sight of is that the alternative is the situation where we had much less to borrow before 2009/10, when we didn’t syndicate and we auctioned everything. One should not be under any illusion that the auction process is a costless process of issuance. The market can demand an auction concession, which could potentially be considerably in excess of any fees paid on a syndication.

The sort of fees we pay in terms of a running cost, especially on our long-dated syndications are less than half a basis point — and sometimes a quarter of a basis point, of the nominal value. These are relatively small amounts in percentage terms. You just need, on the day of an auction, a 2bp market concession built in, which happens quite easily, and

we would easily be paying multiples of that. The big difference of course is that one is an

implicit cost and the other is an explicit cost, so one feels the need to justify it. But to me, I would like to think and hope that the involvement by the GEMMs in our market is not just based on fees that we pay out for syndications. It’s based on the notion that overall involvement has some commercial attraction.

O’Brien, Morgan Stanley: I think syndications have turned from just being a way to shift stock to being major liquidity events, especially for LDI buyers. That would not happen with auctions alone.

Shane, Morgan Stanley: And that’s of great value to the health of the overall market.

Diebel, Lloyds Bank: You may carry out 90% of your issuing activities through regular auctions, but you never know when you need insurance. To introduce something like a syndication when you have never done them before is much more problematic than it is managing one as part of a regular programme that is fully supported by the financial community.

O’Brien, Morgan Stanley: It removes the worry of having a failed auction, which can damage an issuer’s credibility.

Parkinson, RBC Capital Markets: Syndications have become a market event, but GEMMs play an active role in translating generic demand from investors for a sector of the Gilt market into specific demand for the bond that’s for sale.

Stheeman, DMO: They happen throughout the dialogue which all the GEMMs and investors have with us, and in particular, the closer you get to a transaction, the discussions the lead managers will have with the investor base.

It is an iterative process. We learn from that dialogue because we will speak to the GEMMs and the lead managers. The information that we gather, as a result of the whole process, is vastly in excess of what we would gather just through the auction process alone.

Our knowledge of the market over the last four years now as a result of the syndication programme has increased hugely. The quantity and quality of the dialogue with the investor base has increased. That’s ultimately to the benefit of the Treasury and to the Exchequer as well. s

Charlie Diebel, LLoyds Bank


Public Sector borrowerS

ApArt from the Gilt market, there are precious few opportuni-ties in the capital markets to buy UK public sector risk. prayers for a spate of local authority issuance in the UK bond markets have yet to be answered, but investors may be about to be gifted with other oppor-tunities to buy quasi-UK govern-ment debt at a spread to Gilts.

the next potential source of qua-si-government bond issuance in the UK could be housing association debt with a UK sovereign guarantee.

the UK government is offering a guarantee on up to £10bn of debt raised to fund housing. the policy went live in June and works through one of two schemes.

one is the Affordable Housing Guarantee Scheme, which will be run by Affordable Housing finance — part of the Housing finance Cor-poration (tHfC). through it, the government will guarantee up to £3.5bn of debt to lend to housing associations to rent properties to families in need.

the second is the £3.5bn private rented Sector Guarantee Scheme. this enables the likes of proper-ty investors and developers who want to manage homes specifically for private rental, to obtain cheap-er financing rates. the government is looking to attract greater institu-tional investment in this sector.

the government could boost the schemes by a further £3bn which it has kept in reserve.

“the Affordable Housing Guar-antee Scheme is very exciting,” says James Solomon, sterling syndicate at rBC Capital markets in London. “the tHfC group, which is running the scheme through a subsidiary, has a strong and successful record in the capital markets. We expect issuance under it to be longer dated — 10 years and out.”

Any deals are expected to price back of Network rail but inside where the best housing associa-tion debt trades — which is roughly between about Gilts plus 30bp and Gilts plus 90bp, according to one syndicate official.

the potential arrival of further debt issuers with government guar-antees is unlikely to take demand away from the UK’s only agency with an explicit sovereign guaran-tee, Network rail, even though it will pay a healthy spread over the rail provider.

“this is such a rare kind of prod-uct that even with the new scheme out it won’t cannibalise demand for other UK government guaranteed debt,” says Solomon at rBC Cm.

Still hope for local authorities? UK public sector bankers were set all of a flutter two years ago when the UK government whacked up the bor-rowing rate at the public Works Loan Board to 100bp over Gilts (from around 20bp). the move promised a rush of local authority issuance as capital markets finally began to look a competitive funding option.

But in autumn 2012 the govern-ment offered local authorities a 20bp discount for providing more information on their borrowing and spending plans, making pWLB loans as cheap as 80bp over. Suddenly capital markets looked expensive

again and bond issuance plans were put on hold.

the local authority market may not be dead, however.

“It’s a shame local authorities don’t look at issuing, whilst the mar-ket has been volatile over the last two years, at times it has offered opportunities to beat the pWLB,” says James marshall at Lloyds Bank commercial banking in London. “When the Greater London Author-ity got their deal away [in July 2011] at 80bp over Gilts, the itraxx was just over 100bp, in the inter-im spreads did widen significantly but now credit markets are trading tighter. tfL have traded at 60bp over Gilts and the GLA could achieve similar levels.”

A shortage of supply of triple-A or double-A rated debt in sterling aside from the sovereign, plus diminish-ing yields, means that demand for highly rated issuers, such as local authorities, that pay a decent pre-mium over Gilts should be highly prized by investors.

All together now?one way in which local authori-ties could make themselves more attractive is by clubbing together and forming an aggregated issuance vehicle.

“We’ve looked at aggregated issu-ance in the past,” says marshall. “We didn’t get it away in the end but it’s definitely a viable way for smaller issuers to come to the market. that said, it will depend on the names. Issuers would need to be very simi-lar to avoid cross-subsidisation of credit quality. County councils and city councils would work better for investors as they are more visible and have large diversified revenue streams.”

Even ratings aren’t too much of a bother for issuers, says marshall, as many investors are willing to do

Despite the uK’s downgrade this year, appetite remains strong for public sector issuers. And the potential of new issuers arriving on the scene will make this area one to watch. Tessa Wilkie reports.

Housing associations bring variety to tight public sector

“Network Rail has benefited from

a UK guarantee, and from the UK having

a much stronger credit story over the past few years than

many eurozone countries”

Dan Shane, Morgan Stanley

Public Sector borrowerS


the analysis themselves. “these are quasi-public sector issuers and investors are happy with the risk,” he says.

the pWLB, however, provides another slight sticking point to investors. they know that even if a local authority decides to come, if the market gaps out they can resort to the pWLB, so they will only ever likely be a fair weather borrower.

Investor work pays offon the surface, life looks set to get more difficult for Network rail, the authority responsible for the UK’s railway network. It faces an increased borrowing requirement for its next financial year (starting April 2014) of £6.5bn up from £5bn, and has lost its triple-A rating from two rating agencies.

However, its position as the only issuer with a direct UK guarantee and its sheltered position outside the eurozone during the currency bloc’s sovereign debt crisis, plus a lot of investor work, has enabled it to expand its investor base, insulat-ing the impact of those downgrades and leaving it in a strong position for its increased borrowing.

“this issuer treats markets with the utmost care,” says Stu-art mcGregor, head of European SSA DCm at rBC Capital markets in London. “It’s done a lot of work on expanding its investor base. Wearing the shoe leather out is the only way to do that.”

Samantha pitt, Network rail’s group treasurer in London, has plans to expand the investor base further: “there are still a few cen-tral banks that won’t buy our name but we’re working on it and we’ll keep working. We want to continue to expand and diversify our inves-tor base.”

And, although Network rail funds mainly in sterling and dollars, other currencies are an option.

“EIB did a Canadian dollar issue recently which we found very inter-esting,” says pitt. “While Australian dollars has been another popular currency for issuers this year indica-tive pricing has not been consistent for us since the downgrade. Because with the downgrade we are no long-er reserve Bank of Australia repo eligible, the pricing went all over the place. Some banks are putting

us as much as 20bp-25bp wide of KfW. Until we have more consisten-cy in Australian dollar pricing then we will hold off from looking at that market.”

Since the rail company became repo eligible with the Bank of Eng-land 12 months ago, bank treasur-ies — a growing pool of liquidity for SSA issuers as regulation means banks must have a certain percent-age of highly rated paper that they hold in order to bolster their liquid-ity reserves — have begun to buy. Bank treasuries bought 26% of Net-work rail’s most recent benchmark, a $1.75bn 0.875% may 2018.

“Network rail consistently is attracting new investor to its offer-ings, but there are still a handful of accounts that categorise Network rail as a corporate” says Dan Shane, morgan Stanley’s head of SSA syn-dicate.

“It does differ in that respect from some other SSA names, but that means that there is still scope for some upside spread performance for current holders, as there are a few central banks and bank treasuries yet to approve it.”

Network rail has increased its presence in the US since it set up a 144A programme three years ago. In its latest dollar benchmark, 29% was placed in the Americas.

“our dollar spreads have per-formed over the past two years, and we now trade in line with KfW, which is not bad for a double-A rated credit,” says pitt. “Even when the UK was downgraded we man-aged to keep our dollar levels in line with KfW.

However, if Standard & poor’s decides to make it a full house and downgrade the UK to double-A — the agency still has the sovereign on

negative outlook — that could hit Network rail’s spreads, she says.

But the rarity value of the cred-it — even a £6.5bn funding target puts it at about one tenth of what a KfW needs to raise each year — and being virtually the only way to get UK sovereign risk exposure outside sterling (aside from the Bank of Eng-land’s single annual dollar bench-mark) means its paper should con-tinue to be a popular buy.

“Network rail has benefited from having a UK guarantee, and from the UK having a much stronger credit story over the past few years than many eurozone countries,” says morgan Stanley’s Shane.

“As Europe starts to recover, the question has been will investors look elsewhere? that’s not been the case, investors have absolutely stuck with Network rail. In dollars it has con-tinued to outperform relative to its peers. that’s partly due to the size of the funding programme — it has rarity value, but it’s also due to the extremely high quality of its guaran-tee structure.”

transport for London, is anoth-er issuer that straddles the corpo-rate/public sector divide, although it is closer to the corporate side than Network rail as it lacks a govern-ment guarantee.

tfL, which resumed capital mar-kets bond issuance in 2012, having taken a break from bond issuance since 2006, has carved out a niche for itself as a quasi-corporate, quasi-sovereign issuer.

“tfL trades wider than Network rail, but is clearly in a different league to corporates,” says Solo-mon at rBC Capital markets in Lon-don. “they stand on their own at the moment. they’ve done a lot to expand their investor base. s

Network rail’s actual and forecast debt issuance by financial year

Source: Network Rail

0

1

2

3

4

5

6

7

8

2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19

£bn

Actual and forecast issuance by financial year

2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19

GBP-IL Issuance

GBP Issuance USD Issuance

Actual and forecast issuance by financial year

Forecast Issuance

NoN-Profit Sector


The non-profiT-making sector of the Uk economy is surprisingly large, and includes housing associations, universities, charities and parts of the national health Service.

Like the commercial corporate sec-tor — only in some cases, more so — non-profit entities are adjusting to new constraints on banks, and looking to institutional investors for long term capital.

Because of their close ties to the state, before the financial crisis hous-ing associations and universities could borrow from Uk or continental banks for 30 or 40 years at 15bp to 50bp over Libor. “Banks have realised that although these weren’t lossmaking loans, they were lending at lower rates than they could borrow at, and for longer terms,” says priya nair, man-aging director in debt capital markets at rBC Capital markets. “So they put pressure on the housing associations over covenants or when they had to renew loans, and muscled them into changing the terms or repaying.”

The housing associations had the largest debt needs, as they own 2.6m homes and are building more.

“We are open for business with the housing association sector, which we view as very secure and stable,” says

grant Vaughan, associate director, cor-porate debt capital markets, Lloyds Bank in London.

Banks now typically only lend up to five or seven years, not 30. Spreads have risen to more than 100bp or 150bp over Libor.

“The headwinds the housing asso-ciations have faced have caused them to think about other options than just going to their relationship banks,” says nair. “We have been advocating that the bank market is there for short dated and undrawn finance, up to five years, while drawn and long dated debt should come from the institution-al market.”

There have been housing associa-tion bonds since at least the 1990s, but issuance soared in 2012 to £3.3bn, three times more than normal.

Larger associations like Sanctuary, genesis and London & Quadrant were repeat issuers, but a new generation joined their ranks — names like Saxon Weald, great places, raglan and mid-land heart. Some of these are large, others have only 6,000 homes.

A ready marketfar from suffering indigestion, inves-tors have lapped up the deals, since they are desperate for sterling bonds

to buy, as Uk companies do much of their funding in euros and dollars.

greater issuance has tempted more investors to take the trouble to under-stand the social housing sector, so that where deals used to go to a few hand-fuls of investors, now order books often contain 40 or 50. Spreads have tightened markedly.

“The range is about 80bp-140bp over gilts now — about two years ago it was more like 160bp-170bp to 200bp-210bp,” says nair.

Some believe investors are only now pricing the sector properly. “These are highly rated borrowers and they should trade tightly,” says one banker. “Low single-a utilities trade at 105bp or 110bp over gilts, so for some of the best housing association credits which are high single-a or double-a from S&p to trade 15bp to 20bp through them feels quite reasonable.”

Banks like Lloyds Bank and rBC have encouraged investors to differ-entiate in pricing between the larger, stronger and better run housing asso-ciations and their weaker brethren.

investors’ hunger for paper has also made them scrap taboos about only wanting deals of £250m or more. pub-lic bonds down to £100m now attract plenty of investors, and private place-ments have appeared — sometimes the subject of fierce bidding wars.

in July, Canaccord managed to get in this way a spread of just 112bp over gilts for Saffron housing, a small debut issuer, on a £75m 35 year bond.

“at least five or six investors, which tend to be the larger, more sophisti-cated ones, are willing to buy deals that are small and unrated, off bond or loan documentation,” says Vaughan. “The demand from US investors is still there, but has not been so competitive with Uk demand this year.”

Bankers warn associations against thinking they will save money by cut-ting out the banks. “Whatever the

Little by little, the government has stepped back from areas of state provision. Into the vacuum has come private capital, in many forms. Housing associations now rely heavily on bond investors. Universities are beginning to move the same way, and across several sectors, project-style PFI financings are finding their way into institutional investors’ hands. Jon Hay reports.

Homes, colleges, hospitals: bond markets finance social goods

The UK’s NaTioNal health service is no monolith but a network that includes state bodies, independent public sector compa-nies like the Nhs Trusts that now run hospi-tals, and private doctors’ practices.

Financing new hospitals has been since the 1990s an important field for the pri-vate finance initiative (PFi). Private com-panies have built many hospitals and pro-vided cleaning and maintenance services on 30 year concessions. From 1998 to 2008, bonds financing such projects were com-

monplace, often using guarantees from monoline bond insurers.

They vanished when most monolines blew themselves up with structured credit investments in the crisis. since then, most health PFi deals have gone to banks, includ-ing Japanese banks, still willing to lend long term to such projects.

a few deals are getting done private-ly, such as the £237m alder hey Children’s health Park in liverpool, closed in March, with M&G iM and the eiB as lenders. s

Hospital PFIs take private route

NoN-Profit Sector


banks are making in fees is easily off-set by saving only 2bp or 3bp of mar-gin by getting the best bid from the investors,” says one.

Legal & general investment man-agement is one of the most active pp investors, for its annuity fund. “We’re investing in them because they need long dated debt and they offer a rela-tively good track record with respect to their operating and default history,” says georg grodzki, head of credit research at L&g in London. “Liquidity is of secondary importance.”

Not set in stoneBut the sector’s outlook is not cloud-less. The failure of Cosmopolitan housing association in 2012 led to criticism of the regulator, the homes and Communities agency, though it

orchestrated a takeover of Cosmopoli-tan by Sanctuary ha.

The episode showed the sector can resolve failures without harming investors. “The beauty of this sector is that no private sector lender to it has ever lost a penny,” says a banker.

more encouragingly for associa-tions, the government gave them a present in June: the offer of £450m of grants and £3.5bn of loan guarantees for affordable housing providers, with up to £3bn more in reserve.

if the government’s collateral and other requirements are not too oner-ous, housing associations might be able to issue government-guaranteed bonds at perhaps 60bp over gilts — a material spread saving, but not game-changing.

in the long term, grodzki says,

“The sector’s framework and struc-ture is changing and risks are likely to increase, with government support being gradually withdrawn.”

one hypothetical scenario is that the government could become disen-chanted with having 1,500 associa-tions, not all well managed, and try to consolidate and commercialise them, introducing conventional profit-driven capital structures.

investors will be on their guard. The precedent of building society demu-tualisation, which led ultimately to the failures of hBoS, northern rock, alliance & Leicester and others, is not encouraging. The housing association sector’s record of a non-profit-driven commitment to social housing, com-bined with an unblemished credit his-tory, has much to recommend it. s

UNiversiTies are aN extremely rare species in europe’s bond market ornithology, unlike in the Us, where many colleges issue bonds.

in the first half of 2012 there was a sudden spate of 30 year bonds from Us universities, prompted by exceptionally low interest rates. “They can be very opportunistic,” says Mar-cus hiseman, head of european corporate debt capital markets at Morgan stanley in london. “a lot of it comes from the endow-ment side. They know their assets are yield-ing more than the rate they can borrow at, so they put a little leverage on their funds, like Wellcome Trust did.”

The £550m 30 year bond for the aaa/aaa rated UK medical research charity was priced in 2006 at 44bp over Gilts. it was a key pricing benchmark when, in another flash of glamour for the sterling market, the University of Cam-bridge issued its first bond in october 2012.

There have been half a dozen other private and public UK university bonds, most recently De Montfort University’s £110m issue in July 2012. The 30 year aa1 rated bond was priced at around 260bp over Gilts.

But Cambridge’s £350m 40 year bond, led by hsBC, Morgan stanley and royal Bank of scotland and paying just 3.75%, trumpeted the arrival of a new market.

Cambridge had been deliberating on the deal since 2007, to finance new research fa-cilities. But the prompt for many universities like De Montfort has been falling grant sup-port, forcing them to maximise revenue by at-tracting high-paying foreign students and cor-porate donors with modern facilities.

“The Cambridge deal was incredibly well

received,” says hiseman. “Most of the big sterling investors said this was a must-have. i have never seen them show their hands to the extent they did, putting a super-aggres-sive level on the table for us to begin with.”

rated aaa, Cambridge priced at 60bp over Gilts, achieving its goal of being classed with its Us ivy league peer group, and coming 2bp inside triple-a Johnson & Johnson, 12bp tight-er than Transport for london and 20bp inside Wellcome Trust.

The University of Manchester followed in June 2013, with a £300m 40 year bond rat-ed aa1 at 80bp over Gilts, about 25bp outside Cambridge.

several other universities have got rat-ings. “We’ll see more deals come through,” says hiseman. “it takes a lot of time for or-ganisations like universities to go through an

approvals process. But it’s great for the economy — this is exactly how investors should be spend-ing their money.”

investing in university in-frastructure, he argues, helps to foster centres of innovation around universities and creates benefits for the local economy.

another strand of university financings is those done off-bal-ance sheet, such as the project financings this year for the Uni-versities of edinburgh and hert-fordshire. The later had issued a PFi-style bond in 2002, but returned this year for another major campus development, fi-

nanced with a £143.5m bond, placed by rBC Capital Markets with legal & General iM, en-tirely in index-linked form.

