Appendix 'A'
Investment Strategy and Approach
Introduction – the Economic Context
Over the past three years the County Council’s treasury management activities have
taken place against an unprecedented economic background.
On 1st April 2008 the Bank Rate was 5% and the Bank of England was focused on
fighting inflation. This approach continued throughout the summer until the 15th
September 2008 when Lehman Brothers, a US investment bank, filed for bankruptcy
in the absence of any other institution being willing to buy it due to the perceived
levels of its toxic debt. This event caused a shock wave in world financial markets.
On 7th October 2008 the Icelandic government took control of their banks and this
was followed a few days later by the UK government injecting £37bn into three UK
clearing banks, Royal Bank of Scotland, HBOS and Lloyds, as liquidity in the
markets dried up. As the liquidity crisis (commonly called 'the credit crunch')
materialised, western economies were plunged into recession and by March 2009,
the Bank of England's Monetary Policy Committee had reduced interest rates to an
all time low of 0.50% where they have stayed ever since, as part of the measures
employed to try to boost the economy and stave off another recession.
The 2008/09 financial year ended with markets badly disrupted, the real economy
suffering from a lack of credit, short to medium term interest rates at record lows and
a great deal of uncertainty as to how or when recovery would take place. Investment
income returns had been badly hit and the perceived risk of another major default
was rising.
In the past and in common with almost all other local authorities, the only financial
investment instruments allowable under the County Council's treasury management
policies were fixed term bank deposits. At the time this was a low risk policy, but the
credit crunch brought with it severe reductions in bank credit quality and since then,
the continuing economic downturn and emergence of the Euro zone sovereign debt
crisis raised concerns over possible exposures to sovereign debt defaults.
In response to this new environment the County Council made considered changes
to its treasury policies aimed at reducing the financial risks to the County Council by
increasing the security and liquidity of the investment portfolio.
In December 2009 Cabinet approved a treasury management policy which
significantly extended the limits for UK Government, supranational and other
sovereign government bonds (minimum AA+ credit rating and issued in sterling.)
This increased security because sovereign governments should represent the
highest level of credit quality, and it increased liquidity because government bonds
can be sold very easily, enabling the County Council to respond swiftly to changing
market conditions, rather than with fixed deposits for which there is no easy way to
get out of the investment before the deposit maturity date, and therefore at least a
significant proportion of the overall portfolio should be held in Government
guaranteed bonds.
Following approval of the new policy, during the autumn of 2010 as fixed deposits
matured the treasury team began to build a portfolio of bonds. The only fixed
deposits retained were with either major UK banks (and of these the majority are
with the partly nationalised institutions) or with banks of ultra high credit quality.
During 2011 as the euro-zone sovereign debt crisis became more evident, the
County Council's bond portfolio was concentrated around UK Government Bonds
(gilt edged securities known as gilts.)
Below is a chart which shows three measures of credit risk in financial markets with
an interpretation below. This chart relates to the past calendar year and shows the
alarming rise in perceived risk during the summer months of 2011. The County
Treasurer monitors credit risk on a daily basis.
Market - wide Credit Risk Measures
400
350
300
250
200
150
100
50
0
Dec '10
Mar ' 11
£ 3-month LIBOR T-bill margin (bps)
June '11
Sept '11
Dec '11
Itraxx Europe Senoir Financials CDS Indrex
Deposits at ECB (€bn, 4 wk average)
The top line, the Itraxx Europe Senior Financials CDS Index, measures the cost of
insuring a bank deposit against default. The steep upward slope of this curve is
indicative of an increasing level of risk.
The second broken line indicates the level of deposits made with the European
Central Bank (ECB) and is a very strong indicator of credit risk. In normal times this
level would be almost zero because European financial institutions invest with the
ECB at a penalty rate of the Euro benchmark rate (currently 1.00%) less 0.75%. An
increasing level of deposits with the ECB is a signal that banks are not willing to lend
to each other.
