Appendix 'A'
Mid Year Report on treasury management activity April to September 2011
Background
Treasury Management activity is a key risk area within the Council's financial
arrangements and a critical part of ensuring an effective Treasury Management
function is compliance with the CIPFA Treasury Management code of practice
(2009). In accordance with the code and also to promote both good practice and
open and transparent governance, the Cabinet receives a mid-year report which sets
out treasury activity over the first six months of the 2011/12 financial year.
Treasury activity is monitored on a monthly basis by the County Treasurer; the
content of the reports considered by her forms the basis for this report.
Overview of the Treasury Management Strategy
The Council approved the 2011/12 treasury management strategy at its meeting on
24th February 2011.
A key element within the strategy is to ensure priority is given to security of capital
and the liquidity of investments over return. Whilst the County Council aims to
achieve the optimum return on its investments, this must be commensurate with
proper levels of security and liquidity.
Traditionally, local authority treasury management strategies have relied almost
exclusively on fixed term bank deposits. However, a typical fixed term bank deposit
cannot be transferred to another counterparty and is very expensive to end before it
is due to mature. Therefore in an environment where credit reference agencies are
downgrading institutions on a regular basis, these may not represent the most
appropriate investments for the County Council.
The treasury management strategy, rather than restricting the County Council's
investments to just bank deposits, provides the flexibility to move between different
types of investment assets and therefore the investment portfolio can be changed in
response to changes in market risk levels. 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. By allowing the purchase and sale of UK Government
guaranteed bonds, the County Council's treasury management policy enabled the
facility for a 'flight to quality' if the need should arise, and as the economic situation
has significantly worsened since the strategy was approved, this has proved to be
the main aspect of the Council's investment operations since the start of the financial
year.
The borrowing strategy aimed to mitigate the relatively high cost of having long term
debt by postponing long term borrowing and continuing to take advantage of low
variable and short term rates. The view of the County Council has been that interest
rates would stay low for longer than central market expectations and this has proved
to be the case,
The strategy states that the Council will not borrow to lend and that total borrowing
will be contained within the capital financing requirement to ensure borrowing is only
for capital purposes.
The County Treasurer is pleased to report that all treasury management activity
undertaken during the period complied with the approved strategy, the CIPFA Code
of Practice, and the relevant legislative provisions.
Economic Overview
Over the last six months, the outlook for the world economy, and that of the UK, has
deteriorated. According to the OECD, growth across its thirty-four members has now
slowed for four consecutive quarters. Essentially the underlying issues are:







Unsustainable debt levels in both the personal and public sectors in many
countries including the UK.
An unsustainable medium term debt and deficit position in the US.
The emergence of serious sovereign debt problems focussed on Ireland, Greece,
Portugal, and possibly Spain and Italy.
A process of de-leveraging by governments, households and banks in several
countries, at a time when major economies are weak and vulnerable. Never
before have so many countries been adopting large-scale fiscal retrenchment
simultaneously.
There is substantial dispute amongst both politicians and economists about what
the appropriate policy response should be.
This is compounded by the additional problem that governments are running out
of policy instruments, with interest rates at record low levels and budget
constraints severely limiting the scope for fiscal policy to respond to weakness in
the economy.
In many countries banks remain fragile, not least because of their exposure to
sovereign debt. There has recently been a re-emergence of funding difficulties for
some banks which, over the next year or so, will need to re-finance on a large
scale as past borrowings come to maturity.
This is such a problematic set of circumstances that we are clearly not dealing with a
conventional recession and its aftermath. There is a risk of the possibility of an
'austerity trap', which would see low growth rates and declining living standards for
the next few years to come.
As a result of this uncertainty, in August and September investors fled those assets
viewed as riskier (such as fixed bank deposits), for 'safe haven' investments. From
their highs in February 2011, long term gilt yields fell by a full percentage point to
around 3.5% and prices rose sharply. As we move into the second half of the year
the situation is not improving. Despite inflation remaining high due to the rise in VAT
and higher food and fuel prices, the Bank of England Monetary Policy Committee
(MPC) maintains Bank Rate at 0.5% and at the October meeting raised the level of
quantitative easing by £75bn in an attempt to inject demand into the economy.
Interest Rate Forecasts
The analysis above and the MPC response to date would indicate that the current
policy stance is likely to persist for some time to come. At the August and September
and October MPC meetings the members voted 9-0 to keep rates at 0.5% and
subsequently all commentators pushed the likelihood of an increase in bank rate
further into the future.
Long term interest rates remain extremely difficult to predict in these highly uncertain
times but turmoil in European markets and the US Debt ceiling arguments and
ratings downgrade has generated exceptional demand for safe-haven investments,
and it is likely that rates will remain under downward pressure while the threat of
sovereign defaults and economic stagnation persist.