These projects were structured PFi-style, through private consortia. The £62m holy-rood student accommodation deal for edin-burgh in July — and a £102m housing deal in leeds a couple of weeks earlier — were nota-ble for marking the return of monoline wraps.

assured Guaranty, the only monoline still operating in europe, still has pre-crisis guarantees on £8bn of european bonds, but since 2008 had only given one fresh guarantee, on an old hospital PFi bond pre-viously wrapped by ambac. The leeds City Council housing refurbishment PFi bond, placed by lloyds Bank, and rBC’s edin-burgh deal showed monolines could add value on new project financings. s

Universities head for bonds — on or off balance sheet

Cambridge University: an 800 year track record

Banking Sector


Britain’s modest economic recov-ery has supported the banks’ reha-bilitation after the crisis of 2008-09. “there are not too many danger signs in the UK economy. in many ways, the backdrop is more benign for the banks than many people thought it would be two years ago,” says simon adamson, Ceo and senior analyst, european banks, at Creditsights in London.

against this improving back-ground, the country’s banks are performing more strongly on many measures. “We’ve seen for a while that the banks have been gradually improving their balance sheets, capi-

tal ratios and non-performing loan coverage,” notes roger doig, credit analyst at schroder investment man-agement in London.

He cites in particular the govern-ment-owned Lloyds Bank and rBs’s reduction of non-core assets, their writing down of their irish exposures and some progress on their commer-cial real estate lending.

importantly, banks have also bol-stered their depleted capital. “the capital situation at most banks has improved tremendously,” says Clau-dia nelson, senior analyst, financial institutions, at Fitch ratings.

“a number of the banks are remark-ably well into the process of recapital-isation,” agrees doig, who compares

UK lenders’ progress favourably with that of the major French banks — though they started from a position of higher asset quality.

improved fundamentals have won better support from inves-tors. “From a credit perception and spread perspective european banks and especially the UK names have come a long way in the last 12 months. UK financials are now viewed as some of the most defen-sive names in europe,” reports david Carmalt, head of financial institu-tions, dCm, Lloyds Bank.

No longer negative…the sector’s progress was evident recently when moody’s upgraded its outlook on UK banks to neutral from negative. the agency acknowledges the supportive operating environ-ment, including stable interest rates (though the very low level of rates has been challenging for some lend-ers’ net interest margins, it appears to have served to keep borrowers cur-rent who would have struggled oth-erwise).

Consensus is for UK rates to start rising in 2015, though Bank of eng-land governor mark Carney has indi-cated this may not occur until 2016.

moody’s hails improvements in a number of key areas, such as funding and liquidity. “there has been a real-ly material improvement in the UK banks’ funding position,” believes Laurie mayers, associate managing director, financial institutions group at moody’s.

some observers attribute this to the Bank of england and UK treas-ury’s Funding for Lending scheme, which seeks to incentivise banks to lend to small and medium sized enterprises by giving them access to central bank refinancing. the Bank and Hmt extended FLs this april. others point to a terming out of the

sector’s previously heavy reliance on money market funding.

earnings are improving for anoth-er reason besides fundamentals, according to analysts. Hefty con-duct charges imposed on banks for mis-selling both consumer and cor-porate products, such as payment protection insurance (PPi), interest rate swaps and Libor, are now start-ing to fall away — though individual institutions continue to attract fines, as in the case of Barclays (recently forced to compensate borrowers for administrative mistakes on personal loans and threatened with a substan-tial penalty over its crisis-era sale of a stake to the Qatar investment authority, though the bank is appeal-ing this).

…but risks remaineven so, moody’s views these posi-tives as offset by negatives like remaining risk on the banks’ commer-cial real estate loans. “Pressures on the ratings are balanced. We don’t see any bias to either upgrade or down-grade,” mayers notes.

moreover, not all UK banks are recovering equally well. While most of the sector is improving, “some banks are buffeted more than the others by continuing negative factors,” says nelson at Fitch. these are headed by some banks’ continuing exposures to commercial real estate, ireland and continental europe.

the sector’s credit ratings are much lower now than some years ago, Cred-itsights’ adamson notes. apart from HsBC, they are also quite low relative to european peers. Besides the banks’ continuing problems, this reflects the coalition government’s determination to avoid future bail-outs of struggling banks.

Stringent regulationthis determination is reflected in a

With UK banks now sufficiently attractive for the government to finally shed a first tranche of its holding in bailed-out Lloyds Bank, the sector looks at its healthiest in years. Capital ratios, net interest margins and asset quality are all up, while funding costs have fallen. But some analysts see the unexpectedly aggressive environment under the new Prudential Regulatory Authority (PRA) raising the risk of lenders being forced to recognise remaining losses before their recapitalisation is complete, reports Julian Lewis.

Banks’ balance sheet repairs begin to pay off

“There has been a sea-change in UK regulators’ view of subordinated and

hybrid capital. If not equivalent to equity, they see it as close

to equity.”

Simon Adamson, CreditSights

Banking Sector


new regulatory approach that has transferred supervision of banks to a new department twithin the Bank of england, the Prudential regu-latory authority. “the prompt for this change of approach has been the severity of the financial crisis, a crisis that has been through a sear-ing phase of prudential problems — failing banks,” acknowledged andrew Bailey, the authority’s Ceo, in a recent speech.

“the Pra has taken on its new role in a very strong and very serious way,” says Fitch’s nelson. she cites the authority’s requests for additional information from the banks it super-vises, its “quite strong” statements on the sector and its use of rigorous stress analyses.

the Pra’s most critical impact has been to force banks to up their capi-tal. While the authority has not gone as far as suggested by sir John Vick-ers, who chaired the government-mandated independent Commission on Banking in 2010, analysts regard its intervention as significantly more demanding of banks than previously. (sir John recently called for lenders to double their current capital buffers against future losses.)

“our impression is that UK bank reg-ulators have been more forceful than others,” comments Johannes Wassen-berg, managing director, emea bank-ing, at moody’s in London. He regards it as “in general positive” that UK banks have been obliged to strength-en their capital ratios and resolve their problem assets.

“We were surprised at how aggres-sive the Bank of england was,” agrees schroders’ doig. For years regula-tors in the UK allowed banks to take a gradual approach to recovery. But more recently the central bank indi-cated that after four years of very accommodating monetary policy it

would be better for the UK economy if banks were to recognise losses and start lending again.

soon afterwards the Pra reviewed the capital adequacy of banks and building societies. not only was the sector collectively lacking some £27bn of capital at the end of last year, though this deficit had improved to £13.4bn by June, but it also found that some institutions fell short of a new 3% leverage ratio target (calculated under Basel iii and Crd iV).

the clearest victim of this rapid change of stance was the smaller lender Co-operative Bank. even after abandoning a plan to buy some 600 branches from Lloyds Bank, it had to launch a £1.5bn effort to rebuild capi-tal — including an end to its mutual ownership through a partial equity market listing. next month Co-opera-tive will conclude a liability manage-ment exercise that should generate most of the capital it needs by bailing in junior bondholders.

But the much larger Barclays and nationwide were also caught by the speed of the shift. after initially insist-ing that it would reach another Pra target — adjusted 7% fully-loaded common equity — by the end of the year “without recourse to equity capi-tal issuance” and would reduce lever-age “over time”, Barclays subsequently had to launch an underwritten £5.8bn

rights issue (one new for four existing, at a discount of some 40%).

together with deleveraging meas-ures and the issue of new quasi-equi-ty, this should allow it to meet the 3% leverage target. the bank calculated its result on this measure as 2.2% at the end of June (though Pra put it at 2.5%), a £12.8bn shortfall.

Rapid recognition?For bondholders, the biggest risk over the sector is the possibility that regu-lators force further banks to rapidly recognise any hidden losses and put additional capital against them, judg-es schroders’ doig. “if that is the case, there is a risk to junior bondholders of some kind of burden-sharing, given the environment.”

He contrasts this approach with “normal crisis recovery” in which lenders gradually rebuild loss-deplet-ed capital by retaining the earnings from their higher quality, newer loan portfolios.

“there has been a sea-change in UK regulators’ view of subordinated and hybrid capital,” agrees Creditsights’ adamson. “if not equivalent to equity, they see it as close to equity. that is always a threat to bondholders if there is a capital gap.”

the question of how long the banks get is ultimately a political one, doig concludes. “it is out of the banks’ hands.” nelson at Fitch connects this to the Pra’s task of providing “very tight overview to ensure the stability of the sector without any future need for government support.”

“the direction of travel is very clear. it is a question of the timeline and how far regulators and govern-ment will go with bank legislation and requirements for structural and opera-tional changes,” adds Wassenberg. He notes “significant impediments still” to the resolution of large, complex banks and great uncertainty — even with bail-in and ring-fencing of invest-ment and retail operations in place — over whether this could be achieved without triggering consequences for the entire banking system.

While the regulatory environment has become more stringent, analysts are concerned at a lack of transpar-ency over some important aspects of supervision. “the thresholds are not clear at which regulators deem banks to be viable. We can’t see the leeway,” Wassenberg notes. this can lead to

2012 2011 2010 2009Pre-provision income/risk-weighted assets 2.2% 2.3% 2.8% 2.9%

Net income/risk-weighted assets 0.8% 0.7% 0.7% 0.4%

(Market funds – liquid assets)/total assets (4.3%) (1.5%) 1.7% 4.9%

Gross loans/due to customers 84% 91% 113% 120%

Cost to income ratio 64% 62% 56% 54%

Tier one ratio 13.2% 12.6% 12.7% 11.6%

Tangible common equity/risk-weighted assets 12.7% 12.5% 12.5% 10.0%

Problem loans/gross loans 5.1% 5.4% 5.5% 4.6%

Problem loans/(shareholders’ equity + loan loss reserves) 32.7% 36.5% 38.7% 39.1%

Key indicators for the UK banking system

Source: Moody’s

“The PRA has taken on its new role in

a very strong and very serious way”

Claudia Nelson, Fitch Ratings

Banking Sector


negative surprises such as unexpected disclosure of capital deficits and over-leverage, he says.

“’regulatory risk’ is something that many issuers cite,” adds Carmalt at Lloyds Bank. “regardless of your cur-rent capital position or progress made with regards to reaching new targets, regulators can always decide to con-sider a new metric.”

However, mayers sees scope for greater clarity on banks’ overall capi-tal requirements when standardised Basel iii buffers are adopted. “today the buffers are not disclosed.” Banks are even discouraged from discussing them, according to some in the sector. Clarity would increase further if Pil-lar 2a becomes part of the regulatory minimum, mayers adds.

the Pra’s recent actions to ensure large UK banks are adequately capi-talised are not a dramatic shift in approach given their existing prac-tises of using Pillar 2 add-ons and setting stressed capital buffers, she judges. “it is not a 360 degree change. this is taking things one step further,” she argues, citing the interim capi-tal and liquidity regime that the UK authorities put in place as far back as 2008/09.

moreover, the Pra is only one ele-ment of the new regulatory environ-ment. the Bank of england’s Finan-cial Policy Committee provides a

macro-prudential direction for the Pra’s supervision of the sector. its ability to direct the authority to inves-tigate sector-wide issues and to use macro-prudential tools such as adjust-ing risk weightings on commercial real estate is “a very important devel-opment,” she comments.

the FPC’s role and the debate it inspires also stand out because few other countries operate similar bod-ies, adamson at Creditsights says — though he notes a tension between the committee’s prudential, risk-damp-ening mission and its mandate to encourage lending in support of eco-nomic growth.

a key test of this will be when banks start upping the risk of their domes-tic lending — particularly mortgages — for the sake of higher revenues, he believes. “it will be interesting to see when the next asset bubble arises how effective the FPC will be in pricking it,” agrees Wassenberg.

Capital claddingWhile UK banks are starving the senior debt market of supply, thanks to their improved funding positions, they are likely to issue new subordinated and hybrid capital, bankers report. some could do so this year.

For one thing, the Pra is pushing them hard to hold additional capi-tal. For another, regulators have now

finally given a definitive view on new forms of bank capital under Basel iii. as investors now assess their cred-it strength on the basis of the new regime’s fully-loaded version, this enables banks to respond with instru-ments that will receive full credit.

“Banks are now, after further clarifi-cation of which structures are expect-ed to be compliant, in a much better position to plan their capital stacks as we head into Basel iii, with both tran-sition of legacy instruments and the structure of new-style capital far clear-er,” says Lloyds Bank’ Carmalt.

Higher-trigger 7% at1 debt should enable lenders like Barclays and nationwide, the country’s largest mutually-owned building society, to meet the Pra’s 3% target leverage ratio. But now banks are bracing for the Pra to raise its new benchmark beyond 3%.

“a number of investors have ques-tioned whether leverage ratio tar-gets may be increased. While there is always that chance, most issuers we speak to think that this is unlikely,” Carmalt reports. “it is inevitable as banks start to comply that the target will be pushed higher. it is easy to see it going up to 4% and it may go high-er,” believes adamson at Creditsights, who notes that UK banks’ leverage is currently quite high on this measure relative to banks elsewhere. s

The UK governmenT’s reprivatisation of Lloyds Bank and rBs is now under way. In september UK Financial Investments, the holding vehicle for the state’s stakes, sold 6% of Lloyds Bank in a £3.2bn placing. The shares were discounted to a level of 75p, just above the price at which the Treasury bought into the bank during its 2008 rescue — and com-fortably above its indicated 61p break-even.

The further 33% of Lloyds Bank that re-mains in public hands could be shed in time for the 2015 general election, analysts judge. This might be achieved in part through a re-tail-targeted public offering, the coalition gov-ernment has suggested.

The bank’s saleability reflects what Denzil DeBie, director, financial institutions at Fitch ratings, terms “certainly a turnaround from several years of loss-making”. he applauds the bank’s “de-risked balance sheet, smaller tail risks and provisioning levels that mitigate

large losses in Ireland.” “Lloyds Bank is now a straightforward

story — basically a UK retail and commercial bank,” concludes simon Adamson, Ceo and senior analyst, european banks, at Credit-sights.

rBs — where the government’s holding is a far larger 81% — is a significantly more sub-stantial challenge, observers agree. most ex-pect the Treasury’s current strategic review to affirm that the costs of a good bank/bad bank split would outweigh the benefits. But consensus is that the institution’s commer-cial real estate exposures and its ownership of the troubled Ulster Bank, a major lender in both the republic and northern Ireland, will require further action.

one option is for rBs to reduce its size fur-ther, says Adamson. For example, it could pro-ceed to a full sale of Citizens Bank in the Us (rather than the partial sale rBs announced

in February), shrink its investment bank fur-ther and/or cut Ulster Bank back. The ‘divi-dend access share’ that prevents it making payouts to shareholders could also be altered.

The bank has returned to profitability, earning £1.4bn in h1 13 compared to a £1.7bn loss in the same period last year. But despite this performance the UK Business secretary, vince Cable, recently indicated that rBs is unlikely to be reprivatised before the current Parliament ends or “probably” inside five years.

While rBs’s operational performance is close to that of Lloyds Bank, Adamson accepts that the institution’s greater institutional and political complexity will make an eventual sale more challenging. he warns that the val-uation of the bank’s assets that Blackrock is undertaking as part of the Treasury’s review could trigger a further need for capital if rBs is found to have overstated their value. s

Progressing privatisation

Bank finance


UK banK issUance figures make grim reading for syndicate desks. RMbs deals in 2013: four. Pub-lic senior unsecured benchmarks in euros and sterling in 2013: four. covered bond deals since May 2012: zero. The only bright spot for investment bankers with transac-tion fees to consider has been the capital market, to which banks and insurers have been driven in

the last 12 months by regulatory demands.

but the country’s nascent eco-nomic recovery gives those bank-ers renewed hope. as a very general rule, UK banks are long liquidity and short capital. next year FiG bankers predict they will have less of the former and more of the lat-ter, as credit demand improves and banks issue capital either to meet basel iii-compliant ratios or replace old instruments with new ones rec-ognised by the european Union’s capital Requirements Directive (cRD iV). There is even talk of a UK covered bond hitting the market in the next few weeks.

Taking into account that ‘normal’ issuance levels will be half or even a third what they were pre-crisis, 2014 could finally be a full year to which that word applies.

“if we continue to see the eco-nomic situation in the UK improve in the way it has been, and if we

continue to see an improvement in the UK housing market, the demand for credit from UK banks will increase from both the retail and the corporate sector,” says David Hague, head of UK & ireland Fi debt capital markets at Royal bank of scotland.

“On the back of that we may see a return to a more normalised fund-ing requirement from UK banks in 2014, and they can hopefully start to enjoy the benefits of the second-ary spread compression we’ve seen in the last 12-18 months.”

Can’t lend, won’t lend?in those last 12-18 months UK banks simply have not needed the money. banks say there is precious little demand for loans from creditwor-thy companies and individuals, no matter what the government says.

The UK economy has been stag-nant at best for the past three years. individuals have held off on buying that new car and companies have held off on acquiring that new com-petitor. as a result, retail and corpo-rate deposits have swelled, and they are a very cheap alternative fund-ing source. Loan to deposit ratios at the major UK banks have decreased between 10% and 30% since 2011, while customer deposits are around 10% higher and wholesale funding some 40% lower.

into that environment the gov-ernment launched the Funding for Lending scheme in July 2012, offer-ing banks yet more cheap funding at 25bp over the bank of england’s base rate, provided their sterling lending to UK households and non-financial companies was flat to positive between June 2012 and December 2013.

Despite the obvious appeal FLs withdrawals have been limited, at least from the larger UK banks. The extra cost incurred for failing the

terms are high — an extra 25bp for every 1% fall in net lending — and banks don’t want a choice between lending to riskier credits and taking the penalties for not doing so.

“General bank deleveraging, a reduced demand for credit, and increased retail and corporate deposits have all affected the issu-ance profile of UK banks,” says Hague.

“but has the Funding for Lend-ing scheme had a material impact on UK bank issuance? no.”

but putting collateral such as mortgages and credit cards in repo with the boe in exchange for FLs funds can make wrapping them up into securitized products look like an awfully expensive process.

“it is not the biggest factor behind the lack of issuance, but the FLs has clearly had an impact, in particular on the secured market,” says cecile Houlot-Hillary, co-head of FicM FiG coverage in eMea at Morgan stanley.

“Once the FLs was in place it just wasn’t economic to do a securitiza-tion or a covered bond versus where the banks could get money from the bank of england. but it has also had a positive impact in that UK banks have been able to show investors they don’t have a funding need, so they shouldn’t have to pay a premi-um when they do come to market.”

Little, and not oftenas syndicate bankers are fond of saying, it is always best to visit the funding markets when you don’t need the money. but there are downsides to not issuing very often, particularly for smaller issuers.

