PART 1
(OPEN TO THE PUBLIC)
ITEM NO 6
REPORT OF THE CITY TREASURER
TO:
BUDGET SCRUTINY COMMITTEE – 30TH OCTOBER 2007
SUBJECT : MANAGED INVESTMENT – SCOTTISH WIDOWS INVESTMENT
PARTNERSHIP
RECOMMENDATION: Members are requested to comment on the contents of the report
EXECUTIVE SUMMARY:
This report provides a progress report on the investment managed on behalf of the
Council by Scottish Widows Investment Partnership (SWIP).
BACKGROUND DOCUMENTS:
Various working papers in the Finance Division including; Monthly monitoring reports from SWIP
 Review reports and advice from Sector
CONTACT OFFICER: Elaine Marks-Parker
Tel No. 793 3224
ASSESSMENT OF RISK
The investment was placed with SWIP following a tendering and evaluation exercise.
SOURCE OF FUNDING : Revenue Budget
LEGAL ADVICE OBTAINED : Not applicable
FINANCIAL ADVICE OBTAINED : This report has been prepared in the Finance Division
of Customer and Support Services.
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BACKGROUND
On 8th May 1996 approval was given to appoint Hambros Fund Management plc, later
taken over by Investec, to manage a proportion of the Council’s investments for an initial
period of two years, with an option to extend subject to their satisfactory performance. A
deposit of £20M was placed with the fund managers on 5th July 1996.
The performance achieved by the Hambros / Investec fund managers compared to 7 day
LIBID are detailed in Appendix 1 to this report and is summarised in Table 1 below showing
the number of quarters in each year where Investec’s performance shows a gain or loss
compared to 7 day LIBID and the cumulative loss or gain in the year.
Table 1. Investec Performance compared to 7 day LIBID
Year
Qtrs with Gains
Qtrs with Losses
1996-1997
0
3
1997-1998
4
0
1998-1999
3
1
1999-2000
1
1
2000-2001
4
0
2001-2002
1
3
2002-2003
4
0
2003-2004
1
2
Total
18
10
Total overall net gain against 7-day LIBID
Average annual net gain against 7-day LIBID
Cumulative Gain/(Loss)
%
(0.10)
0.36
2.11
(0.34)
1.53
(0.35)
1.58
(0.81)
3.98
0.54
The investment was recalled in early 2004. The timing coincided with a decision to
reschedule debt and repurchase stock to achieve savings built into the 2004-05 revenue
budget. This debt rescheduling gave rise to premiums which were financed from interest
savings during the life of the replacement loans. The payment of these premiums reduced
the balances available for short term investment to the extent that they were insufficient to
sustain an external fund manager.
In 2005-06, following the accumulation of funds and reserves available for investment,
together with a favourable interest rate outlook forecast, a decision was made to re-engage
fund managers and externalise a proportion of the Council’s investment portfolio.
The investment parameters set for the external fund managers enable them to deal in
Government Stocks (Gilts). Fund managers can be expected to outperform cash deposits
in an environment where interest rates are expected to fall. In this environment the gilt
yield usually falls in advance of a movement in interest rates and this is reflected in an
increase in the price of the stock enabling fund managers to achieve a profit from dealing in
gilts. Fund managers undertake two types of dealing in gilts, short term tactical deals to
take advantage of anomalies in the markets and strategic deals based on their
expectations of future movements in the markets.
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Interest rate forecasts available in September 2005 are shown in Table 2 below:Table 2 Interest Rate Forecasts – September 2005
suggesting favourable terms for fund managers in base rate and 5-year gilts
Q/E3
2005
Q/E4
2005
Q/E1
2006
Q/E2
2006
Q/E3
2006
Q/E4
2006
Q/E1
2007
Q/E2
2007
Base Rate
4.50%
4.50%
4.50%
4.25%
4.00%
4.25%
4.25%
4.50%
5yr Gilt Yield
4.25%
4.25%
4.00%
4.00%
4.25%
4.50%
4.50%
4.75%
10yr PWLB Rate
4.50%
4.50%
4.25%
4.25%
4.50%
4.50%
4.75%
4.75%
25yr PWLB Rate
4.50%
4.50%
4.50%
4.50%
4.50%
4.50%
4.75%
4.75%
Source: Sector
On 14th December 2005, following a tender exercise and evaluation, a £20M investment
was placed with the investment fund managers, Scottish Widows Investment Partnership
(SWIP), for a period of up to 3 years subject to satisfactory performance.
Investment parameters were set for SWIP as outlined above, which it was anticipated,
would utilise the expertise of the fund managers and, consequently, result in better returns
than were being achieved by the in-house team.
