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Managing interest rate risk

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  • by David Green
  • in Blogs · David Green
  • — 21 Jun, 2012

Since the Icelandic banks defaulted in 2008, credit risk has remained at the top of most local authority treasurer’s agendas, and rightly so.  Apart from the potential for financial losses, which were thankfully not too great in Iceland, there has been the bad press.  Local newspapers were asking why we have to pay our Council Tax upfront for the town hall to gamble it on the money markets until they get round to spending it.  But it has escaped most journalists’ attention that many local authorities are losing millions of pounds every year through poor interest rate risk management.

In the years between CIPFA introducing the Prudential Code in 2004 and the Bank of England slashing interest rates in 2008 and 2009, many authorities borrowed up to and beyond their capital financing requirements, despite having large (and often growing) cash balances.  With loans borrowed almost exclusively at long-term fixed rates, and investments effectively at variable rates over the long-term, local authorities were left highly exposed to the risk of falling rates.

We can see why this happened.  With central government dropping its capital controls, but still paying grants to support borrowing, local debt was one of the preferred funding options for local infrastructure.  The current government prefers to fully grant fund projects (albeit fewer of them) and manage the debt centrally. And a chronic undersupply of the very long-term high quality bonds craved by life insurance and pension funds produced an inverted yield curve, making 50 year fixed rate loans look very attractive.  Directors of Finance in their late fifties who remembered arranging their first mortgage at 15% were rubbing their hands with glee borrowing on behalf of local taxpayers at under 5% for loans that will not be repaid until after all their staff have retired.

But many authorities are now left with loan books running at around 5% and investment portfolios running at around 1%.  For every £25m doubled-up like that, they are losing £1m a year in interest.  And what can they do about it?  The new shape of the yield curve, coupled with changes in PWLB’s rate setting methodology makes it too expensive to repay or restructure long-term loans.  And investing fixed rate for more than a couple of years is either too risky (with banks), too low-yielding (in government bonds) or too uncertain (with anyone else).

Step forward the interest rate swap.  Still seen by some as the villain that soured relationships between banks and local authorities back in the early 1990s, these very simple derivatives could actually be part of the solution for some Councils.  Entering into “pay floating, received fixed” swaps will be cash positive in the early years, offsetting the low interest being earned on investments.  When (or if) LIBOR rises above the fixed swap rate, the Council will have to make payments back to the bank, but this will be funded from rising investment income.  Swaps are basically a way of locking into long-term fixed rates without taking on the credit risk of making long-term investments.  Alternatively, you can view them as bringing the benefit of future expected interest rate rises back to the present, even if those rate rises don’t actually happen.

You will need to pretty certain that you will have sufficient variable rate investments over the life of the swap, otherwise increasing rates could cause you to pay out more under the swap contract that you receive from investments.  But as long as such instruments are taken out prudently and for good risk management reasons, backed up with professional advice if needed, local authorities needn’t avoid swaps and other simple derivatives as if they are toxic.  With central government, housing associations, universities and companies of all sizes all making use of derivatives to manage their interest rate risks, local authorities are looking increasingly isolated in their approach to risk management.

David Green is Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice.  It should not be relied upon when making investment decisions.

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange
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  • 151 BRIEFS – WHAT’s NEW?

    • Underfunded social care reforms could ‘exacerbate workforce pressures’
    • Nottingham City Council leader labels proposed intervention as “disappointing”
    • Government preparing to intervene in Nottingham City Council
    • Low earners at Surrey County Council receive 7.85% pay increase
    • UK Infrastructure Bank launches plan to deploy £22bn of investment
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