The forecast below is provided by David Llewellyn, Professor of Economics and
consultant economist at leading international brokers ICAP plc. It can be seen that
the expectation of a bank rate increase has now been pushed out to March 2013.
Sterling Consultancy Services, the County Council's treasury management advisors
believe rate rises will occur in advance of these dates, but only by a few months.
Maintaining the current positioning of the County Council's loan portfolio, which takes
advantage of low short-term interest rates over an extended period seems an
appropriate position at the current time.
The risk to the current portfolio is that once the euro-zone crisis passes its peak and
demand for safe haven instruments slackens the markets should see a rebalancing
of yields and a rise in longer term rates towards levels more in keeping with a
positive inflation environment. Interest rates will continue to be closely monitored by
the treasury management team and the County Treasurer in order to protect the
County Council against this risk.
Borrowing
Current market conditions continue to enable the County Council to take advantage
of short term market borrowing following the repayment of £293m of long term fixed
debt in 2010.
The chart below shows the actual level of total debt over the first half of the year and
because a large part of the total is short term market borrowing it can be seen how
quickly the level of borrowing falls if maturities are not replaced.
The chart also shows that borrowing has been contained within the operational
boundary, set as part of the prudential indicators within the current treasury
management strategy.
Millions
LCC DEBT PORTFOLIO 2011-12 in £m
1000
900
800
700
600
500
400
Authorised Limit
Operational Boundary
Actual Borrowing
CFR 31.03.11
Also included on the chart is the capital financing requirement (CFR) valued as at 31
March 2011. The CFR is the element of the County's fixed assets not yet financed,
either by charging the expenditure to revenue through the minimum revenue
provision or by some other method such as applying capital receipts.
The actual level of borrowing may temporarily rise above or fall below this level due
to day to day cash flow management and portfolio management processes, but
overall we would expect borrowing to be around about this level. When the
borrowing total is below CFR, as it was at 31st March, LCC are 'borrowing internally'
or funding capital expenditure from cash flow balances. The short term borrowing
strategy is working very well at the moment and we will be looking to renew or
replace most of the borrowing which is maturing around the end of September with
further short term borrowing rather than more expensive long term fixed borrowing at
this time.
The pie chart below shows the proportions of the various types of borrowing within
the portfolio.
LCC Borrowing as at 30.9.11 £m
Call Loans, 17.00
Bonds, 0.02
Police
and
Fire,
66.83
PWLB Fixed
PWLB Variable
PWLB Fixed,
213.10
ST Market, 290.85
LT Market
ST Market
Bonds
PWLB Variable,
195.75
Call Loans
Police and Fire
LT Market, 50.77
The latest estimate of borrowing activity for the 2011/12 financial year is shown in
the table below. The debt restructure undertaken during 2010/11enabled the County
Council to take advantage of current very low short term interest rates. However it
does mean that the County is more active in the short term money market. The level
of short term borrowing which needs to be replaced in the current financial year,
based on the latest capital programme estimates is shown in the table below.
2010/11
Estimate
£m
Approved Capital
Programme Borrowing
Maturing Long Term Debt
Maturing Short Term Debt
Less transferred debt
repayments
Less Minimum Revenue
Provision
Less advance borrowing
brought forward from
previous years
Total new borrowing
required in the year
Long Term Debt repaid in
the year to be refinanced
Borrowing to be
undertaken in the year
Borrowing Undertaken in
Year :
Short term borrowing in
2010/11
Long term borrowing
2010/11
Borrowing carried forward to
2011/12
2010/11
ACTUAL
£m
2011/12 2012/13
Estimate Estimate
£m
£m
80.950
70.476
42.714
22.624
9.029
-
19.022
-
10.500
194.769
10.000
150.576
-4.069
-3.007
-3.000
-3.000
-24.272
-24.151
-28.567
-26.339
-10.000
-10.000
-65.840
-
51.638
52.340
150.576
149.660
292.781
345.121
-194.769
-216.192
-65.840
The total borrowing requirement for the 2011/12 financial year is £150.576m. This is
made up of £42.714 new borrowing for capital purposes and a net figure of
£107.862m of existing borrowing which will need to be replaced.
At some point the short dated borrowing will be replaced by longer maturities but the
timing of this depends on the shape of the yield curve and the availability of market
borrowing. In other words, we will seek to replace our short term borrowing with
longer term debt when interest rates for those longer term borrowings are at the
most advantageous, to secure the best price for the County Council.
The UK Treasury's decision as part of the Comprehensive Spending Review to
introduce a 1% spread above gilts for PWLB pricing means it is unlikely that future
borrowing will be sourced from the PWLB.