PERFORMANCE
The initial investment was made near to the end of Q3 of the 2005-06 financial year.
Details of SWIP’s performance against target are contained in Appendix 2 to this report and
summarised in Table 3 below.
Table 3 SWIP Performance compared to 7 day LIBID
demonstrates performance has been disappointing
Year
No of months
- Gains
0
6
2
8
2005-06 (From 14/12/05)
2006-07
2007-08
Total
Source: SWIP Valuation Statements ;
No of months
- Losses
3
6
4
13
Gain/(Loss)
(1.83)
0.12
(0.38)
(0.30)
Sector Bulletins
As can be seen from the appendix and the table, SWIP’s performance has been
disappointing. Their performance has been subject to review both informally on receipt of
monthly valuation statements and formally at quarterly meetings with the fund managers
and Sector.
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At these review meetings performance against targets have been assessed and the
economic factors affecting that performance have been taken into account, as well as the
future prospects based on SWIP’s and Sector’s analysis of the market’s economic and
interest rate forecasts.
At the first review meeting early in the 2006-07 financial year interest rate forecasts
suggested that the climate would continue to be favourable and afford fund managers
opportunities to improve on their initially poor results during 2006. The forecast available in
April and May 2006 are shown in Table 4 below.
Table 4 Interest Rate Forecast April/May 2006
base rate forecasts remain favourable
Q/E2
2006
Q/E3
2006
Q/E4
2006
Q/E1
2007
Q/E2
2007
Q/E3
2007
Q/E4
2007
Q/E1
2008
Base Rate
4.50%
4.25%
4.00%
4.00%
4.25%
4.50%
4.75%
4.75%
5yr Gilt Yield
4.00%
4.00%
4.00%
4.25%
4.50%
4.75%
5.00%
4.75%
10yr PWLB Rate
4.25%
4.25%
4.25%
4.50%
4.50%
4.75%
4.75%
4.75%
25yr PWLB Rate
4.25%
4.255
4.25%
4.50%
4.50%
4.75%
4.75%
4.75%
50yr PWLB Rate
4.00%
4.25%
4.25%
4.25%
4.50%
4.50%
4.50%
4.50%
Source: Sector
During 2006 inflation became a major and unexpected (to the money market) issue and the
yield of short dated gilts increased. Despite successful tactical trading in the most part, on
several occasions the strategic moves were unsuccessful and the losses from those trades
more than wiped out the gains from tactical trades.
By July 2006, interest rates forecasts had started to harden, with base rate forecasts now
at 4.5% during late 2006 and into 2007, against 4% previously forecast for Q1 2007, and
similar upward movement in gilt yields. However, opportunities around gilts of up to 10
years duration still remained. The return for 2006-07 was 4.54% (net of fees) compared to
the 7 day LIBID benchmark of 4.84%.
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Table 5 Interest Rate Forecast July 2006
some opportunities still existed
Q/E3
2006
Q/E4
2006
Q/E1
2007
Q/E2
2007
Q/E3
2007
Q/E4
2007
Q/E1
2008
Q/E2
2008
Base Rate
4.50%
4.50%
4.50%
4.50%
4.75%
4.75%
4.75%
4.75%
5yr Gilt Yield
5.00%
4.75%
4.75%
4.75%
4.75%
4.75%
4.75%
4.75%
10yr PWLB Rate
4.75%
4.50%
4.50%
4.50%
4.50%
4.75%
4.75%
4.75%
25yr PWLB Rate
4.50%
4.25%
4.50%
4.50%
4.50%
4.75%
4.75%
4.75%
50yr PWLB Rate
4.50%
4.25%
4.25%
4.50%
4.50%
4.50%
4.50%
4.50%
Source: Sector
The decision of the Bank of England Monetary Policy Committee (MPC) on 2 nd August
2006 to increase Base Rate to 4.75% took the markets by surprise. The increase was
intended to cool the inflationary pressures in the economy. However, the impact on the
economy was not as significant as expected and the markets began to expect a further
increase in rates around November 2006 followed by falls in mid to late 2007. The
predicted increase of ¼% to 5.00% came on 9th November 2006.
The markets were again taken by surprise in January 2007 when the MPC announced a
further increase of ¼% to 5.25%. However, interest rate predictions following that hike are
shown in Table 6 and were still indicating that rates would start to fall by Q3 2007 and
continue to fall during 2008.