“Lloyds bank and Rbs, for exam-ple, have a lot of paper outstand-ing,” says Houlot-Hillary. “even though they are not out there in the primary market they still have a lot of secondary paper that is getting

Heavy deleveraging, a sluggish economy and a central bank that has plied lenders with cheap cash have combined to make UK bank issuance in some markets almost extinct. But with the economy’s green shoots reaching for the light, 2014 may be the year UK banks emerge from their self-imposed blackout, writes Tom Porter.

Banks ready to reclaim their place in the markets

Liquidity rules will be relaxed once

the eight biggest institutions all meet a

7% common equity tier one ratio under Basel III, in order to

stimulate lending

Mark Carney, Governor of the

Bank of England

Bank finance


traded and is very liquid. “The lack of supply is more of an

issue for the mid-size banks, which don’t have many benchmarks out there. For them it is important to have investor engagement and to consider tapping a very strategic part of their curve even if they don’t need the money. it is important to have a reasonably liquid senior curve if you want to issue capital.”

smaller lenders could do worse than santander UK as a role model for keeping a credit visible for investors. The bank has issued five and seven year senior unsecured deals through abbey national this year, as well as a small 30 year deal in the Us, adding liquidity to its curve and completely re-pricing it in the process.

Leading the dialogueWhen banks do return to the fund-ing markets they will find an inves-tor base that is impressed with the country’s response to finan-cial instability. UK banks are seen increasingly as a defensive play in the financial sector, a view that has been enforced by a push for tighter regulation.

“Feedback received from insti-tutional investors suggests the UK banks are a key overweight in both funding and regulatory capital asset classes,” says David carmalt,

head of financial institutions, DcM, Lloyds bank. “The improvement in the credit profile of these institu-tions and the rapidity with which they have worked to adopt new liquidity and capital standards all works in their favour.”

at the forefront has been the Prudential Regulation authority, which opened its doors on april 1 to replace the now defunct Financial services authority as the bank of

england’s city watchdog, and set out to implement basel iii capi-tal ratios and the new 3% leverage ratio faster than everyone else.

“The PRa has been leading the european dialogue on things like total capital levels and particular-ly the leverage ratio,” says Houlot-Hillary. “That is going to have a big impact in 2014 as its view on capital is really transforming the strategies of banks. They will have to look at their existing capital structures and work out how they are going to transition into a new regulator-led capital structure.”

it is hard to argue that a better capitalised bank is a worse invest-ment, but a valid concern for inves-tors is whether tough regulation will drag on the profitability of UK banks as the economy picks up.

“investors take comfort from well regulated issuers,” says Hague, “but it is fair to say that issuing capital is expensive relative to senior fund-ing, even for the strongest issuers.”

The UK’s financial custodians have sought to temper that concern. in his first speech as governor of the bank of england Mark carney said liquidity rules will be relaxed once the eight biggest institutions all meet a 7% common equity tier one ratio under basel iii, in order to stimulate lending.

investors marking the PRa’s card will have one eye on the situation at the co-operative bank, which is set to attempt a controversial exchange offer in October that would convert its subordinated debt into senior bonds issued by the bank’s parent The co-operative Group. if the exer-cise fails — and there is no shortage of opposition — the regulator may have to reveal how hard it is pre-pared to hit senior bondholders in a bank rescue.

Parking the supertankerFiG syndicates are optimistic about UK bank issuance before the end of the year and throughout 2014. There is certainly plenty of capital that needs to be issued or replaced, but bankers also report a desire from UK banks to pre-fund for 2014 in senior unsecured.

“senior should be the market where we see supply increase first, because it much more readily fits in with the primary loss absorbing

capital (PLac) consideration,” says Hague. “With one eye on the PLac, another on encumbrance ratios and another on their modest funding requirements, i expect UK banks will look to issue senior where pos-sible.

“RMbs will remain a popular source of funding but it is difficult to see covered bond supply recover-ing as quickly.”

The UK economy grew by 0.7% in the second quarter of this year, and the Office for national statis-tics expects an identical figure for the third. The economy has now recouped nearly half of the 7.2% of output lost during five consecutive quarters of contraction in 2008 and 2009.

The buyside is growing more con-fident about the economic recovery. When bank of america surveyed investors in the second week of sep-tember they found that 54% want-ed companies to boost their capi-tal spending, the highest figure for eight years.

Deposits are cheap and relia-ble, but banks are keen to see them fall to kick off that virtuous cir-cle between cash withdrawal and increased economic activity. it is only that economic activity that will enable them to increase lending, and by doing so return to the pub-lic markets they know and love for a reason.

“a number of banks and building societies we speak to describe the control of retail funding inflows as being like trying to steer a super-tanker, as it is very difficult to rap-idly alter the level of deposit tak-ing,” says carmalt. “One of the benefits of funding in the wholesale markets is borrowers are able to be highly prescriptive as to the quan-tum they raise at any given point in time.” s

“The PRA has been leading the

European dialogue on things like total

capital levels and particularly the leverage ratio”

Cecile Houlot-Hillary,

Morgan Stanley

“One of the benefits of funding in the

wholesale markets is borrowers are

able to be highly prescriptive as to the

quantum they raise at any given point

in time”

David Carmalt, Lloyds Bank


UK Credits Roundtable

EUROWEEK: What have been the greatest changes in the market since the start of the financial crisis five years ago?

Gary Admans, BP: Increased volatility has been the main theme in all markets over the past few years. The European markets close more often than they ever did and in the US pricing is far more volatile.

Samantha Pitt, Network Rail: There have been times when even as an SSA issuer the market has been closed. A couple of years ago the markets closed and we couldn’t access financing in the same way that we had before. Also, there is increased regulation on banks and more focus on counterparty credit risk which needs to be managed. Finally, market volatility has become more of the norm and needs to be navigated.

Farouk Ramzan, Lloyds Bank: You have to have been living in a cave if you didn’t think the last five years was the greatest period of systemic change ever seen in the financial world.

EUROWEEK: How has the approach of UK borrow-ers to financing changed over the last five years?

Nilay Patel, William Hill: When the financial crisis hit we were a FTSE 250 corporate, financed from the syndi-cated bank loan market. We were one of those corpo-rates that got a little bit caught out by the credit crunch in having all our debt financing from one market. The lesson we’ve taken on board is that it’s important to maintain a diversity of funding markets and so over the last few years we have diversified more into the cor-porate bond market. We’ve also reduced the absolute


Gary Admans, head of funding, treasury, BP

Ben Birgbauer, treasurer, Jaguar Land Rover

Marcus Hiseman, head of European corporate debt capital markets, Morgan Stanley

Simon Kilonback, group treasurer, Transport For London

Nilay Patel, group treasurer, William Hill

Samantha Pitt, group treasurer, Network Rail

Farouk Ramzan, head of capital markets origination, Lloyds Bank

Christoph Seibel, head of corporate debt capital market Europe, RBC Capital Markets

Nina Flitman, moderator, EuroWeek

Crisis over — now the hard work begins for UK credits

UK borrowers have always been different to their European counterparts. Historically, they have been much more diversified when accessing global capital markets than their continental cousins, while also being able to rely on a core group of international — and not just UK — banks for syndicated loans. But like all borrowers, they have felt the effects of the volatility in capital and bank markets over the last few years and have been forced to adapt their financing strategies to suit.

However, after five years of seemingly unrelenting market crises, the light appears to be shining at the end of the economic tunnel — recovery is finally in sight.

So just how will UK borrowers approach markets in the new financing environment and have their funding strategies shifted permanently after years of turmoil? How will rising interest rates determine their choice of instruments and just how will they respond to the potential return of M&A? To find out the answers to these and other key questions, EuroWeek invited some of the country’s leading corporate borrowers and their banks to describe their recent experiences in the capital markets and predict what the future holds for them and the markets.



amount of leverage we’re comfortable with, reflecting the economic conditions and the wider investor environ-ment.

Simon Kilonback, Transport For London: We’ve moved from borrowing almost exclusively from central govern-ments and agencies such as the EIB to actually issuing directly into the capital markets. We have never been reliant on wholesale bank funding in the way some corporates were, so we haven’t felt that contraction in the availability of bank financing. We are aware of this contraction though, as we saw the value for money of PFI deals decrease as the financial crisis made it much harder and much more expensive to raise long term debt. Banks were far more reluctant to take that project risk. So whereas we may have financed projects or rolling stock through PFI or leasing deals in the past, that market is very different now. For us, it’s now much more efficient to finance those purchases on balance sheet, and raise the money ourselves through the capital markets.

Christoph Seibel, RBC Capital Markets: For borrow-ers across Europe, there was a historic over-reliance on the bank market. The onset of the financial crisis and the Lehman Brothers insolvency in particular has changed the mindset of the European treasurer of large cap cor-porates. Issuance activity across the capital markets has gone up. In 2008, UK investment grade issuers had about £16bn in new deals, while in 2012 it was more than dou-ble that at around £35bn. The UK issuer base was always more capital markets friendly than some of their conti-nental European counterparts, but still their diversifica-tion into the bond markets has significantly increased.

Ben Birgbauer, Jaguar Land Rover: Our situation has been somewhat unique. The financial crisis was par-ticularly difficult for the auto sector, while it also came before we had a chance to set up the JLR Treasury organi-sation after the business was acquired by Tata Motors in 2008. During that financial crisis — with the difficul-ties in the auto sector and with new bank relationships to be built — bank credit was very hard to come by. We wound up having to fund the business with very com-plicated secured debt transactions, generally for shorter terms. As our business turned around and performed strongly over the last few years, we saw an opportunity to get credit ratings and access the capital markets. Since then, we have refinanced all of that secured bank debt that we had raised with long term unsecured bonds in the high yield market. We’ve also grown our cash balanc-es and put in place a significant undrawn long term bank credit facility for liquidity insurance.

Ramzan, Lloyds Bank: The development of the sterling high yield market in the UK is interesting. Issuance is up markedly from 2009 to 2013 — issuance year to date is about £8.7bn while last year it was £3.3bn. That’s a huge difference. There are several reasons behind this — you’ve got investors hunting for yield, a greater appetite for risk and maturity to get that yield, and also a willingness by those investors to take up the slack from the banking mar-ket as the banks experienced a reduction in the liquidity they were able to offer in the lending market. Having said that, the HY market is quite sensitive to changes in senti-ment and it shuts down when the public markets catch a bit of a cold, but it’s not going to go away.

EUROWEEK: How have borrowers branched out into international markets?

Pitt, Network Rail: We’ve always gone to the interna-tional markets. Around half of our investor base is inter-national and they’ve always been very important to us. Our core markets are sterling and dollars, roughly split 50/50 between those two currencies. Obviously we’re active in sterling, where we’re the Gilt surrogate with an explicit UK government guarantee, but we’re more focused on dollars now. Dollars is the global currency of choice for most international investors, and as a big issu-er you can’t afford not to issue in US dollars. We started doing 144A issuance three years ago, so the US investor base has become more important to us.

Ramzan, Lloyds Bank: There has been a dramatic increase in the last five years of UK borrowers going to the US dollar markets. Last year, UK issuers raised about 51% of their financing in the dollar market, so there’s more dol-lar issuance than sterling issuance. That may be due to the basis swap, which over the last year has been particu-larly strong, but there has been a stronger argument for UK issuers to go to the dollar markets generally. The US market hasn’t been plagued to the same degree by the sov-ereign debt crisis etc, so execution risk in the US market is perceived to be lower than that in sterling or euros.

Birgbauer, Jaguar Land Rover: We have issued bonds in the US market as well as in the UK, because the size of our funding requirements means we need to issue in cur-rencies other than just sterling. The US market is the big-gest and deepest capital market in the world and so that’s a natural place to go. It also makes sense for us as we do have significant dollar revenues and so issuing debt in dollars is something of a natural hedge against our future dollar revenue.

Admans, BP: We’re an inter-national corporate and around 70% of our bonds are denomi-nated in US dollars, so the US is a key market for us. We treat it as our home market, which is fortunate given that it’s the biggest and deepest. However, pricing in the US has become increasingly vola-tile with secondary spreads moving far quicker.

The core liquidity for BP, like most international cor-porates, remains in US dol-lars and euros but given the increased price volatility we believe it makes sense to widen your pool of investors by going to other markets, as we did in 2012 when we issued in Australia and Canada.

Marcus Hiseman, Morgan Stanley: We’ve seen more Yankee issuance from UK issuers going into the US mar-kets. The big FTSE majors have used the US market more so than they’ve ever done before and have been progres-sively increasing their use of that market. It’s not surpris-ing given the depth of liquidity in the US and given the problems we’ve seen through the euro crisis. These bor-rowers want to depend less on raising big sums in the sterling and euro market. That said, when you look at the companies in the FTSE, many operate predominately dol-lar balance sheets, so effectively it makes sense for them to use the US market.

If you’re dollar functional, you want your debt in

Gary Admans, BP



that particular currency —but the added bonus has been that the US dollar market has been deeper and more liquid than any other market. It’s also been more consistently available, it’s been cheaper than any other market and it offers the widest choice in maturity. So it’s natural that people will gravitate towards that mar-ket, and we’ve seen a greater use of the US market as a proportion of overall borrowing by a lot of the FTSE majors.

There’s actually been an awareness of late that some borrowers have probably become a bit too reliant on that market, so you’ve seen some of these issuers start to diversify. Some are looking to use the Eurodollar or sterling markets instead, while others are looking to Aussie dollar and Canadian markets to tap into new pools of liquidity. The dollar market remains the main-stay of their financing, but they add bolt-on deals in a multitude of other currencies. That’s been a major change.

Seibel, RBC: There has definitely been an increase in activity in the US dollar markets over the last few years. The UK borrower base has always been much more open to access the Yankee market than other European names, but there’s still been an increase. In fact, there’s been a general diversification into the main currencies, as well as into more local markets. For example UK cor-porate issuance in the Canadian market was C$119m in 2008, growing to C$400m in 2010 and C$1.3bn in 2012. There’s definitely a bit of a diversification trend. There’s a general awareness that liquidity is important, that diversified funding sources are important and that good preplanning on funding front and maintaining a good flexibility on balance sheet are good drivers of a treasury team’s decision making process.

Patel, William Hill: In 2012 we generated around 90% of our revenues in the UK. As a primarily UK business, we had generally only looked at the sterling bond mar-ket. But this year we did a significant acquisition in Aus-tralia and are looking to grow our online business inter-nationally as well. So I can see a need for us in future looking at funding in different currencies, either directly or with swap.

EUROWEEK: How have international investors responded to UK borrowers?

Kilonback, TfL: It has been a help being a UK borrower. There have been points over the last three years when financing as a European name would have been difficult, but being a UK credit with a UK-only business insulated us a little. We have found that inward investment from non-traditional sterling investors has picked up over the last couple of years. For our most recent sterling bond deal, over 20% of the book went to Asian investors. The fact that the UK market tends to finance a bit longer is interesting to the Asian investors, especially for the life insurers and pension funds. We haven’t suffered to the degree that Europe has suffered and that makes us more attractive as well, as they feel there isn’t as much risk as with an equivalent euro transaction. For ourselves as a government-related entity, we’re at that rarefied spectrum of the credit rating that really appeals to Asian investors too.

Pitt, Network Rail: UK borrowers have benefitted from being outside the eurozone, and from investors’ flight to quality. The UK has been downgraded by two rating

agencies, but we’re still pricing flat to KfW. We’re still regarded as a safe haven, even now we’re a double-A plus credit, but who knows whether that will last?

Seibel, RBC: In the last five years, the international investor base has viewed the country with varying levels of confidence. But the UK started addressing its issues early on, and that has helped it to remain a low interest rate environment. UK corporates that tend to issue in the bond markets tend to be large, multinational names, and these are the ones that are very well received by investors. As a result, UK borrowers have performed very well in the dollar market — both in Yankee format and the US PP format. They are well received companies that investors want to have in their portfolios.

Hiseman, Morgan Stanley: Canadian and the Australian investors in particular tend to have a very limited choice about who uses their local markets. The local banks are active and a limited number of local corporates choose to use those markets, so the investors crave diversification themselves. When you have a borrower with name recogni-tion and local business pres-ence, or a borrower who’s a global player, it makes sense for them to invest. Network

Rail always benefits from going to the Canadian dol-lar market because of its rating, while BP leads the way with its diversification into multiple markets. Investors from outside of Europe are keen to participate in deals from these borrowers, and they like to see new credits come and raise money in the local markets. Name recog-nition is the most important requirement we hear time and time again from our local syndicate desks in those regions, and it really helps if they have business activity down there.

Ramzan, Lloyds Bank: US investors perceive that the legal enforcement of documentation and the UK legal structure connected to UK deals is just of a better qual-ity. That’s why there’s always a bit of a penchant for UK names. Also, given that on a proportional basis there is still a ‘rarity’ factor to UK issuers in the dollar market the diversity play for US investors is still an attraction.

EUROWEEK: What other products have become interesting for UK borrowers?

Kilonback, TfL: We established a commercial paper facility, and we’ve used that programme alongside build-ing out an extensive bond curve. Both of those issuance programmes will be a mainstay of our funding for the foreseeable future. At the moment we remain sterling focused but may expand in the future.

Patel, William Hill: We’ve looked at the retail bond market very seriously and have had conversations with a number of banks about that. The only reason we haven’t approached it is that our financing needs were too large. In June, we went to the bond market to refinance the bridge loan we’d taken on to fund a couple of our acquisitions. That bond transaction was big for us, and the retail market isn’t yet developed enough to support

Marcus Hiseman, Morgan Stanley



those kinds of sizes. The institutional bond market was our only option. The retail bond market might be attrac-tive for us if it allows us to raise smaller sizes. I can use it to spread the maturity profile of my financing. That market does remain on our radar.

Ramzan, Lloyds Bank: UK borrowers’ issuance in the US private placement market has grown by a compound annual growth rate of 38% between 2009 and 2012. It went from $3.7bn to $9.8bn. The reasons for that are clear — the USPP market is much more flexible than the public bond market, you can get bespoke maturity tranching, while the unrated nature of the system works for issuers. Issuers can get pretty chunky deals done there, while issuing in dollars and swapping back into sterling gives you a pick up based on the currency basis swap over the last couple of years, a lot of UK issuers like the sound of that. You’re likely to see a continuation of UK borrowers going to the USPP market.

Hiseman, Morgan Stanley: Another trend we’ve seen is the use of hybrid capital. BG Group was transforma-tional as the first UK client to do a significant hybrid deal across multiple markets, and that’s led the way for a lot of other corporates to follow on.

EUROWEEK: Is volatility the new stability?

Admans, BP: Yes it seems that way though you always assume the volatility will end, but it’s been crisis after crisis. The turbulence in the bond markets has also been heightened by the reduced secondary liquidity provided by the banks. As yet there seems to be no ready replace-ment for the lost liquidity, so you would expect credit spreads to move around faster. If an investor decides to sell a significant position and no bank is are prepared to hold the paper, then the bond’s yield can move out pretty rapidly.