The bottom line is called the Sterling 3 month LIBOR T-bill margin, and measures the
additional interest that investors require to compensate them for the risk of lending to
16 of the largest banks rather than to the UK government for the short-term. The
sharp increase indicates a general increase in credit and liquidity risk across the
board.
Managing the County Council's Investments in the Economic Climate
Against this background of rising risk, the County Council has increasingly taken
what is known in investment terms as a "defensive portfolio position" which is
fundamentally concerned with protecting the County Council's investments above
return. This was achieved through increasing the proportion of UK Government
guaranteed securities (gilts) within the portfolio.
The table below details the County Council's investment portfolio and sets out how
the proportion of gilts has grown within the investment portfolio.
1st April
2011
£m
%
UK Gilts/UK Govt
Guaranteed
30th Sept
2011
£m
%
30th Nov 2011
£m
%
31st Dec
Projection 2011
£m
%
96.35
20%
162.90
25%
157.74
24%
157.74
24%
Supranational
33.12
7%
53.44
8%
54.69
8%
54.69
8%
Local Authority Bonds
20.79
4%
35.60
5%
35.59
5%
35.59
5%
Fixed Deposits
286.36
59%
336.36
52%
336.36
51%
325.96
50%
Call
46.20
10%
63.55
10%
72.50
11%
82.90
13%
482.82
100%
651.85
100%
656.88
100%
656.88
100%
Other Bonds:
It is good portfolio management practice to avoid putting 'all your eggs in one
basket' and the above table demonstrates how the County Council has, since
December 2009 when the only assets held were fixed bank deposits, diversified the
portfolio to include other financial instruments. It also shows how the proportion of
gilts within the portfolio has been increasing during the current financial year,
At the time of writing fears over Italian sovereign finances and the possibility of the
Euro-zone splitting up in some way remain to the fore, and it seems unlikely that any
clarity on these issues will be forthcoming in the near future. For as long as this
uncertainty persists UK Government Securities is one of the safest places for the
County Council to protect its reserves.
Effect on the County Council's Financial Position
Gilt edged securities are seen throughout the world as a 'safe haven' investment.
Often in times of uncertainty and high market volatility investors leave riskier assets
and move into assets that are backed by large sovereign governments, usually in the
form of US Government bonds or UK Government bonds known as gilts or they buy
precious metals such as gold. This is known as a 'flight to quality' because the risk of
counterparty default is reduced by the institution's high credit quality and by the
liquidity of the instruments which can be sold very quickly and cheaply. The changes
made to the County Council's treasury policy from December 2009 onwards,
allowing the purchase and sale of UK Government guaranteed bonds, has enabled
the County Council to facilitate a 'flight to quality' in these uncertain times.
As the demand for gilts rises the market price of them rises, and because the
securities are available for sale, this creates an unrealised profit within the
investment portfolio which can be realised by selling the securities. During the first
half of 2011 the County Council took the strategic decision to increase its UK Gilt
holdings as a credit risk reduction move as it was believed that the problems in
Southern Europe would infect the European banking system.
Investment discipline is an extremely important part of treasury management. When
the County Council increased its UK Gilt holdings, specific price objectives were set
at which the gains should be realised. This enables the County Council to benefit
from both security, and yield.
Such investment discipline is even more important in time of high tension. When
these "triggers" were reached, the gains were realised through the sale of the Gilt
holdings.
As part of the daily portfolio management undertaken by the Chief Investment Officer
and his team, close attention is paid to the price of Gilts at different maturities; this is
known as the yield curve. At any point in time there will be a number of Gilts or
bonds that are "cheap" to the curve and a number that are "expensive" to the curve
and the portfolio manager can switch between them to constantly maintain the value
of the portfolio in line with the market. In addition the market never moves in the
straight line giving opportunities to time the County Council's exit and re-entry to take
advantage of peaks and troughs. The County Council is only able to participate in
this as it has secured the key professional skills necessary.
Below is a chart taken from the market information system Bloomberg showing the
appreciation of a 30 year benchmark gilt over the last 10 months.