Table 6 Interest Rate Forecast January 2007
more market optimism of future interest rate falls
Q/E1
2007
Q/E2
2007
Q/E3
2007
Q/E4
2007
Q/E1
2008
Q/E2
2008
Q/E3
2008
Q/E4
2008
Base Rate
5.50%
5.50%
5.25%
5.00%
5.00%
5.00%
4.75%
4.75%
5yr Gilt Yield
5.50%
5.25%
5.00%
4.75%
4.50%
4.50%
4.50%
4.50%
10yr PWLB Rate
5.00%
5.00%
4.75%
4.75%
4.50%
4.50%
4.50%
4.50%
25yr PWLB Rate
4.50%
4.50%
4.50%
4.50%
4.50%
4.50%
4.50%
4.50%
50yr PWLB Rate
4.25%
4.25%
4.25%
4.25%
4.25%
4.25%
4.25%
4.25%
Source: Sector
Despite the January 2007 increase in Base Rate inflation continued to rise and the markets
anticipated further rate increases. In common with all fund managers SWIP’s performance
suffered. Its return in the quarter was 0.91% compared to the 7 day LIBID benchmark of
1.36%, an underperformance of 0.45%.
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The expected increases came in May and July 2007 when the MPC increased Bank Rate
to 5.50% and then 5.75% where it remains.
During the third quarter of the current year the money markets have been very volatile as
nervousness over the sub-prime mortgage market in the US has spread across the globe
and this has provided some tactical opportunities. The MPC has recently indicated that it
wishes to hold Bank Rate at 5.75% for the time being and then examine the relative
strength of inflation, housing, high streets and financial markets data before determining its
next step. Returns on short dated certificates of deposit have been high compared to gilts
which should deter fund managers from moving aggressively in to the gilt markets.
The latest valuation statement from SWIP showed a net return at the end of September of
2.47% compared to the 7 day LIBID benchmark of 2.88% for the year to date.
FUTURE PROSPECTS FOR INTEREST RATES
The latest forecast for interest rates, received from Sector on 24th September, is shown in
Table 7 below.
Table 7 Interest Rate Forecast September 2007
rates will begin to fall again by 2008
Q/E 3
2007
Q/E4
2007
Q/E1
2008
Q/E2
2008
Q/E3
2008
Q/E4
2008
Q/E1
2009
Q/E2
2009
Q/E3
2009
Q/E4
2009
Base Rate
5.75% 5.75% 5.75% 5.75% 5.75% 5.50% 5.25% 5.00% 5.00% 5.00%
5yr Gilt Yield
5.50% 5.50% 5.45% 5.35% 5.25% 5.05% 5.00% 4.85% 4.85% 4.85%
10yr PWLB Rate 5.30% 5.25% 5.20% 5.05% 4.95% 4.85% 4.75% 4.65% 4.65% 4.65%
25yr PWLB Rate 4.90% 4.85% 4.80% 4.70% 4.65% 4.60% 4.55% 4.55% 4.55% 4.55%
50yr PWLB Rate 4.60% 4.55% 4.50% 4.50% 4.45% 4.45% 4.40% 4.40% 4.40% 4.40%
Source: Sector
CONCLUSION
SWIP’s performance since their engagement has undoubtedly been disappointing, albeit
not out of line with the performance of other fund managers during the period of
investment.
A long term perspective has to be taken with externally managed funds as sudden market
changes can have an adverse impact in the short term. Overall performance in the past
with Investec demonstrated this to be a successful venture, notwithstanding the fact that
they experienced periods of under-performance.
Funds were externalised with SWIP in the expectation of favourable market conditions.
The economic conditions soon after their appointment started to change with interest rates
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beginning to move upwards to combat inflationary pressures.
Repeated market
expectations that this upward movement in interest rates would not be prolonged have
turned out to be false dawns. Conditions for all fund managers have therefore been
consistently unfavourable during the period of SWIP’s fund management.
This has led to repeated expectations of seeing through the adverse returns on gilts in the
belief that better returns were in prospect, hence continuing to remain with SWIP.
We are once again in a familiar situation as recent times, whereby future prospects are
once again predicting that interest rates will fall and hence gilt prices will increase. It has
now become a credibility issue as to whether there can be sufficient confidence in market
predictions as to have the confidence to sustain SWIP’s continued appointment.
The half-yearly review of SWIP’s performance is due to take place in early December when
there will be a critical review of the prospects for better returns, taking account of market
forecasts and their credibility.
Economic conditions during July, August and September offered favourable opportunities
for SWIP to make tactical trades in gilts as prices rose in response to reductions in longer
dated interest rates. It is disappointing, therefore, that SWIP did not take advantage of
these opportunities in any significant way, only making modest returns.
The imminent half-yearly review will be pivotal as to whether we can have sufficient
confidence in SWIP’s performance looking ahead to what could be favourable market
conditions as to sustain their continued engagement.
RECOMMENDATION
Members are requested to comment on the contents of this report.
JOHN SPINK
City Treasurer
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