Birgbauer, Jaguar Land Rover: Over the last few years there has been a lot of volatility — whether that’s from the euro crisis or, more recently, from the markets responding to input from the Fed on tapering or other events. Markets perhaps do seem more sensitive than in the past. So in that environment, you need to maintain flexibility in funding and not to put yourself in a posi-tion where you have to fund when you don’t want to fund. You want to be in a position where you can fund opportunistically and be ahead of the curve.

Hiseman, Morgan Stanley: Corporates recognise that ultimately there are so many events out there and they do their best to navigate the markets. Many of the fre-quent borrowers are extremely nimble in their approach to the capital markets.

Patel, William Hill: Certainly it’s an advantage to be able to be flexible. Our problem is that while we’re in the FTSE 100 we’re not an overly sophisticated or large treasury operation so it’s difficult for us to be as speedy as some of the bigger players and the regular issuers. We issued a bond at the beginning of June, but only days later government bond yields started creeping up. Had we done our deal a week later we would have paid a higher coupon. It had taken us three months to get that bond out the door from start to finish — we don’t have an EMTN programme as we’re such an infrequent issuer. So if you can be speedy it is an advantage in these markets.

Pitt, Network Rail: As noted above, I think volatility is now part of the norm. You have to be able to manage it.

Ramzan, Lloyds Bank: I’m not a Trotskyite, but I think constant revolution is where we’re at as regards the finan-cial markets. UK treasurers are well aware of the need to have quick decision-making and have lots of optional-ity available, because it’s not like there’s a risk on-risk off attitude these days. People are very used to having days when a deal will work and then within the same week, it’s not possible. You do see reasonable fluctuations in sentiment that can have substantial impact on execution risk of a new deal in the market. So it’s much harder for banks to forensically gauge the levels of interest from investors ahead of execution, but I think issuers have an understanding of this when they listen to the execution advice from their bookrunners.

EUROWEEK: In such a volatile environment, how important is the role of investor relations?

Hiseman, Morgan Stanley: Borrowers are extremely forthright in their investor communication and they’re disciplined about that process. I think they’ve upped their game in regards to their professionalism in manag-ing their investor base. That investor base has changed over the last five years. Central banks are now invest-ing in corporate credit while a few years ago they were purely focused on government bonds, and corporates are investing in corporate credit. We’ve seen a great deal of diversification on the investor side, so borrow-ers know they need to do a lot of investor work to keep up. They have to be disciplined in their approach to the buyer base, and that helps with accessing the market. UK borrowers have been setting the gold standard in their investor communication work.

Birgbauer, Jaguar Land Rover: Businesses always have creditors — whether they’re bond investors or banks or otherwise — and there’s always a need to maintain relationships with those creditors. The nature of the relationship with bond investors is different to bank relationships, but there’s a need to communicate to investors whoever they are to help them understand the business. You need to let them know what’s going on with the business. Any investor providing credit to a business wants to be comfortable they understand it. It probably shouldn’t be surprising in the environment we’ve been in that the level of detail investors want to understand about a business has increased which has only increased the importance of investor relations.

Pitt, Network Rail: You can’t expect investors to come to you — you have to sell your product and differentiate yourself. While there are a lot of German government backed issuers, we are the only UK government backed borrower and the only one that issues in currencies other than sterling. So we have a unique selling point — we can say to international investors that if they want exposure to the UK sovereign outside of sterling, we’re your only opportunity. That’s especially true in the dol-

Farouk Ramzan, lloydS Bank



lar market. The Bank of England issues one US dollar bond a year but we issue far more. That gives us a USP that makes us attractive to investors. As long as they’re interested in the UK credit, they know that to get UK sovereign exposure, it’s us or Gilts.

Kilonback, TfL: Over the last 18 months in particular we’ve done a lot of work with investors to get them to understand that we are a government-related issuer and that we are more an SSA than a corporate. It’s been an intense education process, but we’ve seen our spreads pretty much halve over that 18 month period. Now that we’ve established a maturity curve and have pric-ing points of reference from five years up to 35 years, it’s far easier to have discussions about fair value and relative value compared to other agency or quasi-gov-ernment borrowers. We see our trajectory continuing to move closer to those than where we started a couple of years ago.

Ramzan, Lloyds Bank: There’s been a marked increase in the number of roadshows going out — whether they’re deal-related or not. Credit updates are on the rise, and UK investors say that they’re short of credit analysts — there are so many potential issuers in the market investors don’t have enough analysts to go to all these meetings. It’s not just about frequency, but also about the type of product in the market. We’ve seen a rise in hybrids in the UK market in the last 18 months — hybrid deals now account for 12% of UK corporate issuance year to date. So you need to introduce and update investors not only to the credits but also to the structures on offer.

EUROWEEK: What has been the focus of borrowers’ financing strategy? Is diversification still key?

Pitt, Network Rail: For us, it’s all about diversification. When you’re issuing £5bn to £6bn a year, you have to be focused on diversifying your funding sources and your investor base.

Hiseman, Morgan Stanley: We are still in diversifica-tion mode. Many corporates feel that even if they haven’t accessed a particular mar-ket for a while, they want to put a fresh benchmark out to maintain their presence in

certain markets. The euro market has got more competi-tive in pricing and the basis swap to sterling is more favourable than it was, so we’re seeing some names tap that market. The only issue is that there is a price to pay to put the hedging in place. Over the past five years the hedging costs have got higher as banks charge more for their credit line. Treasurers are carefully weighing up what their preferred currency to fund in is. They want to limit the amount of hedging needed to do on the back of their debt financing, and the way to do that is to go directly to the currency they need rather than using swap derivatives. People are trying to focus their bor-rowing tactics around that.

Seibel, RBC: They are still in diversification mode, but not at any price. With increased regulatory pressure and

pricing pressure on the derivatives front, borrowers are looking at the all-in cost. It’s a much more holistic view of funding mix and balance sheet structure than it was in the past. Patel, William Hill: We’ve come through the credit crunch and our firm has performed relatively strongly for a consumer facing business. We’re now in the phase where the board is keen to progress with a growth agenda — we have some organic growth opportunities looking at the online sector, but we’re also looking to grow by acquisition. Clearly from a company point of view, part of my job is to make sure we have access to the funding required in order to implement the board’s growth agenda. It’s not just about diversification any more — it’s also about having access to funding from every source. That might be through turning to the bank market for bridge loans or through tapping the bond market. We’ve also gone to our shareholders for fund-ing — we’ve done a rights issue to finance some of our acquisitions. So it’s using all the resources available to us to access liquidity.

Birgbauer, Jaguar Land Rover: Being in the cycli-cal auto industry, our strategy for funding is to main-tain long term funding and strong liquidity, cash and undrawn committed bank lines, to support our funding requirements through the business cycle. It doesn’t real-ly change depending on what the economic situation is at the time — we always want to have in place that kind of financing strategy.

EUROWEEK: Is UK plc still in recovery mode or has 2013 seen it turn a corner?

Birgbauer, Jaguar Land Rover: The auto industry in the UK has been performing pretty well for a while now, and the broader economic data particularly in the last couple of months has been strong. So the outlook does look more optimistic.

Seibel, RBC: The UK as a whole seems to be more in recovery mode now, and that is making its way through to corporates as well. Over the crisis, more jobs have been created in the private sector than were lost in the public sector, so I’m not so sure that UK plc was in as much trouble as the UK government. There is a growing degree of confidence, but people are not forgetting the still recent memories of what’s happened in the market. The events in June, when the markets wobbled with the expectation of the end of the tapering in the US, showed issuers that they still need to be on their toes and need to be flexible about what they want to do.

Kilonback, TfL: There are certainly signs that the econo-my is beginning to pick up — this is particularly true in London, although the capital does seem to outstrip the rest of the UK economy. Clearly, as a business we are very dependent on the strength of the London economy and on the growing population of the city. The London population has expanded much more rapidly than any-body expected — it’s about 600,000 higher today than it was expected to be at the time of the last census in 2001. With that population growth there’s an expected increase in jobs to go with it, and that’s really key for us. I get the feeling that London is performing far ahead of the rest of the UK, but while conditions remain quite hard, there are signs of optimism for the rest of the UK economy. Manufacturers are becoming world leaders again and

Samantha Pitt, network rail



we’re beginning to export goods to the rest of the world as well.

Pitt, Network Rail: If you look at the economic data that’s coming out it has been more positive and growth forecasts have been upgraded. We are seeing signs of recovery, but it’s still early days.

Patel, William Hill: I think we’re moving in the right direction. There’s improving news coming out of the economy that gives people confidence. But treasurers are still concerned that there could be another wobble in Europe, another geo-political problem or a slowdown in Asia that might affect the markets. Those things do give us cause to not be quite as gung-ho as we might have been. But in the UK things are starting to turn a corner, and that does give people confidence.

EUROWEEK: How important is it still to maintain a fortress balance sheet?

Kilonback, TfL: People are still fairly cognisant of how difficult it has been and at the moment they will feel more comfortable having a higher amount of cash avail-able to them on their balance sheets. They have experi-enced difficulties in obtaining or renewing bank lines in the past.

Birgbauer, Jaguar Land Rover: Given that the auto industry is cyclical, auto companies tend to maintain rela-tively high liquidity levels compared to companies from some other sectors. We continue to believe that we need to maintain a strong balance sheet with long term fund-ing, strong cash balances and good undrawn committed liquidity facilities. That doesn’t change depending on what part of the economic cycle we’re in.

However, this doesn’t mean we aren’t investing in the business. We are investing significantly to continue growing the JLR business. A strong balance sheet helps give us the confidence to do this.

Admans, BP: Clearly most corporates still think that cash has a strong value on the balance sheet. Before the financial crisis, cash on the balance sheet was considered an underperforming asset. Many corporates were put under pressure to return cash to shareholders because cash seemed to be only measured against return on capi-tal. In the US there have recently been some bond issues linked to share buybacks, but there is not the clamour that existed in the mid-2000s to return cash to sharehold-ers. Equity investors remain cautious over corporate debt liquidity and so are tolerant of high cash balances.

Patel, William Hill: I think we’re more confident than we were a few years ago during the depths of the down-turn, but I wouldn’t say we’ve gone back to pre-crisis levels. I think that’s reflected by the attitude of inves-tors. Given our position in the betting and gaming sector, we’re a very cash generative company. Before the credit crunch, our shareholders were very happy with our lev-erage of 3.5 times net debt to Ebitda, and some suggest-ed we should take it north of there. Those same share-holders now would be horrified if you suggested leverage of that level. People have been scarred by their experi-ences with companies with balance sheets that were not as rock solid as they might be, so there is an element of caution. But it’s not as bad as it was. We’ve increased our leverage significantly to undertake acquisitions, and other companies in other sectors have done similarly.

Seibel, RBC: There’s a con-viction sneaking through that this isn’t a little blip, but that we’re at the beginning of a more sustainable, modest economic recovery. So stra-tegic initiatives are moving higher up in the priority list, rising above the need for for-tress balance sheets that was a critical priority in late 2008 and 2009. It is a fine balance for most companies. There’s definitely more of a focus on financial planning, balance sheet management, liquid-ity, financial flexibility than there was in 2006 or 2007. If the M&A bankers go to discuss opportunities with corporate clients, one of the first questions is ‘how will this affect my balance sheet?’ The balance sheet is important, but borrowers are beginning to take a more balanced approach than before. Hiseman, Morgan Stanley: There’s still an element of cautiousness around borrowers’ approach to their balance sheet. People are still in the mode of prefund-ing. A few corporates were scarred in 2008 when they had bridges out that they needed to refinance, and the markets ran away from them. In some instances rights issues had to be done to repair the balance sheet. I think most borrowers really understand that they have to make sure they are ahead of any upcoming maturi-ties. Having an evenly tuned maturity profile is a prior-ity for them. So I don’t expect to see corporates move away from that cautious approach. With rates still at an attractive level for them and only expected to go in one direction from here, borrowers are more willing to put in longer duration debt and keep it fixed.

Ramzan, Lloyds Bank: One of the defensive plays for any corporate is the amount of cash it holds. Now, cash and cash equivalents by FTSE 100 companies has hit £166bn, up from £42bn from 2008. That’s a lot of cash. But there’s been a shift recently. People are much more comfortable, and a little more confident in terms of the outlook. Banks are signalling that there’s more liquidity available in the lending market. There’s a shift to expansion strategies and according to surveys nearly half of CFOs are much more comfortable looking ahead and taking more risk on to their balance sheet. All the indications are that UK plc has turned a corner, but the key question is whether M&A will follow.

EUROWEEK: Do you think there’s increased confi-dence to use that cash on balance sheet?

Admans, BP: The market does seem settled with high cash balances but this could change if global economies start improving. Then treasurers will increasingly face questions about why they’re sitting on cash earning near 0% (in the US), when the return on capital from using the cash elsewhere (for example, acquisitions) would probably be far greater. Treasurers still remem-ber the extreme liquidity crisis of five years ago and even now corporates still have the odd blip in liquidity. The euro markets can still be shut down for a month if there’s a crisis. There’ll always be a limit to the amount of cash shareholders will tolerate on the balance sheet

Christoph Seibel, rBC CaPital MarketS



in the long term, but for now the liquidity function of cash dominates.

Hiseman, Morgan Stanley: The majority of compa-nies are maintaining comfortable cash balances and aren’t becoming aggressive in the way the balance sheet is positioned. But I would say the frequency of discussions about potential M&A deals has increased, and we’re talking to more people about deals than we have been for a while. When you see a big deal like Verizon Communications’ hit the tapes, it sud-denly wakes a lot of people up to the possibility of jumbo financing. A deal like this is a huge positive for the market — it’ll give people a lot of confidence, and it’ll raise board rooms’ interest in the bond markets. Treasurers have been on the conservative side over the last few years since the financial crisis and the concern they’ve felt over their access to markets. Jumbo events like the Verizon deal may get people to look at M&A, but they’ll do that from a position of balance sheet strength having had a cautious initial approach to the market.

EUROWEEK: How do borrowers manage their funding strategy to navigate the uncertain interest rate environment?

Ramzan, Lloyds Bank: Those companies that have very publically talked about bottom fishing and try-ing to get in at the lowest point in the cycle are feeling reasonably smug. They can see that Gilts have risen by 125bp over the last year. Interest rates are histori-cally low and are expected to be low over the rest of the year but then who knows. A lot of people have had their cake and they’re eating it.

Kilonback, TfL: As an organi-sation we plan over a 10 year horizon, so we tend to base our borrowing strategy around those plans. Because we have that fixed funding envelope, it’s important for us to get some certainty — knowing that we’ll need to do that incremental borrow-ing over planned period. For example, for our recent bond deal we brought forward some of next year’s planned fundraising because we felt that it was better to lock in

20 year money at today’s rates rather than waiting to get it done next year.

Pitt, Network Rail: I wish I had a crystal ball! No seri-ously, we are a regulated utility, we have a govern-ment guarantee of our debt and get the majority of our revenue from the UK government as well. So we tend to be more of a fixed rate issuer as that gives us more certainty. We can’t afford to have any shocks in our cashflows as a result of interest rate changes. We do a lot of interest rate risk management — we look to pre-hedge a certain proportion of future interest rates to match our needs, but you never know over the long term whether you’re going to get it right or not and whether rates will go up or down. The markets cur-rently are extremely volatile and the interest rate risk is asymmetric.

Seibel, RBC: On May 2, 10 year UK government yields were at 162bp, and in early September they were at 3% — they’ve basically doubled. That’s clearly had a big impact on people who fund themselves in fixed rate, and a lot of companies have a relatively large propor-tion of fixed rate debt. Some may look at switching more into floating, because if you look at Libor over the same period, for example, it has gone up by only 2bp. These are the sort of debates that are becoming more active within treasury teams —how do you man-age your fixed floating mix in a lively interest rate envi-ronment?

Admans, BP: We look at interest rates and liquidity separately. Our first concern is making sure that the company is liquid and has the required cash available, and the second is managing interest rate risk. As we are lowly geared our interest risk is low which has enabled us to have a bias towards floating rates as fixed rate costs are typically higher than for floating rates.

Birgbauer, Jaguar Land Rover: It’s difficult to know with certainty what will happen with interest rates. The market expects interest rates will rise going forward. In any event, treasurers need to look ahead at what their funding requirements are and try to have a fund-ing plan over some time horizon. You want to try to access the market opportunistically when the market’s relatively more favourable over the time horizon but I think what’s most important is to stay ahead of the curve of when funding is actually needed.

Patel, William Hill: The Bank of England has said that the base rate will remain low for an extended period, but the markets think that rates will have to rise sooner than that and this is reflected in bond yields.

As a company, we’re generally quite risk-averse, so we tend to have a greater proportion of fixed interest rate debt. That does mean that we may not be paying as cheaply as we might, but it enables us to sleep at night. Financing is there to support the business, so as long as we think the business can generate the profits and we can fix the cost, we know everyone’s happy. Ultimately when I look at the cost of financing, I’m only concerned about whether I can afford it — it might not be the cheapest cost I could have got, but if the company can support it without putting pressure on the business we can concentrate on growing the operational and commercial aspects of the company.

Hiseman, Morgan Stanley: Many corporates tend to compartmentalise their need for liquidity and their interest rate exposure and manage both things sepa-rately. We feel pretty confident that credit spreads will remain fairly middle of the range, around where they are now, as there’s nothing to suggest that corporate defaults are on the rise. The real risk for borrowers is the underlying benchmark and government yields moving higher, pushing borrowing costs higher. Many borrowers pre-hedge against that risk, and many of our clients are pre-hedged for longer periods into the future than I’ve ever experienced. Borrowers have been pre-hedging for three or five years ahead. Providing you can point to a maturing piece of debt, it’s a good thing to execute that pre-hedge.

Other borrowers don’t like the pre-hedging approach and pre-fund instead, although that’s less efficient as you have a cost of carry associated with the cash sitting on your balance sheet. s

Simon Kilonback, tranSPort For london

Blue chip companies


UK blUe chip corporates have a wealth of opportunity in the bond markets. They can find a receptive audience at home in sterling — or overseas in dollars or euros — in almost any maturity they require. pricing was already tight but now banks are keener to lend too, provid-ing alternatives to the bond market.

For UK investment grade issuers in sterling and euros, what Farouk Ramzan, managing director and head of capital markets origina-tion at lloyds bank, calls “a perfect storm” set in last year.

That storm consisted of lower com-peting supply from bank issuers and a stronger bid for safe haven assets from sovereign debt crisis-scarred investors in a market where rates were low.

One year on, there are some differ-ences, but the atmosphere remains positive. “We’re certainly continuing to see extremely favourable condi-tions for UK investment grade corpo-rates,” says Marcus hiseman, head of european corporate debt capital markets at Morgan Stanley. “For the top blue chips, with large balance sheets, which are still generating robust cashflows, they are definitely still in high favour with investors.”

last summer Morgan Stanley was one of the leads on the lowest cou-pon in corporate history for Unilever, which paid 45bp and 85bp respec-tively for three and five year bonds. “This year we are not getting the low-est coupons, but still huge deals are being done with the same level of order books,” hiseman adds.

however, the prospect of quanti-tative easing (Qe) tapering in the US drove a $110bn net outflow from US bond mutual funds in May alone, and £7bn of net outflows from UK bond funds in June, suggesting the long-expected great rotation from bonds to equities may be underway.