As the County Council already held a gilt portfolio prior to this substantial rise, the
increase in value created by the flight to quality has been captured within the County
Council's bond portfolio.
The decision was taken to lock in some of the gains for the benefit of the County
Council by selling some of the holding and therefore realising the gain in their value.
The gains are accounted for as interest earned in exactly the same way as a fixed
deposit interest payment, and the gains are therefore a direct benefit to the County
Council's revenue budget. Appendix 1 sets out for Cabinet the key principles of
managing a bond portfolio.
The current economic circumstances of negligible economic growth in developed
economies combined with the banking, liquidity and sovereign debt crises is an
exceptional situation which has lead to a substantial and rapid rise in bond prices
and hence a one off financial benefit to the County Council. It must be stressed
that the financial benefit is exceptional, and has occurred in extra-ordinary
circumstances. The scale of the flight to quality and increase in prices is
almost unprecedented.
As at the 30th November the average interest rate earned on the overall investment
portfolio as a whole, (excluding payment of interest on school balances and
investment charges) was 8.09%. The breakdown of this figure between the bond
portfolio and other investments is as follows:
Average Balance
1st April – 30st Nov
£m
Interest Earned
Interest Earned
£m
%
Bonds
206.591
46.167
22.35
Other Investments
476.741
9.132
1.92
Total
683.332
55.299
8.09
Given that interest rates are currently at a historically low level, this is significantly
above the estimate contained within the 2011/12 revenue budget. The investment
interest rate assumed in the revenue budget is 1.93% whereas this level of interest
earned to the end of November represents an annual rate of 12.14%.
Because the majority of this interest has come from realising the appreciation of the
market value of the gilts, it would be highly imprudent to assume that the same level
of interest would be earned over the remainder of the financial year and beyond.
Nevertheless, there is now an exceptional reduction in the County Council's costs as
a result of the management of the County Council's gilts.
In addition there is an underspend projected on the statutory debt financing charge
made to the revenue account (minimum revenue provision or MRP) because
borrowing has also been lower than anticipated in the budget.
As at the 30th November 2011, the projection of the financing charges budget to the
2011/12 financial year end is as follows, and shows a reduction in the County
Council's costs of £47.593m
Revenue
Budget
2011/12
£m
Forecast for
the year as at
November
2011
£m
Change
Change
£m
%
Minimum Revenue
Provision
Interest Paid
28.567
26.532
(2.035)
16.292
17.100
0.808
Interest Earned
(7.734)
(54.100)
(46.366)
Grants Received
(0.400)
(0.400)
-
Total
36.725
(10.868)
(47.593)
(129.59)
What this table shows is that the impact of the bond portfolio will be significant in
2011/12, delivering further one-off savings of £33m above that reported to Cabinet in
December.
Managing Future Volatility
The economic position remains volatile, financial markets and conditions can change
very quickly. It cannot be emphasised strongly enough that this level of income is
highly unlikely to continue. The primary objective of the County Council's treasury
management strategy is to ensure the security and liquidity of funds and only once
these have been secured consider the yield. Therefore, actions may be taken in the
future which preserve security at the expense of yield.
Investments which are guaranteed by the UK government are very secure and
government bonds are very liquid, but the market value can be volatile and it is not
clear how the market will develop over the next few months, as the Eurozone issues
are worked through.
In order to manage the impact of this potential volatility, it is recommended that a
volatility reserve of at least £7m be created, and that any further gains on the County
Council's gilts made by the end of the financial year be added to the reserve. This
will help protect the County Council from volatility within the financial markets,
ensuring that such volatility will not negatively impact upon the County Council's
budget.
Conclusion
Interest rate markets have exhibited extraordinary volatility since the demise of
Lehman Brothers in 2008 and the over optimistic assumption, from most market
participants and monetary authorities in 2010 that "normality" would resume in 2011
has proved to be just that – optimistic.
The central view now is that we cannot expect a return to "normal" growth and
interest rates for at least another 3-4yrs and that it is possible that the whole "credit
crunch" cycle is likely to last a total of 10 yrs plus (from 2008). In this case, the
prognosis for interest rates in the developed world is for those rates to remain close
to zero for the whole of this cycle.
