5.2. The UK situation
5.2.1. Prior to the onset of the financial crisis, the UK PPP bond market was supported by a core group of institutional investors comprising pension funds and fund managers. These investors bought approximately £15 billion of bonds issued by PPP project companies in the UK between 1997 and 2008. Since January 2008, no bonds have been issued to fund PPPs.
UK institutional investors historically active in the PPP bond market |
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| Assets under | |
Aberdeen Asset Management | £146.2
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* Most recently reported total assets under management. Dates for figures vary according to individual companies' reporting schedules and currency units match companies' home currencies. All of these investors with the exception of British Steel Pension Fund and Hermes, which is owned by and man-ages the BT Pension Scheme, are asset managers which make investments on behalf of large numbers of institu-tional and retail investors. The insurance companies in the list are also asset managers and the figures shown are related to their asset management activities, not the portfolios of their life insurance affiliates. | ||
Source: public information
5.2.2. The large majority of UK PPP bonds have been index-linked. It is important to note that the prevalence in the UK of index-linked debt, while a natural fit for many investors as explained in 1.3.9 4), is exposing the procurers to a potentially higher inflation risk 5). UK Treasury guidance has since required authorities to assess the po-tential impact of inflation assumed by the public sector over the life of the project when funding is provided through index-linked debt, which will potentially make this funding route less attractive relative to fixed rate bank or bond debt than it has been in the past. It is too early to know if this will be the case, the inflation risk guidance having been issued only shortly before the onset of the financial crisis.
In the United Kingdom, the question is clearly one of revival rather than invention. There is a pipeline of several hundred million pounds of projects of a sufficient size to provide the liquidity that bond investors require. The obstacles to a return to bond financing have been given earlier in this paper and need not be repeated here. The factors that brought UK institutional investors to the PPP debt market in the 1990s continue to exist: attractive risk-adjusted returns and long-term maturities that match their liabilities. UK institutional investors have expressed interest in re-entering the market, and the UK government has made efforts to ensure that capital markets financing solutions are considered for projects currently in procurement.
5.2.3. For the time being, there has been little movement from institutional investors. There are sufficient alterna-tive investments for investors to avoid addressing the impediments to their lending to PPPs in a systematic way and the government continues to be able to deliver its project pipeline using the banking market with the backstop of the Treasury's Infrastructure Finance Unit 6). It is likely that one or both of these circumstances will need to change before UK institutional investors re-engage with the PPP market.
Example of payment flows for an indexed linked bond issued by the French Treasury: Referenced bond = OATi 3.40% due 25/07/2029 Annual payment to bondholder = Bond coupon x par value x indexation coefficient Indexation coefficient = daily inflation reference/base in-dex for the referenced OATi In practice, it is not necessary to calculate the daily infla-tion reference because the indexation coefficient for each OATi is published by the Agence France Trésor for every day. For the most recent interest payment date of the ref-erenced bond, 25/07/2009 , the indexation coefficient was 1.17435 and the interest paid on €1,000,000 of par value would have been: 3.40% x €1,000,000 x 1.17435 = €39,927.90 When the bond matures in 2029, the principal due will also be multiplied by the indexation coefficient at the time, which will compensate bondholders for the 30 years of inflation since the issuance of the bond in 1999. The effect of this mechanism is to transfer the risk that inflation will exceed the interest rate on the bond from the bondholder to the issuer. Because it is generally the case that inflation is expected to be a positive figure over a long period, the stated coupon on a conventional bond is higher than that on an indexed linked bond to compensate investors for taking the inflation risk. It is therefore possible at any point in time to calculate the break-even inflation rate at which investors would be indifferent to buying conventional and indexed-linked bonds of the same du-ration. This calculation is made by comparing the forward yield curves of the two types of securities and is published by the AFT for each OATi issuance. For the OATi used in the example, this break-even inflation rate was 1.9% as of 1/12/2009, i.e. if annual inflation turns out to be below 1.9% for the remaining life of the bond, investors would be bet-ter off buying the fixed rate 5.5% OAT due in 2029 rather than the referenced OATi. |
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4) The appetite for indexed linked debt was also driven on the public sector side by project evaluation criteria that allowed authorities to somewhat artificially improve project affordability by using the lower nominal interest payments of index-linked debt, relative to fixed rate debt, in the early years of a project to bring down the payments to the project company. These relatively lower early payments would, of course, later be reversed in a normal inflationary environment, but this factor was not given significant weight in the assessment of project cost.
5) Or indeed lower.
6) The Infrastructure Finance Unit was established as a separate unit within HM Treasury in March 2009 to provide funding for PFI projects which do not have sufficient private sector funding. It does not compete with the private market and is intended to provide funding at the market price to fill a gap or to avoid delays in closing caused by the withdrawal of a lender from a project nearing financial close. At the date of this paper, it has lent to one project, a waste management scheme sponsored by the Greater Manchester Waste Authority. In that case, a bank in the lending group reduced the amount of its commitment in the two weeks prior to scheduled financial close and the Infrastructure Finance Unit lent £120 million to make up the shortfall and allow the project to close as planned. It has been recently announced that TIFU will be merged into the newly created Infrastructure UK.