“We’re sitting on that cusp right

now,” says christoph Seibel, head of corporate DcM for europe at Rbc capital Markets.

issuance levels are lower to match. UK investment grade corpo-rate issuance in sterling is down by 39% year on year, and euros 13%.

investors are also being more selective about which credits they buy. “it’s the same investors as a year ago, but whereas then there was almost an indifference in terms of credit fundamentals, now you can see them being more dis-ciplined in picking the credits they really support,” says hiseman.

That said, the Federal Open Mar-kets committee’s announcement in mid-September that it will not be decelerating Qe at the rate many expected could change things again. ”Many borrowers might see it as a renewed opportunity for financing in this lower interest rate environment,” says Nicholas Denman, managing director, investment grade finance at Jp Morgan.

Deep dollarsThe dollar markets remain the most popular location for borrow-ers because it offers the biggest deal sizes and the quickest access. “The quantum of money available means drive-by deals can be done very quickly in the dollar market,” Ramzan says. “The perception is you get deals done in a safer environ-ment there.”

in February Vodafone raised $6bn in a five tranche deal, covering three to 30 year durations, in April Dia-geo took $3.25bn with a $10bn order book, again at three to 30 years and there have also been other large deals from the likes of bp, Glaxo-SmithKline, Rio Tinto, imperial Tobacco, AstraZeneca and SAbMiller.

in 2009, Ramzan says, 42% of all UK corporate bonds were in ster-ling, compared to 25% in 2013 year

to date, while the share in dollars have grown from 38% to 51% over the same period.

One sticking point for some euro-pean issuers to accessing the US market can be the onerous amounts of documentation required but this has not been such a hindrance to UK borrowers.”Many of them have oper-ated in the US for a long time and are already following US regulation any-way,” says Seibel.

And the appetite for UK names in the Yankee market is redoubtable. Much of that has to do with the fact that so many UK-based multination-als run businesses that operate pre-dominately on dollar cashflows or have big operations in the US that need financing. Or, like the oil com-panies, they are involved with a product that trades in the currency.

“What amazes me about the Yan-kee market is the ability for the oil majors to come back time and time again every three to six months,” says hiseman. The bp trades are a classic example. “They have done a phenomenal job, rationing their vis-its to two or three a year, and print-ing what investors like: a predictable and regular supply of bonds refresh-ing the curve and keeping bench-marks in the market.” it’s perfect, he says, for index followers and for big money managers who want liquid names to be able to trade.

euros, oddly given that the eU

UK corporate borrowers have had their pick of bond funding options of late and have taken full advantage. Corporate bond bankers are earning their keep by helping firms navigate each market’s nuances, while keeping one eye over their shoulder as bank lending makes a comeback, writes Christopher Wright.

UK corporates awash with capital raising options

“The volume of 20 year tenors and

over account for 70% of total sterling issuance for UK cor-porates this year, up from 44% last year”

Farouk Ramzan, Lloyds Bank

Blue chip companies


is the UK’s biggest export market, seem to have missed out. Seibel says that year to date, 55% of issuance by investment grade UK corporates has been in the dollar market, 23% in sterling but only 18% from euros. This has had to do with the relative pricing on offer, which has made euro issuance unattractive to UK firms, although there are signs now that medium maturities in euros are offering more compelling levels.

Many recent euro deals have been successful and interesting, often combining a euro tranche with another in sterling. NGG Finance, for example, the borrowing entity for the UK’s National Grid electric-ity and gas transmission company, sold €1.25bn of 60 year, non-call 7.25 paper and £1bn of 60 year, non-call 12.25 paper in March — the com-pany’s debut in the hybrid mar-ket. in December, Rio Tinto com-bined euro tranches of €750m and €500m in seven and 12 year funding respectively, with one 17 year clip of £500m.

Whereas a handful of institutional buyers dominate the sterling market, the euro market offers a far broad-er range of investors and in bigger numbers. “in a sense, you get bet-ter execution and price discov-ery because you are using a larger number of investors to distribute the bond through,” says Ramzan.

however, with its sharp pric-ing, the bond market is not the thing that is stopping greater issu-ance levels. The swap market, used to exchange proceeds of the bond into a required currency and to hedge interest rate risk, has become more expensive as a result of bank regulation meaning borrow-ers save money overall by avoiding cross-currency swaps, even if they pay a few extra basis points on the bond itself.

Long termbeing dominated by pension funds and insurers means there is plenty of term funding on offer. And with rates so low, investors are looking further along the curve for yield.

“The volume of 20 year tenors and over account for 70% of total sterling issuance for UK corporates this year, up from 44% last year,” says Ramzan.

Sterling also offers borrowers a better chance of picking an exact

maturity to suit its needs rath-er than the standard five, 10 and 30 year benchmarks available in say, dollars. Arqiva, which raised £750m in two tranches — one with 22.3 years duration, the other, just under 20 — in February, and high Speed Rail Finance 1, which raised £760m in 25.7 year funding two weeks earlier, and a GlaxoSmith-Kline £1.4bn deal, some raised in 33 year money in December, all exemplify that point.

but not every issuer is able to take advantage of those characteristics. The lack of investors gives them a bigger say in pricing and not every borrower needs long dated debt. Also, UK borrowers do not always need sterling and although they will be comfortable raising cash in their home market, they will be put off by the cross-currency swap costs of converting the proceeds into anoth-er more useful currency, which are especially high for the sort of long dated deals characteristic of the ster-ling market.

but there may be opportunities outside of the three main markets.

Australian and canadian dollars “are much overlooked markets by UK cor-porates,” hiseman says.

Seibel adds: “bhp, National Grid and bp have all branched out into canadian and Australian dollars. That approach — looking for further diversification, adapting to different market environments, looking at the capital structure in a holistic con-text — is a constructive and positive development of the UK market.”

Loan market fights backAnd, increasingly, there are loans on offer. “in the last 12 months we have seen a significant increase in the number of participants in the market, which means there has

been an increased level of liquidity, and pressure on pricing and struc-ture,” says Simon Allocca, head of loan markets at lloyds bank, who has seen a reduction of around 12bp on undrawn pricing for investment grade UK corporates.

That has consequences for the bond market. “if you are able to get that kind of pricing and liquidity, we go back to the dynamic of 2006, where people take cheap loans and don’t need to go to the bond market,” says Allocca.

At first glance, the market does appear to be moving back in that direction. Ramzan says that last year, the ratio of european funding shifted towards something resem-bling the US, where debt capital mar-ket funding outweighs bank lending: it moved to 57% bonds, 43% loans. “but this year it’s gone back the other way: 48% bonds, 52% loans.”

but bond bankers will be keen to remind corporates not to use up all of their loan facilities just because the pricing is cheaper now, and instead use the bond market to leave some room for bridge loan financing when the firms need it.

Seibel notes that the longer term trend has been for the percentage of bank lending versus other forms of debt capital to decrease as a result of the financial crisis and the delever-aging of banks.

“but the large scale corporates don’t have problems raising bank funding, because they are the ones with the greatest global reach and the biggest ancillary fee pool,” he says. “banks clearly think: if i give a dollar to one of those blue-chips, the hope that i can earn equity under-writing or FX fees is larger than with a small SMe that only operates in the UK. The availability of bank cred-it to those companies remains very strong.” s

“The top blue chips, with large balance sheets, which are

still generating robust cashflows, are definitely still

in high favour with investors”

Marcus Hiseman, Morgan Stanley

“BHP, National Grid and BP have

all branched out into Canadian and Australian dollars”

Christoph Seibel, RBC Capital

Markets


Order book for Retail Bonds (ORB) Roundtable

EUROWEEK: As Provident Financial is one of the bor-rowers that has been a repeat issuer in the ORB mar-ket, how has it fitted into your financing strategy?

Phil Shepherd, Provident Financial: Provident Financial is a FTSE 250 business with, for a financial institution, a relatively modest funding requirement of a little over £1bn. Before the crisis, we were predomi-nantly funded through the bank markets with a small amount of US private placements. With our require-ment, we are almost too small for the institutional bond markets as we can’t be a repeat issuer. We do have an institutional bond in issue, but it’s relatively illiquid given our size. So we identified the retail bond market early on as being a good market for us, and we’ve now done four issues. We were one of the first originators back in April 2010, and we’ve done an issue in March

or April every year since.The attraction of the retail bond market was to diver-

sify our financing, but we were also interested in the ability to do smaller issue sizes. A size of £50m-£100m meets our requirements on a repeat issuance basis. We’ve enjoyed strong success in the market by making sure that we price appropriately and by having a very clear view of what we wanted to achieve in the market. This has helped us to achieve our overall objective of diversifying our funding.

Marcus Coverdale, Lloyds Bank: I think the ability to print in small sizes is key to the importance of the retail bond market. Many borrowers have had institutional bonds in issue of £200m-£300m, which is the minimum benchmark size, and they’ve all suffered from poor sec-ondary market performance. This can impact the next


Simon Atkinson, group treasurer, London Stock Exchange Group

Marcus Coverdale, director fixed income debt capital markets, Lloyds Bank

Patrick Gordon, senior investment strategist, head of fixed income, Killik & Co LLP

Darren Ruane, head of fixed income, Investec Wealth & Investment

Phil Shepherd, group treasurer, Provident Financial

Gerard Tyler, treasurer, Severn Trent

Gillian Walmsley, head of fixed income UK, London Stock Exchange

Moderated by Nina Flitman, syndicated loans and leveraged finance editor, EuroWeek

ORB at the centre of corporate financing shift

In February 2010, the London Stock Exchange’s Order book for Retail Bonds (ORB) opened the debt capital markets to UK retail investors, allowing them to access selected Gilts, supranational and corporate bonds. For the domestic corporate borrower base looking for an alternative, flexible source of capital to bank funding, the ORB has become increasingly attractive, while the platform has also provided greater accessibility and transparency in secondary market bond trading for private investors.

Since its launch, ORB has enabled UK firms to raise over £3.4bn, but now the focus has shifted to how the platform can grow to attract a wider range of participants on both sides of the market.

Some of the investors and borrowers that have participated in ORB transactions gathered in London in early September to discuss their experiences of the market and how they want it to develop.



time you want to come to the market and the pricing you can achieve. So I think the small deal sizes you can do in the retail market is really important.

EUROWEEK: How can the small sizes of deals availa-ble allow borrowers to manage their maturity curves?

Shepherd, Provident Financial: If you look at our bal-ance sheet, our £250m institutional bond made up at the time of its issue about a quarter of our debt, and has a bullet repayment. I think doing £50m deals over a num-ber of years enables you to have a smoother maturity profile. Having £50m or £100m maturing in any single year is clearly more sensible for a business like ours than having £250m maturing in a single year.

Darren Ruane, Investec: If I can add to that point, from what we see from the investor’s side, issuers quite like the idea. Many of them come to us and say that they have bank financing that’s due in the next two or three years and that they’d like to term that out as far as they can. As interest rates are quite low at the moment, they want to term it out at these rates. For many of these issu-ers it makes sense for them to do smaller deals on a retail basis.

Patrick Gordon, Killik: I think the fact that under the ISA rules a bond needs to have five years until maturity at the time of purchase in order to qualify for inclusion in the ISA means that this product fits that gap in the market that is slightly beyond a company’s traditional bank financing. So for a deal to also be of interest in the secondary market for ISA investment, 5-1/2 to seven years seems to be the sweet spot.

Gillian Walmsley, London Stock Exchange: In terms of the funding sizes, we’ve seen really good, strong liquidity in the £25m and £35m issues. What’s been particularly attractive to all issuers is that there’s quite a diversity in terms of the size that can come to market. ORB can sup-port a small issue of £25m or £35m and the much larger issues, like the £282.5m from National Grid and the £300m from the Stock Exchange Group.

Simon Atkinson, London Stock Exchange Group: Speaking of our deal, I would support Phil’s objectives for issuing — it was equally about diversifying away from bank financing and also extending the maturities of our debt profile.

We came to the retail bond market last autumn for the

first time. We were keen to push our maturity profile beyond 2020, and one of the questions for us with our lead managers at that time was about whether the market would have appetite for that. But that was something that was not an issue in the end — a nine year deal was clearly not beyond the market, and we achieved a very big size. The London Stock Exchange Group has now moved its debt levels up to beyond £1bn with the financ-ing of the recent acquisition of 58% of the LCH Clearnet Group, and so the £300m retail bond fits reasonably well into that profile. We also have a growth strategy as a group, and potentially as our earnings increase, our debt capacity will increase as well.

So not only was the amount helpful to us, in the con-text of what we’ve financed since, but also the appetite we found in the longer maturity certainly helped our profile.

Gerard Tyler, Severn Trent: From our point of view at Severn Trent, the £75m retail bond we did is never going to replace our reliance on the wholesale market —we did £500m there earlier this year and that market’s always going to be the mainstay of our funding. So our retail deal was a diversification play, but we’re also interested in a couple of other things.

One was that we have quite a wide, small investor base that is a legacy of our privatisation 20-odd years ago. We realised that there was probably quite a con-siderable following of small shareholders who might be interested in investing into our bonds through their ISAs or their pension schemes. We were also quite keen to be able to use it as a bit of promotion for the company. When we go on the road and talk to the fund manag-ers and the brokers they’re interested in our equity, but bonds are an adjunct to that. They’re a useful addition. But while retail bonds are a source of diversification they will never replace either bank financing or wholesale bonds for us.

Atkinson, London Stock Exchange Group: Gerard’s point about brand and name is a good one, and it’s important in this market. There’s a great promotional opportunity here for issuers that shouldn’t be underesti-mated. Maybe that’s where the market needs to position itself to potential retail investors.

We had advice that our name would trade well in the market, and indeed it did ultimately. The ORB is also a good debt diversification play for us. We’ve got two institutional bonds out in the sterling market, and so our retail issue diversifies the investor base for us. But it is still important to have a recognisable name to ensure success at this stage — particularly if a large size of deal is targeted.

Shepherd, Provident Financial: Provident Financial clearly isn’t a household name for investors in the retail bond market, but we are a FTSE 250 business, we’re a rated entity, we have a good track record, we priced our issues appropriately and they sat appropriately in the capital structure. They are senior unsecured, along with our bank debt and our institutional bond. So I don’t think it’s necessarily about the brand. Certainly, through our repeat issuance and through being very clear about our objectives and how we were going to price the issues, we have been able to establish a good and strong presence in this market.

Gordon, Killik: If you want a large issue size, brand is Simon Atkinson, London Stock ExchangE group



a real help. But that’s only one end of the spectrum in terms of the issuers in this market.

Ruane, Investec: From our perspective, I think brand name does help issuers in terms of pricing, but that’s not to say that we are not very happy to invest in names that the household wouldn’t know. There have been lots of issues from companies that are FTSE 250 or maybe smaller property companies, and we’ve been happy to invest in them because we’ve looked at them from a credit point of view.

Credit ratings also really help. Not having them really reduces the number of people who might buy a deal — we have clients that are charities, and we have a man-date to say that we can only buy bonds that are invest-ment grade. If they don’t have a rating, we can’t buy it.

EUROWEEK: How key is this idea of the importance of a public ratings and how much information issuers have to provide to the investors?

Ruane, Investec: As an investor we prefer to see ratings because it’s going to increase the number of people that might want to buy the bonds. But we also review every bond we buy. We’ve got access to the rating agencies’ methodologies; we will rate them ourselves according to where we think they are so they go under the same credit review process, whether they’re rated or not.

Gordon, Killik: I’d endorse that completely. Whether an issuer has a credit rating or not, we would do our own analysis and due diligence on the bond.

In order to make the universe of potential investors as large as possible, it does help to have a credit rating. From a portfolio manager’s point of view, there’s a limit to how many unrated bonds you want to have in a port-folio.

Tyler, Severn Trent: Like most larger corporates we are rated and have been for a long time, so it isn’t really a consideration for us. But for smaller companies coming to the market for the first time, having to get a rating is a time consuming, expensive and unusual process for them. Once you’ve got a rating you’ve got to maintain it as well. So needing a rating might be a negative factor for companies making the decision whether to move from bank funding exclusively to access this market.

Coverdale, Lloyds Bank: It’s a really important part of this market though. The investors have the capacity to

do their own credit work and to look at unrated paper, so this does provide that bridge for smaller companies to move from the bank markets to alternative sources of funding. For these names, the wholesale bond market is quite a distance away — you really need to be quite a big firm to need £250m of debt on your balance sheet. So I think for the FTSE 250 community, having that unrated bridge into the public market is really important.

Ruane, Investec: We do see lots of issuers that might come and say that seeing as they only want to have to do one bond deal, there’s no point in us having a credit rating. And we completely understand that, and we’ll do the credit work. But the reality is that our investor base has got to be smaller as a result.

Atkinson, London Stock Exchange Group: It’s a careful judgement for a smaller company to make. You need to get a sense of how the different agencies oper-ate around your sector. You need to be aware of what stage of your growth/development cycle you’re at and whether the rating is going to add value to the issuance process. I would agree with Gerard that in terms of cost, resource and effort it’s quite a time consuming exercise, particularly at the outset.

EUROWEEK: Aside from ratings, how does the pro-cess of coming to the retail bond market differ from issuing in the wholesale market?

Tyler, Severn Trent: It’s a very different process. For the wholesale market, we keep in regular contact with our major wholesale investors, and we know that there are 10-20 key investors in the City of London who will make a bond issue go well if they support it. And the exposure to the market is a morning — we’ll launch around breakfast time and close before lunch. Building the book is a very rapid process and investors are price-sensitive. The retail market is very different. There was a lot of work on the road before we launched, meeting the new investor base, and then the deal sat open for two weeks. The brokers are going back to individual clients, circulating the details of the transaction and then getting subscriptions coming in. As a borrower, though, we could see the book build, day-by-day, as we went through that two-week period.

Coverdale, Lloyds Bank: Were you nervous about Gilt rate fluctuations during that period?

Tyler, Severn Trent: Because it was relatively small transaction compared with the size of our debt that mat-tered less. We went out knowing that the company runs that risk, but on a relatively small bond you just have to go with that. For a wholesale bond what is going on in the market is critical, and one of the reasons that you finish before lunch is that you don’t want any disrup-tions to impact pricing. But the investors buying in the retail space, the people who are going to tuck that bond away as part of an ISA or a pension scheme, mean that it’s going to stay there for a number of years or to matu-rity. You know that once they’ve got it, they’ll hang on to it.

Shepherd, Provident Financial: For smaller issuers it’s not a question of the retail market versus the insti-tutional market, but a retail bond transaction versus the bank or the private placement market. These two routes

Darren Ruane, InvEStEc WEaLth & InvEStmEnt



are very different. One is a private transaction where you have a bilateral relationship with a bank or other debt lender, while the retail market is more remote and you won’t know the ultimate lender. That’s a very differ-ent dynamic for a lot of smaller corporates who’ve never had any experience of the public debt market.