In order to protect the County Council's funds during this time, the best approach to
treasury management in these circumstances is continue with "active risk
management" and we will continue to operate in this way. Understanding the risks
involved in Local Government finance is key and the use of all available tools to
control and mitigate those risks vital.
Historically Councils have had an inactive approach. The current much more
challenging environment will not allow that luxury without a major impact either on
capital security or investment performance, and therefore the revenue budget. Given
the overall shape of public sector finances, it is vital that every pound of taxpayers
money works as hard as possible, as safely as possible.
Appendix 1
Bond Portfolio Management
Managing a bond portfolio is a very different function to managing short term cash
deposits. Bond portfolios require a much more active approach as the measures
used to assess individual bonds and portfolios are very sensitive to market
movements.
There are a number of factors to be taken into account in both the construction of a
portfolio and then the on going management of a portfolio:
Construction
When establishing any portfolio the rational for the portfolio must be carefully
established:




What cash-flows are being matched
What degree of ongoing liquidity will be or may be required
What quality of credit is acceptable for investment
What level of tolerances within the investments are acceptable – for example.
do investment maturities need to exactly match cash-flows and if not what
level of tolerances are acceptable.
Firstly an analysis of balances, reserves and other cash-flows must be undertaken to
establish the form, longevity and variability of cash-flows generated. Once these
have been modelled then a matching or mirroring portfolio can be constructed. In
order to be practical exact cash-flows usually cannot be matched but bonds are
taken out with different maturity levels (called a maturity slice approach) and is
considered a suitable proxy for matching investments with cash flows:
0-2yrs
2-5yr
5-10yr
10-20yr
20-30yr
30-50yr
slice 1
slice 2
slice 3
slice4
slice 5
slice 6
As the principal duty of treasury management within Local Authorities is to protect
capital above all else, the types of instruments available are at the higher end of the
credit spectrum e.g. government or government guaranteed and supranational
bonds are suitable for Local Authority portfolios. Using these bonds does generally
bring the advantage of good liquidity as they can be traded in the markets at any
time for immediate cash.
Management
Effective bond portfolio management requires a number of "rules" to be established
that guide investment decisions, and are essentially about the organisation's appetite
for risk. For the County Council, our risk appetite is practically nil, with our whole
approach based on security of capital. Key issues to consider are:




What ratings event trigger a re-allocation
What changes in available liquidity trigger re-allocation
What changes in "duration " (see later) trigger action
What changes in reinvestment risk are acceptable
Credit ratings are by no means fixed. The major agencies are in the current
environment, cutting ratings on a regular basis, but helpfully they generally place
bodies on a watch list before they act giving investors the opportunity to change
portfolios if required. Within our treasury management policy, the credit ratings
acceptable to the County Council remain very high, and any downgrading of an
organisation's credit rating would trigger action.
The need for liquidity is constantly under review, if, as has happened in recent years,
liquidity provided by the market reduces then the implications for a portfolio must be
assessed and investments changed as needed.
As bonds are established with different characteristics such as the timing of the cash
flow of payments, in practical terms it is important to note that bonds of the same
maturity will react differently to changes in interest rate. Bonds which have a low
interest rate are more sensitive than bonds of a higher interest rate with the same
maturity. This will impact upon when bonds will need to be either bought or sold
within a portfolio.
As interest rates rise or fall and whether they do so quickly or slowly will affect the
composition of a portfolio and active management of the results of these various
types of moves are very variable. As a rule of thumb as rates fall and prices rise,
portfolios should be reduced in absolute size, and as rates rise and bond prices fall
portfolios should be increased. This countercyclical activity is good discipline but also
on average it is good for performance and will act as a check on exuberance.
The last major factor to take into account is reinvestment risk. The total return of a
low interest bond bought at a low price is likely to be higher than the total return of a
high coupon bond bought at a higher price but when current rates are close to
coupon rates this effect dimishes.