Cutting out the banks

11th July 2012

Banks have probably never been so unpopular as they are at this moment. And bonds have never yielded so little – with returns on safer offerings negative after inflation.

Putting these two thoughts together – as some smart corporate players have done – can produce a win-win for firms and financials that cuts out the banks, in the same way as peer to peer products in personal loans (such as Zopa), small business borrowing (Funding Circle) and even currency exchange deals (Currency Fair), can bypass banks in small transactions.

But while peer to peer transactions are still very much in their infancy – banks reckon they don't add up to much more than a small town branch or two in their totality – the nation's most disliked have more to fear from the still new phenomenon of institutions financing major projects.

Beating the banks at their own game

It's almost totally unpublicised, with virtually all projects protected by a wall of confidentiality but the amounts involved can often be to the tune of tens of millions. The bank-beating activity is an extension of the infrastructure investment concept that has seen many pension funds and other institutions backing roads, river projects, railway lines, bridges and airports.

The reasons are clear. Pension and other funds have to match their assets to their liabilities such as payments to members in retirement or potential life assurance claims. And for most, the only way to ensure that fit is via top quality bonds – equities are too risky especially for final salary pension plans that have few members still working.

Bonds yields need microscope

But bonds have a fatal flaw.  After more than a decade of beating just about every other asset class out of sight, they are overpriced.  The benchmark UK 10 year gilt yields just 1.58%, marginally ahead of the US 1.53%. The German figure is 1.33% while Japan offers a microscopic 0.80%. Even going 30 years out in the United States only produces 2.62%.

These generally fail to keep up with inflation and as they often back payments which are linked to prices, must represent a wasting asset.  This is worsened by the lack of new money coming into these funds.

Real assets beat paper

The answer for many funds is to take a leaf out of the property investment book and look for real assets. Just as many pension and insurance vehicles backed real estate ventures such as office blocks and retail developments in return for long term returns higher than bonds or cash but linked to rising prices (or prosperity) thanks to the five yearly upwards only rent reviews, they could now do infrastructure deals that offered similar benefits but often with implicit or explicit government backing.

Even so, according to a report in the Financial Times, "pension funds globally are pulling back back from infrastructure investments in a worrying trend for cash-strapped western governments seeking to attract private money to the sector."

In the past five years until the end of April 2012, pension funds around the world have reduced their allocation, or deployment of capital, to such $49.46bn, according to research by Infrastructure Investor, a publication for infrastructure finance and investment.

Combining the best of two worlds

Some investors now believe they can go further than this basic model, exploiting both the commercial property and the infrastructure models. They are willing to forego any government guarantee of income on a project in return for a better yield  by acting as bank-style lenders to corporates. In effect, the fund lends the company money which it secures on fixed assets, primarily property to give security.

The financial fund wins because it receives a substantial uplift on the bond yield – more than enough to compensate for increased risk and the lack of a credit rating. Correctly structured, it should offer more than most junk bond categories.

And the corporate wins because it pays less for this form of financing than for a long term bank loan – often two or three per cent less, allowing it to afford a degree of inflation-linking.

But if that's too risky for some investors, and traditional infrastructure models have become less attractive, they can always try this new local government financing  package.

According to the Public Finance website, agreements have been reached to devolve economic powers to six of the largest cities in England – Birmingham, Bristol, Leeds, Newcastle, Nottingham and Sheffield – as part of the government ‘city deals' structure. 

These six cities join Liverpool and Manchester in signing deals to give the authorities a greater role in training, job creation and infrastructure development.

The city deals include backing for Tax Increment Finance schemes to fund infrastructure in Newcastle, Sheffield and Nottingham.

Nottingham City Council will be given powers to create a venture capital fund to invest in high tech business start-ups and growth businesses, creating further opportunities for investors.

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