Walmsley, London Stock Exchange: I want to return to the point about distribution mechanisms and the two weeks it generally takes for the offer period. This is an entirely new model that has arisen because of the retail bond market, and really I think the longer marketing process can be quite helpful for the smaller companies. It helps in terms of brand awareness: lesser known com-panies that might not be a recognisable brand name can hold roadshows and discussions, and engage with inves-tors over that marketing period. An education process about the company has effectively been worked into this new retail distribution model.

Gordon, Killik: Also, that initial two week period has come in quite significantly. A lot of the bond issues have closed earlier than that two weeks that was set out. The whole process has become much more efficient.

Walmsley, London Stock Exchange: Yes, absolutely, and that’s part of the natural evolution of the market as it becomes more sophisticated, and as that investor base grows. Books are closing much earlier, and we see this as a sign of the growing depth of appetite.

Coverdale, Lloyds Bank: We’re also looking at differ-ent methodologies and hybrid mechanisms for getting deals done. We recently did an intra-day deal targeting the retail wealth management community that worked very well. We’re also looking at bringing in institutional demand to get things done on an intra-day basis, and that might point a way forward.

Atkinson, London Stock Exchange Group: From a larger corporate’s perspective, I think the interesting thing about the retail market versus the institutional market is that you have a dynamic of demand discovery rather than price discovery. The price is set, and then you go out and try to attract the demand. At one level, there’s a different type of anxiety. But we were well sup-ported by our lead managers and the information flow was accurate — I had a real-time, web-based update on the book that I could follow hour by hour.

Ruane, Investec: It’s probably worth noting that when

we talk about the retail investor base, it’s very diverse. We will look at deal centrally and decide whether we like it or not. If we do, we’ll put the information out to all of our 16 branches around the UK. However, the ability to buy the bonds goes right through to the man in the street who sees in his weekend paper that, say, Severn Trent or Provident Financial is doing a deal. He may decide that he’d like to buy some of that — without having the ability to do any credit work on it, just taking a view on it because it’s there.

Another thing that’s important is that we feel that a retail transaction should get the same terms as an institu-tional deal. If a firm already has some institutional deals out there and they try to get much better terms from retail investors, we think that’s not fair and we don’t participate. There should be a fair playing field.

Gordon, Killik: I’d agree.

Coverdale, Lloyds Bank: This is a very important point in the Lloyds Bank view. We are very keen to see retail investors treated fairly in relation to any bank lend-ing, and particularly any bank security that might be in place. We will not work on a transaction which we don’t feel would work in the institutional market on similar terms. That’s not to say that deals don’t get done in that format. There are arrangers out there that will take the view that the market should find its own level, that investors should make their own decisions, and it should be priced correctly. But our house view is that retail investors should not be treated unfairly compared to bank lenders.

Tyler, Severn Trent: I’d like to bring up some documen-tary issues here, because the prospectus directive and reporting requirements for a deal are a real constraint on this market. For example, we issued from our par-ent company, which is a public company, as that’s the company that complies with the semi-annual accounting and reporting requirements. But our main bond issu-ing company doesn’t issue semi-annual accounts. The requirements mean that if an issuer, who may be quoted on one of the exchanges, wants to issue retail bonds, they’re almost forced to do so through the parent com-pany. That might put the retail debt structurally subordi-nate to normal bank debt, which will be much closer to the assets of the group.

If I were to suggest one thing that needs to develop in this market it would be sorting the prospectus direc-tive so that companies that issue can have less onerous reporting requirements, or can issue from the company that is quite satisfactory for the wholesale market.

Atkinson, London Stock Exchange Group: I under-stand this point, although we issued out of the same company that we used for the institutional bonds, which is the holding company of the group.

We were sensitive to wanting to find a fair price for retail investors — particularly given last year’s bond was our debut issue and we run the ORB market. That in itself requires some work — you’ve got to make sure the economics work and make sure you’re getting good value from the retail market. But equally, being a com-pany that issues in the institutional market as well, we don’t want to be seen to disadvantage our institutional investors. There’s a middle ground that needs to be found.

Also, potential issuers need to consider quite carefully

Patrick Gordon, kILLIk & co LLp



the rigorous process around disclosure, the construction of a prospectus and the various risk factors involved. It continues to be somewhat of a concern to companies that there is a need to do more work for retail investors as opposed to institutional investors because of the pro-spectus directive — and this is understandable because this is a sensitive area. It’s perhaps more of an issue, and more obvious, for larger companies that will go to the institutional market as an alternative.

Shepherd, Provident Financial: We also issue from the holding company, which is where our bank debt is issued from and there are various guarantees in place from certain of our operating companies. I do think it’s important for issuers to understand that there’s a broad spectrum of retail investors, many of whom are as sophisticated as institutions. However, there are also the individuals who see an advert in the newspaper and invest with no guidance or advice.

There are two things all investors need to consider. The first is the probability of default. For most compa-nies, especially plcs, there’s a lot of information available on strategy, results and management that investors can use to make an informed assessment of this.

The other aspect is the loss given default — i.e. how much will I lose if it goes wrong. It’s clearly more dif-ficult for a retail investor to make an assessment of this, especially if there’s a complicated capital structure or there’s structural subordination. In the equity markets, retail customers understand those markets well and use the history of companies that have failed to better understand and predict what they might lose.

EUROWEEK: Might it be that once the market is more established investors will become more com-fortable with what happens in a default?

Coverdale, Lloyds Bank: There’s an ongoing require-ment for investor education and a need to understand credit as opposed to equities. In terms of personal investment, the UK has an equity culture and credit can seem to be a bit of a mystery for some people. If you look at the last five years of performance in the FTSE 250, for example, you can see how many defaults there have been. How robust has the credit been in that com-munity? That may be a good proxy for retail bond issu-ers. As banks and as market commentators, we need to focus on getting the message out to investors that single name credit can be a good asset class, but you have to do your homework.

Atkinson, London Stock Exchange Group: Interestingly, there have been one or two issuances on the ORB that have been pulled, which may have been a warning shot to the market.

But the important thing to remember is that there is a rump of retail investor demand channelled through sophisticated wealth managers, such as Investec or Killik, and if their support isn’t there a deal is unlikely to be successful. So I think there are checks and balances in place already to add some control.

Ruane, Investec: Of course, you have to remember that retail investors have experienced defaults in the bond market in the last five years. Investors in Bradford & Bingley debt, Northern Rock debt or Co-op debt may have held their investments for 15 to 20 years before discovering that these things can go down to zero.

But the responsibility is on all of us in this room — issuers, managers and investors — that if a weak deal comes we reject it.

Gordon, Killik: That’s right. I think the whole due dili-gence process is absolutely essential, to weed out issuers who should not be coming to the market. I think it’s important we all play a role in that.

Also I believe that education is essential. There is a big problem with the word bond itself. It is often assumed to be a fixed deposit account in a bank — a savings bond. A large part of the investor base has now recognised the difference and recognise the risks that are involved in corporate bond investing relative to a fixed deposit account, but it is an ongoing educational process.

Walmsley: London Stock Exchange: There does seem to be some confusion — especially with ‘mini-bonds’ or ‘brand loyalty bonds’. There’s been an increase in these mini-bonds recently, which are unlisted, brand loyalty products where coupons are offered alongside other incentives such as chocolate or wine. These are quite often mentioned alongside retail bonds on the ORB as if they are like for like. There needs to be a significant drive in education, because it may be that investors don’t understand the difference between a listed cor-porate bond — which has been through a prospectus review, which is traded on the London Stock Exchange and for which there will be continuous quoting of a sec-ondary market price — and an unlisted security where there just isn’t any transparency or tradeablity.

And then there is also confusion about the term bond being used to denote a deposit account, as well as why those types of bonds are covered by the Financial Services Compensation Scheme and why corporate bonds are not. There are a number of perfectly valid rea-sons why that should not be the case.

Tyler, Severn Trent: One reason why we’re keen on this market is that we’ve identified trends in savings and investment. As more people go into defined contribu-tion or auto-enrolment pension schemes, they’re going to start paying more attention to what they are invested in. Some of them will choose to run parts of their money for themselves, or through wealth managers, and therefore will be interested in things that earn them a bit more than the traditional Gilts and investment safe havens.

We looked at what happens on the continent; the ‘Belgian dentist’ is a key buyer of retail bonds over there,

Marcus Coverdale, LLoydS Bank



and in the US there’s a very deep retail market. That’s what we would expect to see at some stage in the UK.

Gordon, Killik: I think that’s right. There’s a growing recognition of the corporate bonds asset class among investors now.

Walmsley, London Stock Exchange: I think this point about a growing appetite and a shift into fixed income is an important one. When we launched the retail bond market in 2010, it was in response to market conditions where we saw a shift in retail appetite for fixed income. There was huge appetite for bonds. One of the questions that was put to us was whether this appetite would disappear when the market swung back. But we would say absolutely not. We’ve seen the start of the process of UK investors recog-nising that bonds should form part of a balanced portfolio. Many UK investors have historically been unbalanced in terms of their focus on equity. If you look at other retail bond markets such as the US, Germany and Italy, there’s an entirely different culture in terms of investing in fixed income products. These investors are highly sophisticated, they understand the mechanics of bond pricing and they do some of the credit analysis themselves. Our aim is to improve education in the UK, and I think we’ve already made a good start on that.

Ruane, Investec: One of the key developments for this market has been that you can buy these bonds in £1,000 denominations. In the past, the prospectus directive meant that unless there was a lot of disclosure, borrows could only issue their bonds in £100,000 minimum denominations. That meant that most retail investors couldn’t buy individual retail bonds, and that led to the exorbitant growth of the corporate bond fund industry. But now retail investors find it hard to buy individual corporate bonds.

EUROWEEK: So the smaller denominations of £1,000 or £2,000 available is encouraging diversifica-tion and enabling investors to manage a well spread portfolio on their own?

Gordon, Killik: It is. It allows you to invest in more than one individual corporate bond. You can build a portfolio of individual corporate bonds, and benefit from the vis-ibility that that affords you.

EUROWEEK: Similarly, you have the transparency of a secondary market where you can just log on to the website and see where everything is trading. How much of a benefit is that?

Gordon, Killik: Pricing transparency certainly helps, and as a reference point even for off order book trades hopefully it’ll bring in the spreads. We do still think that some spreads are quite wide and we would like to see them narrow further, and I guess with more market makers joining the platform, that may happen.

Walmsley, London Stock Exchange: We’ve seen a tightening of spreads over time since the introduction of the electronic platform. There are 11 market makers now quoting on the platform. It’s key for us to develop that secondary market liquidity, because it’s so important in terms of supporting the primary market for retail bonds.

Ruane, Invsetec: The lack of liquidity is one of the dis-

advantages of the market. If you want to do something of a reasonable size, such as a few hundred thousand pounds worth, it can be difficult. Some of these bonds are locked away, and some investors don’t want to trade them. So we would welcome the development of that side of the market over time. Generally as a large company we prefer to see larger issue sizes. The bigger the issue, the greater the likelihood of liquidity in the secondary market.

Walmsley, London Stock Exchange: I think that’s true. But we’ve actually been surprised by the levels of liquidity even in those small size issues of £25m or £35m. Because we have a model where there are mul-tiple market makers, even though those market mak-ers may be quoting in relatively small size when you compare it to the wholesale markets, if there are several quoting at the same time that means there’s always a reasonable size being shown on the screen.

EUROWEEK: How important is it to the borrowers to have liquidity in the secondary market?

Shepherd, Provident Financial: For us it’s very impor-tant as we are a repeat issuer. Giving investors a good experience and seeing liquidity in the secondary market is vitally important.

Tyler, Severn Trent: I disagree. We don’t see a great deal of trading in the secondary market. But we’ve got a very deep portfolio of wholesale bonds, so when we come back to the retail bond market, any future price discovery will be based on looking quite closely at where our institutional bonds are trading. We will price relative to our curve of institutional bonds.

As we went round on the road before our issue though, we got the sense that the investors had a certain benchmark minimum price in mind. I think one reason a lot of corporates haven’t come to the market in current conditions is that they can issue institutional bonds for longer maturities and at lower coupons than are availa-ble in the retail market. So for index-linked we were told investors wanted to see at least 1%, partly because that’s the fee that the custodians and the managers will take. Investors were used to receiving 5% plus for deposits, and haven’t quite caught up to the fact that bank depos-its now offer far lower than that and wholesale rates are lower. As interest rates rise, then expectations will align much more with the wholesale market, and we won’t see as much pricing inefficiency in the retail market.

Gerard Tyler, SEvErn trEnt



Shepherd, Provident Financial: We’re a very different entity — obviously Severn Trent has more institutional debt than retail, but we’re the other way around. Just as I’m sure Gerard looks at how his institutional bonds are trading, we look at how our retail bonds are trading. Also, we’ve seen a benefit to the trading of our institu-tional bond through our access to the retail bond market.

Atkinson, London Stock Exchange Group: Now that the Gilt is rising perhaps the retail market bond market will become more attractive to bigger corporates? For us, it was an interesting journey. We issued in what could be considered benchmark size for the institutional market. We clearly set ourselves up to sell to the retail market initially, but I wonder whether institutions then were attracted in by the benchmark size of the issuance. There was very strong secondary trading in the month or two after we issued. We were also in the position where we already had two institutional bonds, which were very thinly traded. For us, the reasoning behind issuing a retail bond was partly about diversifying the investor base, but also about adding that little bit of competitive tension — signalling to investors that we can go to more than one market.

EUROWEEK: Is there a pricing premium to pay to come to the retail market over the institutional mar-ket?

Tyler, Severn Trent: I think that’s why there haven’t been more bonds issued by large corporates. One rea-son we went to the index-linked format is that it was a better fit for us and because there was less of a pre-mium. We could see a premium that we’d have to pay to issue a successful wholesale fixed rate bond at that time, because of where rates were, but an index-linked issue had much better arbitrage. We provided what was quite a rare investment opportunity to retail investors, and it priced very well. But I think it’s the shape of the yield curve that has probably meant that other large corporates who might look at the retail market have just found it so cheap at the moment to issue in the insti-tutional market. They don’t need to come to this retail market now. But we considered it as important to start diversifying our sources of funding, and if there was a small premium then we could stand that this time, because we were sure we were opening the door for the future.

Ruane, Investec: It was an unwelcome development in the market that some people on the investor side gave feedback that they wanted to see bonds that had a 5% minimum coupon. This was going a little while back, when Gilt yields were much lower. We would really like to see some really good blue chip companies come to this market and give us an institutional type deals that can be accessed by retail names.

In our view, investment grade credit at the moment is actually fully priced. For example, BAT came to the mar-ket at the start of September with a 13 year deal priced at Gilts plus 120bp. So for us, one of the good things about the retail market is that you can find much higher spreads. The downside to that is that we have to look at companies that maybe we don’t know as well, and that means that we have got to do a bit more work on our side. But I would certainly welcome more companies of a blue chip nature, maybe offering institutional-type returns but in retail size.

Atkinson, London Stock Exchange Group: Issuers in the retail market — and especially larger issuers — need to be conscious that retail investors are looking at a dif-ferent portfolio of alternative investments. Conditions last year were right for us to look at the retail market as a viable alternative to the institutional market, because the yields worked for us and clearly investors as well and compared very well to the alternatives available to retail investors at that time. Comparison to alterna-tive yields in other assets is going to continue to be an important factor for investors but also in steering the decisions made by issuers.

Gordon, Killik: I think that is right. Most investors com-ing to the fixed income market are coming for yield, ultimately, and I think there is competition out there from other products.

Where the Gilt market is moving at the moment, we might come back to an environment where we can see some of these bigger names coming to the market. Recent issuance has become very focused on certain sec-tors, such as property, so I think greater diversification would be welcomed.

EUROWEEK: How might the involvement of insti-tutional investors in retail bonds affect the market, both in terms of liquidity and pricing?

Walmsley, London Stock Exchange: I think it will be important in terms of further building liquidity. The Italian retail bond market is highly liquid and because of the retail liquidity that’s built on that platform, it has attracted institutional liquidity.

In the UK market, increased institutional investor interest would be helpful in terms of attracting new issuers. We might see hybrid distribution structures, as Marcus mentioned earlier, and it will certainly be of interest if it means that it will lead to greater diversifica-tion of the types of companies that are coming to the platform. But it’s not to say that we’re aiming to develop an institutional market. This market was developed in response to what we heard from private investors and retail brokers, and they very much wanted a dedicated retail market from the London Stock Exchange.

Coverdale, Lloyds Bank: Obviously Gilt movements have been pretty volatile over the last four months or so, and that impacts on some issuers and also on some inves-tors. Some of the big institutional investors are nervous about the exposure there in extended bookbuilds.

Walmsley, London Stock Exchange: If partial institu-tional investor participation in a transaction means that the window will be shortened, that might be interesting for companies who may have been deterred by the two week standard offer period.

Ruane, Investec: It could certainly shorten the book-build. Then we could work out a way of doing intra-day bookbuilds for retail-type deals, so that all the buyers can respond within that kind of time frame.

EUROWEEK: So this will remain primarily a retail market, but the involvement of institutional investors might enable more sophisticated transactions?

Ruane, Investec: We have to be careful with defini-tions. We have around £22bn in assets under manage-



ment, so arguably we’re of an institutional size. But all our underlying clients are private investors. If there’s an institutional deal, we can turn our commitment around in an hour or two. But we’d have a lot more comfort if we have a day, or two, or even a week, because we’ll have more chance for the wealth managers to speak to their clients and to build bigger demand.

Gordon, Killik: Yes, I think that a pre-marketing period before the deal is actually launched would be helpful.

Coverdale, Lloyds Bank: So if you announced the deal, ran a proper roadshow and had a considered feedback period before you opened the book, investors would be engaged properly and have the time to do the work.

Gordon, Killik: We’d also like to see that extend beyond just the discretionary pools of money and reach out to an advisory base as well.

Ruane, Investec: What you’ve just outlined is exactly what happens in the institutional market: a roadshow, then a discussion around pricing, then the launch and you participate.

Coverdale, Lloyds Bank: Absolutely, but often those institutional roadshows will be focused on the big investment houses, and smaller retail funds may not get as much focus as the really big accounts.

Atkinson, London Stock Exchange Group: I wanted to go back to the credit rating point. Darren, within your firm do you have limits on how much you can invest in individual issuances? Is that determined also by whether they’re rated or not?

Ruane, Investec: It does and it doesn’t. Within our business there are several desks that will each have a couple of billion in assets under management. Often they will have mandates that say they can only hold investment grade credit. For private investors, of course, we don’t have such mandates. These investors won’t ever say never to buy high yield bonds, as this might exclude buying into the likes of the Daily Mail, William Hill or Ladbrokes. It’s a mix, really.

Tyler, Severn Trent: This brings up the topic of mainte-nance. In terms of investor relations, it’s good practice, once a bond’s out there, for a company to spend a num-ber of days a year visiting the main investors and bringing them up to date with the story. That prepares the ground for them to come back to the market again one day.