Investments
Stresses in the European financial markets, in particular the potential effects on the
global banking system and the reduction in interbank liquidity, have lead the
Treasury Management team to actively reduce the bank exposure of the County
Council, emphasising strongly the security of capital ahead of return. We have cut
limits for banks and where possible deposits have been withdrawn. Resultant cash
has been invested in UK Gilts, Government guaranteed and AAA supranational
bonds denominated in sterling. As part of this approach, we have also reduced our
index linked holdings to guard against the risk of deflation.
Having pre-empted the market moves by a month or so the prices paid for these
bonds are low compared to current values. The driver for the re-allocation was
security; however, the net effect is both a substantial reduction in credit risk and a
simultaneous increase in returns and capital values.
This credit risk reduction strategy will stay in place as long as the sense of
heightened risk remains in the markets. At the moment there appears to be a limited
prospect of a successful solution being developed by regulators and policy makers in
the short term and it is likely that risks and volatility will continue to increase.
Our view is that these events will keep interest rates at extremely low levels for much
longer than the market in general had originally expected, at least until 2013.
Besides the additional £75bn of QE announced in October, further policy measures
may be enacted by the Bank of England in the future, either a reduction in base rate
to US/Swiss levels (i.e. "close to zero"), further QE or structural changes to longer
term interest rates, and in extremis all three weapons may be used. The effect
should be a lowering of long term rates ("flattening of the yield curve") and a
reduction in inflation expectations and thence the value of index linked securities.
Consequently over the period of this report, the vast majority of bank deposit
maturities have not been replaced and call accounts have been run down. In their
place we have established a maturity balanced portfolio via UK Gilts, and although
this is primarily a capital security strategy, the rise in UK Government gilt prices over
the summer has contributed to a rise in the value of the County Council's investment
portfolio. The extent of this rise and the effect the County Council's income and
expenditure budget monitoring are currently being reviewed.
Credit risk (the risk that individual counterparties will default on contractual payment
obligations) is monitored very closely by the Treasury Management team, and
reported to the County Treasurer. The current assessment of the financial
environment is such that only a small number of very high quality banks and their
subsidiaries remain on the County Council's counterparty lending list. They are:
BANK
SOVEREIGN
DOMAIN
UK
UK
UK
Singapore
Singapore
Netherlands
Lloyds TSB
RBS
HSBC
OCBC
DBS
Rabobank
Svenska
Handlesbanken Sweeden
INFORMATION
Implicit UK Government Guarantee
Implicit UK Government Guarantee
AA credit rating, CDS price implied AAA rating
A+ credit rating, CDS price implied AAA rating
AA- credit rating, CDS price implied AAA rating
AAA credit rating, CDS price implied AAA rating
AA- credit rating, CDS implied AAA rating
In the past six months LCC have made only one fixed term bank deposit, a renewal
of a £30m 4 month deposit with OCBC.
Since 2009, we have been working to reduce the level of investment risk the County
Council is exposed to. In 2009, the entire portfolio consisted of bank deposits of
various maturities. The overall investment portfolio at the 30th September 2011 is
shown below with a reduced overall credit risk as just under half of the total portfolio
is now invested in bank deposits.
Of the long term fixed deposits 77% are with UK Government owned banks, The call
accounts and money market funds are instant access and bonds are shown at par
value.
Spread of Investments as at 30.9.11
Bonds and deposits with other
L.A.s 6.3%
7.16% 6.30%
Short Term Fixed Deposits 10.09%
10.09%
19.91%
Long Term Structured Deposits
37.91%
Colateralised Deposits 2.87%
Call Accounts 1.94%
Supra National Bonds 13.82%
13.82%
37.91%
UK Govt Guaranteed Bonds
19.91%
1.94%
2.87%
AAA Rated Money Market Funds
7.16%
In the current environment any bank deposit would be restricted to banks holding
long-term credit ratings no lower than A+ or equivalent, and at present maturity is
being restricted to a maximum of 3 months. In addition due diligence is being
conducted on a number of money market funds which would provide a mechanism to
reduce exposure to the banking system for funds held as call deposits.
Review of the County Council's Investment Policy
On the 1st April 2011 following a contract tender exercise Sterling Consultancy
Services were appointed as treasury advisors to the County Council. As a result the
investment policy needs to be amended to fall in line with credit rating information as
provided under the new contract.
In addition, it is proposed that the Cabinet considers further changes to the
investment policy in order to reduce counterparty credit risk. In respect of fixed bank
deposit lending, it is proposed that both maximum individual investment levels and
maximum duration period for deposits are significantly reduced in the light of the
increased credit risk prevalent at the current time. Apart from UK nationalised banks,
no deposit will be placed with any bank holding a long term credit rating lower than
A+ and the maximum duration for any such deposit will be 364 days.
