A.53 HM Treasury's May 2006 Application Note "Interest-rate & Inflation Risks in PFI Contracts"1 (Interest-Rate & Inflation Application Note) contains guidance on hedging issues for projects at various stages in procurement through to financial close. In particular, it includes guidance on the execution process for interest rate swaps that are common to most PFI projects (see section 2.7 of the note).
A.54 The interest-rate swap is a very important part of the cost of the overall financing arrangement and it is important that Authorities are aware of the issues which arise and able to manage the process so as to protect their interests.
A.55 In addition to those set out in the Interest-Rate & Inflation Application Note, Authorities should consider the following points:
• credit spreads have increased significantly since the Note was published. Authorities should be mindful of how these spreads are set and how long lenders will hold them for;
• credit spreads should be set under a competitive process where practical, similarly to loan margins. As such they should be considered within the context of any funding competition;
• as well as credit spreads, transparency in the underlying swap rate is also critical. Where a competitive process cannot be adopted for the determination of that rate then it is important that it is rigorously benchmarked (both the underlying rate and the execution spread) by the Authority's financial advisors or a specialist in this area; and
• swap credit margins can have implications for compensation on termination and refinancing calculations in a way that increased loan margins generally do not. The termination of a swap generally involves the payment of the present value of future swap margin whereas the prepayment of a loan normally does not involve any recognition of future margins forgone. This acceleration of the swap credit spread following prepayment may have a significantly adverse effect on the value for money assessment of any future refinancing.
A.56 Funders committing to a loan on a take and hold basis typically amortise the upfront fee over the loan life. However, in some cases the value of the swap credit spread is recognised upfront and by a different department within the financial institution. This has a number of implications:
• deciding which lenders will arrange the swap(s) and whether or not they can be removed from the financing / swap provider group should be a key part of the financing competition / book-build process rather than an afterthought. In some cases, a separate swap competition may be appropriate. This arrangement is a matter for the bidder but the public sector should understand and agree the key aspects of the process given they take the price risk on swap rates;
• not all lenders in a club are equally positioned when it comes to providing hedging. For example, building societies are generally unable to provide swaps but may provide other solutions. The Authority and its advisers should seek to understand the bidder's overall hedging strategy early on and in particular whether it requires any derogations from SoPC4; and
• particularly for larger transactions, there is a balance to be struck between too many swap participants and too few. If every lender in the club is given the right to participate there may be a large number of participants seeking to execute trades at the same time which may lead to market confusion. Alternatively, if there are too few swap participants, the Authority may lose the option of removing a swap provider / lender from the transaction should they no longer offer value for money.
A.57 Further to section 3.2 of the Interest-Rate & Inflation Application Note, the VfM baseline should be a matching of indexation of the service charges to the underlying inflation exposure of the contactor's costs2 during the service delivery period. Any Authority seeking an alternative treatment will require the approval of Infrastructure UK as part of the business case and VfM assessments.
A.58 In addition, Authorities should note that the inflation swap market is smaller and less transparent than the interest rate swap market and therefore more difficult to benchmark. As such, the principles set out herein are particularly important for inflation (e.g. RPI) swaps.
A.59 These are complex matters with significant commercial importance to the participants. Authorities should therefore seek input from their financial advisers and/or Infrastructure UK.
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1 http://www.hm-treasury.gov.uk/ppp_finance_guidance.htm
2 Selection of indices is covered at paragraph 1 5.2 of SoPC4 and section 3.3 of HM Treasury's May 2006 Application Note "Interest-rate & Inflation Risks in PFI Contracts"