EUROWEEK: How difficult is that for a provider like you? If you’ve already got institutional investors to meet, are you doubling your workload by seeing retail investors as well?

Tyler, Severn Trent: We often have the materials pre-pared from talking to the institutional equity market and the institutional bond market. But over the last 18 months we focused on meeting with the broker market. And we found that of the private client brokers who are represented on our share register, the number of shares they represent has gone up. So there’s been a beneficial effect from the work we’ve done with targeting that retail bond investor market in the equity base. A sub-stantial section of the UK investor base now has better

knowledge of our company.

EUROWEEK: How do others around the table feel that the retail bond market may develop in future?

Walmsley, London Stock Exchange: The natural pro-gression of the market is that we would expect that investor base to widen out, and then potentially compa-nies could come and issue in US dollars or euros. But I don’t think we’re there yet. This is predominantly a ster-ling market for the time being, and that’s always been our focus in establishing it. We think we need to build out the UK investor base and widen that sterling pool of funding before it progresses to euro and US dollar.

Ruane, Investec: If you have a predominantly UK retail investor base, they want to have UK denominated assets on the bond side. These will often be the lower risk assets within their portfolio, so that’s the bit that will help them on a rainy day. In equities, on the other hand, they’re quite happy to go into US equities, European equities and Asian equities, and they tend to take more risks there. So at the moment we probably see less demand for retail bonds that are denominated in euros.

One development we’d like to see that has already been mentioned is the greater diversification of issuers. We do have a lot of financial and property names in the market, and it would be nice to see a few more non-financials.

Gordon, Killik: I agree. Diversification of the market is key to its development, or at least a very important part of its development.

Most people coming into this market are still probably looking for income, so will look for fixed coupon deals. But given where we are now with interest rates poten-tially rising, there may be some more interest in floating rate note perhaps, and maybe some linkers. But gener-ally, I’d just like to see the market widening out and get-ting more names out there.

Coverdale, Lloyds Bank: Floaters might be a really interesting one. We’ve not seen anything like that yet, but I think there are investors out there who would be delighted to see that kind of development coming along. But from a structural perspective, it’s probably steady as she goes — we don’t want to overburden investors with complexity at this stage.

For example, we’ve thought about looking at bank tier two. What’s happened this year with the Co-op

Gilliam Walmsley, London Stock ExchangE



has raised some questions about that sort of space as a retail investor product. But it could be an interesting one, because it does open up yield for investors in a low yield environment.

Gordon, Killik: The interesting thing about that is that you do have investor participation on the secondary market for those instruments anyway. So while I don’t think it should necessarily be precluded, I’m not sure what the wider appeal would be.

Ruane, Investec: We would find lower tier two capi-tal very interesting. But it raises some issues — some people say this bond market should be very simple, it should be senior and it should be as safe as it can be. Other people argue that maybe it should be offering higher returns, with investors getting 8% for taking a bit more risk. If you can get the right sorts of investors that can understand those risks, well, maybe that’s appropri-ate for the market too. I think we’d be happy with that, but we want to do what’s right for everybody, rather than maybe a certain few investors.

Coverdale, Lloyds Bank: Yes, I think there’s a limit to how racy you can get in terms of structures. We need to see more issuers and higher quality issuers. That’s criti-cal. The potential unwinding of the Funding for Lending scheme (FLS) towards the end of next year will hopeful-ly encourage issuers to look away from the bank funding market, and see how they can diversify their funding.

Gordon, Killik: That’s an interesting point. The FLS has played its part in keeping deposit rates low for savers, so that has created in itself more demand from investors looking for greater returns through the fixed income market.

EUROWEEK: Looking back to when this retail bond market was set up, what did you each hope that this market would achieve? And how has it matched up to your expectations?

Shepherd, Provident Financial: We were keen for the diversification and to issue at smaller ticket sizes, and I think for Provident Financial it’s met our expectations. We’ve been able to do four issues and established a strong presence in the market. However, the lack of new issues over the last 12 months has been disappointing.

Tyler, Severn Trent: For us, I suppose the first test

was that we were happy with the bond that we got away last year. We saw this as a diversification play, not a replacement for our existing sources of funding. I think that if the interest rate dynamic changes there will be more issuers coming in, because it’ll become more economically attractive. The only concern I have is that some of the documentary requirements that are out there will make it harder for first time issuers who aren’t familiar to take the plunge and leave the world of bank debt. But it’s still early days in a market that we think has still a long way to go.

Atkinson, London Stock Exchange Group: I would agree with that. From our point of view, whilst there had always been the desire to support ORB, we seriously considered the timing for our first transaction. Clearly there was sufficient momentum last summer to persuade us that there was demand for a larger issuance. And not only was the issuance successful, but the economics worked versus the institutional market at that time.

We were delighted with the success of the issuance and the sub-5% coupon. It’s traded very well since, so I’ve been very happy with it. Like Severn Trent, we will continue to look at a number of markets for our borrow-ing sources, including the banks, because we desire flex-ibility and diversification in our funding arrangements.

We’re an organisation with an increasingly euro denominated balance sheet, so developments into euros would be great for us. We looked at the Italian retail bond (the MOT) market last year, which is also owned by this group, but competing issuer yields in that market would have made it a very expensive issue at that time. We may possibly return to that market at some point.

But I still see lots of progress ahead of the ORB in terms of new issuance. What the market needs in my view is borrowers who are going to be repeat issuers — maybe not borrowers who will take large, institutional sized deals, but who will come back and tap the market from time to time. I think that would be very helpful.

Coverdale, Lloyds Bank: There are issuers who have maybe one institutional bond of £300m out there, who roll it every five or seven years. It would be good to see those types of names breaking that one issue up into three or four £75m pieces, to spread out their debt maturity profile and provide some ongoing issuance into the retail market.

Gordon, Killik: From an investor’s perspective, there is a recognition of the importance of corporate bonds in a portfolio for diversification purposes and for income generation. Certainly the demand is there, and demo-graphic trends are in favour of the market’s continued development.

Walmsley, London Stock Exchange: We’ve been very encouraged by the success of the market. We shouldn’t forget that it’s a brand new market and a brand new inves-tor base. It’s a new distribution model in the primary market and in just a relatively short period of time — 3-1/2 years — a number of companies have raised a total of over £3.4bn. We are still looking to diversify and attract new companies to the market, and to build secondary market liquidity. Of course, we wouldn’t expect companies to rely solely on the retail market, but we’d like to be one of the options that companies look at when they’re financing, along with bank financing and the institutional markets. We think that the ORB has done well in terms of establish-ing itself as a valid option for borrowers to consider. s

Phil Shepherd, provIdEnt FInancIaL

MIDCAPS AnD SMEs


For the UK’s small and medium sized companies, things are — don’t jinx it — beginning to look up. After one of the longest slumps in living memory — though by no means the worst, on some important measures — Britain’s economy is growing.

Company liquidation rates are head-ing back towards record low territory and unemployment is falling. how-ever, there is little cause for celebra-tion yet. Growth of 0.7% across the economy means some companies and industries may be expanding decent-ly, but others are still flatlining or con-tracting. hope is returning, but has not yet been fulfilled.

“Investment intentions have really rebounded in the past few quarters,” says Lee hopley, chief economist at eeF, the manufacturers’ trade body.

“they’ve been very depressed since 2008 but are now at their highest level for six years. We expect actual pur-chases of new capital equipment to start to rise.”

As the mood lightens, the UK’s obsession with whether banks are starving the economy of credit is beginning to ease and become more nuanced.

“the interface between banks and customers was damaged in the cri-sis and hasn’t really recovered yet,” says hopley. “Companies may not be willing to have discussions with their finance providers, perhaps because they think costs will be prohibitive, or collateral requirements too much.”

there is some evidence for this in the quarterly sMe Finance Monitor survey of 5,000 sMes — though it also

says 76% of sMes were happy not to seek finance in the past 12 months.

stephen Pegge, group external rela-tions director, Lloyds Bank, says sMes’ deposits are still growing as they hoard cash, while they are only using about 50% or 55% of the overdrafts available to them. “We have to hope businesses do start to invest, because unless they invest in developing new markets, in r&D, they are not going to have the most competitive positions,” Pegge says.

Bucking the trendLloyds Bank has managed to grow its sMe loan book 5% to about £25bn in the year to June, in a market that shrank 3% overall — an uptick from Lloyds Bank’ 3% or 4% growth rate throughout the contraction.

Fears that UK industry could not escape recession because it was in the cold, hard grip of miserly banks have proved unfounded. The tens of billions of credit continuously provided by banks have seen most companies through, with some casualties. Innovative financing techniques like private placements, direct lending, retail bonds and crowdfunding have helped at the margins. But as Jon Hay reports, it is when companies begin to grow that these instruments may come into their own.

Banks are not the only fruit: firms seek new funding tools

US private placementS have long been a favourite financing technique for a select group of UK investment grade borrowers.

issuers do need to be of a certain size and credit strength, but the US insurance compa-nies that buy pps are willing to look at unrat-ed, unlisted companies and do not need deals to be of liquid size. this can make the market more attractive than public bonds for suc-cessful midcap companies.

after 2012’s record issuance of $53bn,

of which $10bn was from the UK, volume is down a bit this year, but only because compa-nies are well-funded.

“the vast majority of US pp investors are very willing to lend to UK plc, though some do have concerns about europe as a whole, not just the southern nations,” says David cleary, co-head of US private placements at lloyds Bank in london. “the market is in great shape — books are hugely oversubscribed.”

UK midcap or unrated issuers this year have included Sage Group, Serco, BBc commercial Holdings, the portman es-tate, Johnson matthey, Genesis Housing association and associated British ports.

US investors are so keen that they are competing to offer borrowers extra con-venience features.

One is the ability to issue in sterling. a record 38% of UK issuance this year, cleary reckons, has been in sterling.

that includes paper from UK institu-tions like m&G or the Bae Systems pen-sion fund, which are interested in home-

grown pps, and from US investors willing to use their own credit strength to swap deals advantageously for a borrower.

investors are also willing to agree delayed settlement dates — on one recent deal the borrower will not receive the money for nine months after closing. this means issuers can obtain certainty of funding well before they need the money, but not suffer negative car-ry. investors usually give up to three months’ delay free, then charge 5bp a month. But is-suers can more than recoup this through the favourable basis swap back to sterling.

While the US pp market is fully mature, its european wing remains juvenile. “in an ideal world, five or 10 years from now, it would be fantastic to have deep pools of liquidity in the US, UK and europe,” says cleary. “at the mo-ment there is a deep pool in the US, some in-stitutions in london and a handful in europe. We haven’t got the depth of liquidity we need. Unfortunately, if i’m a classic UK unrated but triple-B corporate issuer, i will generally get the best reception from US firms.” s

Widening range of UK firms find path to US honeypot

“In an ideal world, five or 10 years

from now, it would be fantastic to

have deep pools of liquidity in the US,

UK and Europe”

David Cleary, Lloyds Bank

MIDCAPS AnD SMEs


the government’s Funding for Lending scheme has helped some-what, most agree, if only as an interest subsidy for some new borrowers.

“the real hard battle in going out and finding customers has been to fight the discouragement factor — the sense that ‘finance isn’t available, so I won’t borrow’,” Pegge says. “the great thing about sMes is that they are very diverse. Where we’ve made headway has been where we have industry spe-cialists targeting particular sectors.”

others who work with sMes say it is not so much that banks won’t lend, but that they are stuck in an unhelp-ful mindset. “there is a bureaucratic/regulatory/capital cost/fear of los-ing money logjam in banks,” says Bill Blain, head of the special situations group at Mint Partners, a division of BGC Brokers. “Do you really want one financial sector to be doing 100% of the lending to the growth drivers of the economy? We want to create a more interesting variety by encouraging the growth of a private placement market.”

Sweet spotWhile companies at or near invest-ment grade — and unrated equiva-lents — have long enjoyed many financing options (see box on US pri-vate placements), many players are now striving to broaden choice for the next tier down.

“Companies that are deemed too small to come to the private place-ment market are incredibly well served by the banks at the moment,” says David Cleary, co-head of Us pri-vate placements at Lloyds Bank. “Banks are short of assets, they want new clients and loan pricing is very competitive. the hardest question for a CFo is when to go from all bank funding to put another piece in the capital structure — do you bring in another bank or diversify?”

the UK’s steadily growing retail bond market, where deals of £25m to £60m are common, suits companies of this scale, especially if they have transparent business models that can readily be explained to retail investors (see roundtable, page 48).

But a few UK institutional investors and specialist credit funds are trying to build a domestic PP market for mid-market companies.

“Most corporate finance in the Us happens through alternative net-works, PPs or direct lending,” says

Blain. “But too many investors are wedded to the idea of only buying bonds that they think are liquid. the costs of ratings and legal fees are also way too high — we think you can get it down from six figures to five by using common sense and standard documents.”

New talk on the streetAt the bottom of the sMe food chain, PPs may sound very remote. But even here, innovation and diver-sity are changing the landscape.

Alex Jackman, senior policy adviser at the Forum of Private Business — most of whose members have fewer than 10 employees — highlights the strain on small business of late pay-ment by customers.

“there’s £36bn tied up that doesn’t need to be,” he says. An eU directive, now UK law, imposes a statutory inter-est charge on invoices more than 60 days late.

“But there are ways your custom-er will get round it,” says Jackman. “Marks & spencer have extended their payment terms from 60 to 75 days, sainsbury’s from 30 to 75.” Big compa-

nies are effectively using small ones as a free source of working capital.

to ease it, Lloyds Bank has intro-duced supplier finance, where big companies can borrow from the bank on the strength of their own credit and pay suppliers on the nail, at a small discount reflecting the borrowing cost.

Jackman also welcomes the gov-ernment’s new Business Bank, a one-stop shop for entrepreneurs to access help, and its start Up Loans, as well as trends like crowdfunding. “I don’t think there is that much of a shortage of finance,” he says. “It’s just that busi-nesses need to be more expansive in where they look for it.” s

m&G inveStment manaGement caught the limelight in 2009 when it launched its first UK companies Financing Fund, to help business find alternatives to bank funding amid the credit crisis.

the idea may well have contributed to the government’s decision to invest £1.2bn in a Business Finance partnership scheme. most of this, £863m so far, has been handed to six fund managers, among them m&G, interme-diate capital Group, ares and alcentra.

each will lend government and private money together to businesses with turnover between £25m and £500m. another set of lenders are targeting smaller companies.

While m&G’s first fund lent £930m to 11 companies that were roughly in the FtSe 250 band, this time it is delving deeper into the middle market.

“this is really the core area for banks because the midmarket returns are attrac-tive versus larger corporates,” says James pearce, director of fixed income, who man-ages the UK companies Financing Fund 2. “it’s good to be targeting a space the banks like.”

this kind of company is mostly too small to issue bonds or US private placements, so

until now has had no alternative to banks. the problem is not lack of bank funding but lack of diversity.

the banks, pearce says, “all offer the same thing and all want ancillary business.”

m&G’s proposition is to be as user-friend-ly as a bank, using similar documentation and covenants, but offer longer debt out to 10 years, at around 300bp-600bp over li-bor, without any demand for ancillary busi-ness — useful for a small company that does not have enough to feed two or three big banks.

“people really desire diversity of fund-ing sources and the longer tenor, otherwise they can end up on a refinancing round-about,” says pearce. “a piece of longer pa-per is less time-consuming and gives a more stable structure.” that can make it easier for a company to focus on growing its busi-ness.

launched with £200m of government money and £250m from m&G clients early in 2013, the fund has so far lent £10m to Begbies traynor, the corporate insolvency specialist, and £45m to Workspace, which provides serviced offices for small busi-nesses. s

M&G digs deeper into UK midmarket

“The real hard battle in going out and

finding customers has been to fight

the discouragement factor”

Stephen Pegge, Lloyds Bank

UK IN FIGURES


Over the following pages EuroWeek provides a snapshot of UK economic and banking sector data. We have used the latest data available from the three leading rating agencies, as well as sources such as the Bank of England and HM Treasury. For further information, please refer to the websites of these institutions.

UK in figures: an economic snapshot

• Standard & Poor’s: AAA (Negative Outlook)

• Moody’s: Aa1 (Stable Outlook) • Fitch: AA+ (Stable Outlook)

Bank of England

HM TrEasury

dEBT ManagEMEnT officE

PrudEnTial rEgulaTion auTHoriTy

uk financial invEsTMEnTs

financial conducT auTHoriTy

george osborne MP Chancellor of the Exchequer

robert stheeman Chief executive

Paul Tucker Deputy governor, financial stability

Paul fisher Executive director, markets

andy HaldaneExecutive director financial stability

andrew Bailey Chief executive

robin BudenbergChairman

James leigh-Pemberton Chief executive

Martin Wheatley Chief executive

danny alexander MP Chief secretary to the Treasury

Jo Whelan Deputy chief executive

greg clark MP Financial secretary to the Treasury

Joanne Perez Co-Head of Policy and Markets

Mark carney Governor

charles Bean Deputy governor, monetary policy

sElEcTEd kEy officials

*Leigh-Pemberton will become UKFI executive chairman in Jan 2014

UK IN FIGURES


Strengths:

• A wealthy, open, and diversified economy.

• Effective political institutions that can react quickly to economic challenges.

• Large liquid market for government debt issuance, entirely funded in domestic currency at long maturities.

Weaknesses:

• Structural deterioration in the country’s fiscal position.

• Constraints on medium-term growth prospects.

Rationale

The unsolicited ratings on the U.K. reflect our view that the U.K. government remains committed to implementing its fiscal program, and that it has the ability and willingness to respond rapidly to economic challenges. In addition, the ratings are supported by the U.K.’s wealthy and diverse economy, fiscal and monetary policy flexibility, and adaptable product and labour markets. We also view the U.K. as having deep capital markets with strong demand for long-dated government bonds (gilts) by both domestic and nonresident institutional investors.

We expect real GDP growth to average 1.6% per year in 2013-2016, following growth of 0.3% in 2012. We base our projections on the government’s current fiscal consolidation plans, an assessment of various measures designed to support and shield the economy, and our assumption that the eurozone will return to growth in 2014. It also reflects our expectation that governance issues with specific institutions or changes in EU-wide bank or tax policy will not materially diminish London’s position as the EU’s preeminent financial center. Finally, our forecasts are predicated on the U.K. remaining a member of the EU, with its implications for economic growth and the external position, via the

impact on trade in goods and services, and foreign investment. Therefore, our baseline assumption is that business investment will not be affected by uncertainty regarding the outcome of a possible referendum on EU membership.

In our opinion, the factors that have constrained economic growth in recent years will likely continue to do so. We continue to believe the government’s efforts over the next few years to cut its fiscal deficit will likely drag on economic growth, although we note that the pace of consolidation is expected to ease in the short term. We expect continued deleveraging by banks and households will also restrain growth, while weak external demand will hurt U.K. export performance and slow the pace of economic rebalancing--the eurozone accounts for about half of the U.K.’s overall trade. With weak private-sector domestic demand, corporate investment is likely to recover only as the external environment improves.