The proposed policy is set out below:
Instrument
UK Govt Gilts &
Treasury Bills
Sterling Supranational
Bonds Sterling G10
Sovereign Bonds
Term Deposits with UK
and Overseas Banks
(domiciled in UK) and
Building Societies
Non credit rated
“nationalised” banks
Credit Rating
(using SCS criteria)
Maximum
Individual
Investment
(£m)
Maximum Period
AA+
500
50 yrs
AA+
500
50 yrs
Banks holding longterm credit ratings no
lower than A+ or
equivalent
50
364 days
Royal Bank of Scotland
Group
100
5yrs
Lloyds Banking Group
Public Works Loan
Board – Debt
Management Office
Deposit Facility
Government Institution
250
364 days
Other Local Authorities
AAA (implied currently)
250
50yrs
Money Market Funds
with constant or
accumulating net asset
values.
AAA Rated
100
Certificates of Deposit.
Collateralised lending
agreements backed by
higher quality
government or local
government and supra
national sterling
securities.
AA, with AAA for any
collateral used
250
These
investments do
not have a
defined maturity
date. Funds are
'on call'
25yrs
As with the current policy, placing deposits into call accounts including those with the
County Council’s bank, National Westminster, by virtue of the facility to withdraw
funds with immediate notice are considered very low risk and will not count against
the above individual counterparty limits.
Prudential Indicators
In accordance with its statutory duty and with the requirements of the Prudential
Code for Capital Finance and the CIPFA Code for Treasury Management, the
County Council produces each year a set of prudential indicators which regulate and
control its treasury management activities.
The table below shows the position at 30th Sept 2011 compared with the indicators
agreed as part of the 2011/12 treasury management strategy.
The indicators will be reviewed over the coming months to ensure they are
appropriate for the current economic environment and in line with the forecast capital
programme.
Treasury Management Prudential Indicators
2011/12
£M
1. Adoption of the CIPFA Code of Practice for
Treasury Management
2011/12
30-Sept
£M
This has been fully adopted
2. Authorised limit for external debt - A prudent
estimate of debt, which reflects the Authority’s
capital expenditure plans and allows sufficient
headroom for unusual cash movements.
Borrowing
1000
834
400
191
1400
1025
Borrowing
950
834
Other long-term liabilities
390
191
1340
1025
90%
60.41%
90%
39.59%
Other long-term liabilities(eg leases)
TOTAL
3. Operational boundary for external debt - A
prudent estimate of debt, but no provision for
unusual cash movements. It represents the
estimated maximum external debt arising as a
consequence of the County Council's current
plans.
TOTAL
4. Upper limit for fixed interest rate debt
5. Upper limit for variable rate debt
The limits shown at 4 and 5 above are consistent
with current practice and reflect prudent levels in
the current economic climate.
6. Upper limit for total principal sums invested
for over 364 days (per original period to
maturity):
75%
40.77%
7. Maturity structure of debt
Upper/Lower
Limit %
2011/12
Under 12 Months
12 months and within 2 years
2 years and within 5 years
5 years and within 10 years
10 years and within 15 years
Maturing after 15 years
75 / 0
75 / 0
75 / 0
100 / 25
100 / 25
100 / 25
Actual
30Sept 2011
46.24
6.39
0
21.42
5.89
20.06
Revenue Budget Monitoring
The financing charges budget has been set at £37.125m for 2011/12. As reported to
Cabinet in September 2011, the current forecast year end position is £33.436m, a
surplus of £3.689m. This is due to additional savings arising from a reduction in the
level of interest paid by the County Council, being the full year effect the debt
restructuring exercise undertaken during the summer of 2010, where long term fixed
rate debt was repaid are refinanced by variable rate and short term borrowing. In
addition as a result of the appreciation in value of the UK Government Gilts portfolio
over the summer following investors 'flight to quality', there is the potential that
interest earned by the County Council may be higher than originally forecast and this
issue is currently being reviewed by the County Treasurer.
Update on Landsbanki
An appeal to the Icelandic Supreme Court has been lodged by Landsbanki's nonpriority creditors to overturn the decisions of the Winding Up Board and the District
Court in recognising the British and Dutch local authorities as priority creditors. The
hearing was heard on 14th and 15th September and a final decision is expected
within one month. If the Supreme Court upholds the District Court judgement local
authorities can expect to recover up to 98% of the deposit.
Recommendation
The Cabinet is recommended to:


Note the treasury management activity half year report, and
recommend that Full Council approves the revised investment policy in order
to further safeguard the County Council's funds.