The authorities have been taking measures to support and stimulate credit growth, and have been encouraging banks to build capital through measures other than by shrinking loan books, but we do not expect these steps to have a substantial impact on net lending. Nevertheless, we note that the BoE’s highly accommodative policy stance should help to keep private-sector debt-servicing costs moderate, and the currency competitive.

We believe the general government deficit for calendar-year 2012 on the accruals-based European (ESA 95) accounting standard was flattered by the transfer of the Royal Mail pension fund onto the government’s balance sheet. As this was a one-off, we expect a rise in the deficit in 2013, followed by steady fiscal consolidation such that the deficit should fall to approximately 4.2% of GDP in calendar 2016.

Our projection is higher than the Office for Budgetary Responsibility’s (OBR’s) 3.5% of GDP

forecast for fiscal year 2016/2017 on ESA 95 accounting. This is largely based on our view that economic growth will likely be lower than that forecast by the OBR, though we acknowledge that this projection is subject to considerable uncertainty. We anticipate the general government net debt burden will peak in 2016, at just over 95% of GDP, on ESA 95 accounting, before gradually declining. We currently expect that the coalition government’s consensus on fiscal policy will hold and that the government will implement the measures specified in its fiscal consolidation program to achieve the targeted savings.

Outlook

The negative outlook reflects our view of at least a one-in-three chance that we could lower the ratings during the next two years if the U.K.’s economic and fiscal performances were to weaken beyond our current expectations. This weaker growth scenario could see net general government debt approach 100% of GDP, by our calculations, from its estimated current level of 85%.

We could lower the ratings if we were to conclude that the pace and extent of fiscal consolidation has slowed beyond what we currently expect. This could stem from a reappraisal of our view of the government’s willingness and ability to implement its ambitious fiscal strategy or from weaker economic growth than we currently expect. We note risks to growth from falling productivity and private sector deleveraging, as well as the possibility that our assumptions about investor confidence in U.K.-EU-eurozone relations do not hold.

We could revise the outlook on the long-term rating to stable if the economy were to recover more quickly and strongly than we currently anticipate, enabling net general government debt as a percentage of GDP to stabilise during 2014-2015.

April 9, 2013

sTandard & Poor’s oPinion

2007 2008 2009 2010 2011 2012 2013F 2014F

Real GDP (% change) 3.6 -1.0 -4.0 1.8 1.0 0.3 0.5 1.4

CPI inflation (year end, % change) 2.1 3.1 2.8 3.7 4.2 2.7 2.6 2.3

General government financial balance/GDP -2.8 -5.0 -11.4 -10.2 -7.8 -6.3 -6.8 -6.3

General government primary balance/GDP -0.6 -2.8 -9.5 -7.2 -4.5 -3.4 -3.8 -3.1

General government debt/GDP 44.2 52.7 67.8 79.4 85.5 90.0 92.2 94.4

General government debt/revenues 108.2 123.6 170.0 197.3 209.4 213.5 221.3 227.5

General government Interest payment/revs 5.4 5.4 4.8 7.4 8.0 7.1 7.3 7.7

Current account balance/GDP -2.2 -1.0 -1.2 -2.5 -1.3 -3.7 -2.6 -2.3

Source: Moody’s

kEy EconoMic indicaTors

Gross debt-to-income ratio of households

Source: Moody’s Investors Service and Eurostat

0%

50%

100%

150%

200%

250%

EU 17 Germany Ireland France UK

2000 2008 2011

Unemployment rate

Source: Moody’s Investors Service and Eurostat

0%

2%

4%

6%

8%

10%

12%

14%

2000 01 02 03 04 05 06 07 08 09 10 11 12 13F 14F

Germany UK France

US Euro Area

gross dEBT-To-incoME raTio of HousEHolds unEMPloyMEnT raTE

Source: Moody’s, Eurostat Source: Moody’s, Eurostat

UK IN FIGURES


On 22 February 2013, we downgraded the UK’s government bond rating by one notch to Aa1 from Aaa and assigned a stable outlook. Our decision was driven by the following three interrelated factors:

1. The continuing weakness in the UK’s medium-term growth outlook, with a period of sluggish growth, which we now expect will extend into the second half of the decade;

2. The challenges that subdued medium-term growth prospects pose to the government’s fiscal consolidation programme, which will extend well into the next parliament;

3. And, as a consequence of the UK’s high and rising debt burden, a deterioration in the shock-absorption capacity of the government’s balance sheet, which is unlikely to reverse before 2016.

The main driver underpinning the downgrade to Aa1 was the increasing clarity that, despite considerable structural economic strengths, the UK’s economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the UK from the domestic public- and private-sector deleveraging process. We believe that the country’s current economic recovery has already proven to be significantly slower - and believe that it will likely remain so - compared with the recovery observed after previous recessions, such as those of the 1970s, early 1980s and early 1990s. Moreover, while the government’s recent Funding for Lending Scheme has the potential to support a pick-up in growth, we believe that the risks to the growth outlook remain skewed to the downside.

The sluggish growth environment in turn poses an increasing challenge to the government’s fiscal consolidation efforts, which represents the second driver informing the one-notch downgrade of the UK’s

sovereign rating. When we changed the outlook on the UK’s (then Aaa) rating to negative in February 2012, we cited concerns about the increased uncertainty regarding the pace of fiscal consolidation due to materially weaker growth prospects, which contributed to higher than previously expected projections for the deficit, and consequently also an expected rise in the debt burden. We now expect that the UK’s gross general government debt level will peak at just over 96% in 2016. We would have expected the debt level to peak at an even higher level if the government had not reduced its debt stock by transferring funds from the Asset Purchase Facility - which will equal to roughly 3.7% of GDP in total - as announced in November 2012.

More specifically, projected tax revenue increases have been difficult to achieve in the UK due to the challenging economic environment. As a result, the weaker economic outturn has substantially slowed the anticipated pace of deficit and debt-to-GDP reduction, and is likely to continue to do so over the medium term. After it was elected in 2010, the current coalition government outlined a fiscal consolidation programme that would run through this parliament’s five-year term and place the net public-sector debt-to-GDP ratio on a declining trajectory by the 2015-16 financial year. (Although it was not one of the government’s targets, we had expected the UK’s gross general government Debt -- a key debt metric in our analysis -- to start declining in the 2014-15 financial year.) However, the government has since announced that fiscal consolidation will extend into the next parliament, which necessarily makes implementation less certain.

Taken together, the slower-than-expected recovery, the higher debt load and the policy uncertainties combined to form the third driver of the downgrade - namely, the erosion of the shock-absorption capacity of the UK’s balance sheet. We believe that the mounting debt levels in a low-growth environment have impaired

the sovereign’s ability to contain and quickly reverse the impact of adverse economic or financial shocks. For example, given the pace of deficit and debt reduction that we have observed since 2010, there is a risk that the UK government may not be able to reverse the debt trajectory before the next economic shock or cyclical downturn in the economy.

In summary, although the UK’s debt-servicing capacity remains very strong and very capable of withstanding further adverse economic and financial shocks, it does not at present possess the extraordinary resilience common to Aaa-rated issuers.

Rating Outlook

The stable outlook on the UK’s Aa1 sovereign rating partly reflects the strengths that underpin the Aa1 rating itself - the underlying economic strength and fiscal policy commitment which we expect will ultimately allow the UK government to reverse the debt trajectory. The stable outlook also reflects that we do not expect a further material deterioration in the UK’s economic prospects or additional material difficulties in implementing fiscal consolidation.

The outlook also reflects the greater capacity of the UK government compared with its euro area peers to absorb shocks resulting from any further escalation in the euro area sovereign debt crisis, given (1) the absence of the contingent liabilities from mutual support mechanisms that euro area members face, (2) the UK’s more limited trade dependence on the euro area and (3) the policy flexibility that the UK derives from having its own currency, which is a global reserve currency. Lastly, the UK also benefits from a considerably longer-than-average debt maturity schedule, making the country’s debt-servicing costs less vulnerable to swings in interest rates.

July 4, 2013

Moody’s oPinion

Source: Moody’s Investors Service

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

2001 02 03 04 05 06 07 08 09 10 11 12 13F 14F 15F 16F 17F

France UK Germany

Italy Spain

Real GDP (year-on-year change)

rEal gdP (yEar-on-yEar cHangE)

Source: Moody’s

Public finances trajectory (% of GDP)

Source: Eurostat and Moody’s

- 9

- 8

- 7

- 6

- 5

- 4

- 3

- 2

- 1

0

78

80

82

84

86

88

90

92

94

96

98

100

2011 2012 2013F 2014F 2015F

Debt (LHS) Deficit (RHS)

PuBlic financEs TraJEcTory (% of gdP)

Source: Eurostat, Moody’s

UK IN FIGURES


1

2

3

4

Jan 10 Feb 11 Mar 12 Apr 13

EZ US UK

Inflation Expectations5Y forward 5Y break even inflation

(%)

Source: Fitch Ratings, Datastream

-8

-6

-4

-2

0

2

4

6

1980 1987 1994 2001 2008 2015

Sep 11 Mar 13

Output Gap Estimates

(%)

Source: Fitch Ratings, Oxford economics

inflaTion ExPEcTaTions fivE yEar forWard fivE yEar BrEak-EvEn inflaTion

ouTPuT gaP EsTiMaTEs

Source: Fitch Ratings, Datastream Source: Fitch Ratings, Oxford economics

Rating Watch Resolved: Fitch Ratings downgraded the UK’s Long-Term ratings to AA+ from AAA on 19 April 2013 as we concluded the review of the UK’s sovereign ratings initiated on 22 March 2013. The Outlook is Stable, indicating a less than 50% chance of a further rating change in the next few years.

Debt Peaking Higher and Later: Fitch expects the general government gross debt (GGGD) to peak at 101% of GDP in 2015-2016 (equivalent to 86% of GDP for public sector net debt, PSND) and to gradually decline from 2017-2018. This compares with our previous projection for GGGD peaking at 97% and declining from 2016-2017 and the AAA median of around 50%.

Limited Fiscal Space: Fitch has previously commented that failure to stabilise debt below 100% of GDP and place it on a firm downward path towards 90% of GDP over the medium - term would likely trigger a rating downgrade. Despite the UK’s strong fiscal financing flexibility underpinned by its own currency with reserve currency status and the long average maturity of public debt, the fiscal space to absorb further adverse economic and financial shocks is no longer consistent with a AAA rating.

Unexpectedly Weak Economy: Budget deficits and debt that is higher than previously forecast reflects the weak growth performance of the UK economy in recent years, which is partly due to private and public sector deleveraging and the eurozone crisis. Overall GDP growth of 0.3% in 2012 was disappointing and below the 1.0% growth in

2011. Fitch expects growth of 0.8% in 2013 and 1.8% in 2014.

Debt Falling Over Medium Term: Under the baseline scenario, which assumes a continued policy commitment to reducing the underlying budget deficit and medium-term annual growth potential of 2%-2¼%, government debt gradually falls as a share of national income in the latter half of the decade. While this growth rate would be below the pre-crisis average, due to the UK’s strong fundamentals and flexibility of labour and product markets, Fitch maintains its view that the UK economy will grow faster than most of its EU peers.

Strong Institutional Framework: The effective control of public expenditure and tax administration with the broad-based political and public commitment to deficit reduction underpins Fitch’s assumption that fiscal consolidation will be sustained beyond the term of the current parliament through a combination of spending and tax measures. Nevertheless the admitted failure to meet the target of debt peaking in 2014-2015 erodes the credibility of the UK’s fiscal framework.

Rating Sensitivities

Failure to Stabilise Debt: Not being able to stabilize the debt over the medium term would be rating negative.

Macro-Financial Stability Risks: Adverse financial shocks, like the intensification of the eurozone crisis or an erosion of confidence in the UK’s policy

commitment to price stability could put pressure on the rating.

Declining Deficit and Debt: Budget deficits and debt declining at a faster pace than currently projected so that GGGD is on a sustainable path towards 90% of GDP and below could lead to a positive rating action. A stronger-than-expected recovery and rebalancing of the UK economy would also be rating positive.

Scope of Report

This report focuses on three topics: assessing the output gap and potential growth prospects of the UK economy; the updated debt dynamics calculations and; comparing the UK’s credit profile to other highly rated peers, identified as key factors for reviewing the rating when Fitch placed the UK on Rating Watch Negative on 22 March 2013.

Weak Economic Recovery

The UK economy grew by 0.3% in 2012, with a volatile quarterly profile due to temporary effects, like the Diamond Jubilee in Q212 and the Olympics in Q312. Economic growth gradually slowed from 1.8% in 2010 and 0.9% in 2011 to near stagnation in 2012. While the recovery from the 2008-2009 financial crisis was always expected to be lengthy and uneven, due mainly to the parallel deleveraging of the private and public sectors and the eurozone crisis, the weakness of activity in 2012 was a surprise to most forecasters, including Fitch.

April 24, 2013

fiTcH oPinion

80

85

90

95

100

105

110

2009 2010 2011 2012 2013 2014 2015 2016

Debt Peak 'AAA' Comparision

(Debt/GDP, %)

Source: Fitch estimates, national sources, IMF

(Debt peaking in)

UK April 2013

France

UK March 2012UK Sep 2012

US

Germany

dEBT PEak ‘aaa’ coMParision

Source: Fitch estimates, national sources, IMF

UK IN FIGURES


Consolidated Domestic Domestic Gross mortgage Long-term bank Standalone Adjusted total assets as of market share market share lending market deposit rating credit strength* BCA end-December (SME loans, in %) (deposits, in %) share (2011) (local currency) and outlook Name 2012 (in £bn) and outlook

RBS 1,312 24% 15% 7.5% A3/ RUR DGN D+/ baa3/RUR DGN baa3

Barclays 1,490 18% 13% 8.3% A2/ Neg C- /baa2/Stable baa2

Lloyds*** 925 23% 25% 26.7% A2/ Neg C-/ baa2/Stable baa2

HSBC Bank** 815 15% 14% 5.5% Aa3/ Neg C/ a3/Stable a1

Santander UK 293 5% 13% 13.9% A2/Neg C- /baa1/Stable baa1

Five large banks 4,836 85% 80% 62% A2 C-/baa2 Baa2

* Bank Financial Strength (BFSR) ratings express a bank’s standalone credit strength on a scale from A to E, without taking support considerations into account. Long-Term (LT) Bank

Deposit Ratings reflect both a bank’s stand-alone credit strength and support considerations. For more detail, see Moody’s banking methodology webpage

** Moody’s applies the BFSR methodology only to operating companies, consequently HSBC Holdings does not have a BFSR; however, Moody’s views the intrinsic financial strength

of the overall HSBC Group as corresponding to a1. HSBC Holdings long-term ratings incorporate two-notch uplift for systemic support from the UK government and a one notch

reduction to take into account the structural subordination of the holding company

*** Lloyds was required to divest 4.6% market share in the personal current account market by 30 November 2013.

Source: Moody’s Banking System Outlook, July 2013

raTEd Banks

System aggregates for Tier 1 capital ratios

Source: Moody’s Investors Service adjusted financials

0%2%4%6%8%

10%12%14%16%18%

20%

2008 YE 2009 YE 2010 YE 2011 YE 2012 YE

Austria Denmark France Germany Italy Portugal Spain Sweden Switzerland UK

Problem loans / gross loans for rated banks, by system

Austria Denmark France Germany Italy Portugal Spain Sweden Switzerland UK


0%

2%

4%

6%

8%

10%

12%

14%

2008 YE 2009 YE 2010 YE 2011 YE 2012 YE

sysTEM aggrEgaTEs for TiEr onE caPiTal raTios

ProBlEM loans / gross loans for raTEd Banks, By sysTEM



UK IN FIGURES


Deleveraging strategies of largest UK banks o�set FLS stimulus of lending to UK private sector

[1] Certified Base Stock of loans as at 30/06/12 (£m)

Source: Moody’s Investors Service on Bank of England

-25

-20

-15

-10

-5

0

5

10

15

FLS drawings Net lending to Private sector (June - 12 March 13)

Lloyds Banking Group

£bn

RBS Group

Santander Barclays

Nationwide Building Society Banks with between £5bn and £150 billion stock loans [1]

Banks with stock loans below £5bn [1]

Impairment charges at large UK banks (£ billion)


0

2

4

6

8

10

12

14

16

18

HSBC Lloyds RBS Barclays Santander UK

2009 2010 2011 2012

Five-largest UK banks’ net exposure to GIIPS C relative to Tier 1 capital year-end 2012 £bn

Source: Moody’s Investors Service on Company Reports: Lloyds, HSBC Holdings, Barclays, RBS, Santander UK

0

50

100

150

200

250

300

Aggregate GIIPSC exposure Aggregate Tier 1 capital

Sovereign Banks and Corporates Personal Others Tier 1 capital

Uplift in UK banks ratings due to parental or systemic support

Source: Moody's Investors Service

Co-Operative Bank Plc

West Bromwich Building Society

Bank of Ireland (UK) Plc

Skipton Building Society

Principality Building Society

Kleinwort Benson Bank Ltd

Investec Bank Plc

ICICI Bank UK Plc

Ulster Bank Limited

Yorkshire Building Society

Nottingham Building Society

Nedbank Private Wealth Limited

National Westminster Bank PLC

Royal Bank of Scotland plc

Coventry Building Society

Leeds Building Society

Close Brothers Ltd

Barclays Bank PLC

Bank of Scotland plc

Lloyds TSB Bank Plc

Santander UK PLC

Nationwide Building Society

Clydesdale Bank plc

HSBC Bank plc

Baseline Credit Assesment (BCA) Parental support Systemic support

Ca Caa2 B3 B1 Ba2 Baa3 Baa1 A2 Aa3

Short-term wholesale funding and liquidity buers at large UK banks have stabilised at comfortable levels £bn

Source: Moody’s

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

0

100

200

300

400

500

600

700

2008 2009 2010 2011 2012

Primary (FSA eligible) liquidity buer

ST wholesale debt (Market Funds - Liquid Assets) / Total Assets - RHS

Lending to UK industries and resident sectors April 2013

Source: Moody’s Investors Service on Bank of England

Manufacturing1%

Construction & Real Estate 9%

Services 6%

Other 4%

Financial Corporations34%

Personal Secured42%

Personal Unsecured4%

dElEvEraging sTraTEgiEs of largEsT uk Banks offsET fls sTiMulus of lEnding To uk PrivaTE sEcTor

uPlifT in uk Banks raTings duE To ParEnTal or sysTEMic suPPorT

sHorT-TErM WHolEsalE funding and liquidiTy BuffErs aT largE uk Banks HavE sTaBilisEd aT coMforTaBlE lEvEls (£bn)

lEnding To uk indusTriEs and rEsidEnT sEcTors aPril 2013

iMPairMEnT cHargEs aT largE uk Banks (£bn)

fivE largEsT uk Banks’ nET ExPosurE To giiPs-c rElaTivE To TiEr onE caPiTal yEar-End 2012 (£bn)

Source: Bank of England, Moody’s Banking System Outlook, July 2013





Source: Bank of England, Moody’s Banking System Outlook, July 2013

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