Arlingclose’s Mark Horsfield talks to Room151

Mark Horsfield is a founding director of advisory services at Arlingclose. He began his career at Suffolk County Council on its accountancy trainee programme. After that he worked at UBS Phillips & Drew, Sector Treasury Services and Cazenove Asset Management before establishing Arlingclose in 2004.

Room151: It looks like another tough year ahead. How do you think local authority treasurers will play it in general?

Mark Horsfield: I think local authority treasurers are pretty used to tough times as they have had them for quite a few years now. It almost comes with the territory. That does not make it any easier though. The public sector is at the forefront of the Coalition Government’s plans to resolve the structural deficit and as a consequence it is only going to get tougher. Against that backdrop Arlingclose advises its clients on strategies that dovetail with their wider financial plans and provide opportunities where the rewards provide adequate return for the risks being taken.

A continuing example would be how the cost of carry associated with longer term debt costs contrasts with the benefits of affordability and flexibility associated with shorter term debt. We are keeping a watchful eye on the risk reward relationship of this successful ‘trade’ as longer term yields have been driven lower. In relation to investments, I see no change in how treasurers will play it. Activity will reflect the objectives enshrined within the annual investment strategies approved by elected councillors.

R151: Security invariably comes first in local authority treasury strategies. Do you think that’s borne out on the whole in investment choices?

MH: Without exception all published strategies refer to the importance of capital preservation but the reality can, in some instances, be surprising. I am not sure, for example, how you can reconcile a capital preservation objective with the use of fixed deposits in institutions that have credit ratings in speculative or “junk” territory. None of our clients do. Equally, at Arlingclose we think that diversification is an important issue within security. A good example would be in the case of Money Market Funds where we think it is important to maintain a disciplined approach towards exposure at both the individual fund and group level.

R151: You’re well known for having advised clients to get out of Icelandic banks before 2008. What are you most concerned about in 2012?

MH: Arlingclose is proud of the service we give our clients and specific investment advice is an important component of our service; it is an area where we have made a number of proactive recommendations over and above our stance towards Iceland that we feel were equally important. But our first step has always been to look at credit risk as a wider feature of treasury strategy. For instance, the timing of borrowing will have a direct impact on the level of investment balances and this is important in the development of strategy with clients. This has been especially the case in the last four years or so when we have not seen a particularly positive backdrop in credit markets at the same time as interest rates have plummeted.

We have barely begun 2012 and yet quite a lot has already happened so it is difficult to paint too positive an outlook I’m afraid. There are tentative positive signals from the US economy which we should not underestimate and our own inflation outlook is improving sharply but the overriding focus has to be on the continuing mess in the Eurozone and its periphery.

Until sovereign governments own up to the fact that they are effectively bankrupt then it has the potential to lurch and spiral into some very nasty outcomes. By this we mean double dip recession, wider sovereign downgrades, higher yields and ultimately bank failures. If you look at how markets are pricing risk then at Arlingclose we believe it is right to adopt a clear and cautious stance in relation to treasury management activity.

R151: What developments are you seeing at the more innovative end of treasury investment – beyond cash instruments?

MH: Whilst our indicators remain adverse in relation to the credit risk characteristics of financial institutions the credit risk attributes of many companies are, in fact, positive but they are not without risk.

Over the last seven years Arlingclose has developed, with a number of our clients, a much wider investment universe than the usual cash and short dated gilt options, which are followed by the majority of local authorities (including our clients). So we are looking ahead with interest to the ability of local authorities to utilise corporate bonds more widely. However, there are very few easy wins and corporate bonds pay more because they are riskier. The trick is to understand the risks and establish whether they are appropriate for you. This is how we approach investment strategy with all our clients.

The utilisation of fund management companies and the resources at their disposal in relation to risk management are attractive but are not a guarantee of year on year success in terms of performance returns (measured on a relative or absolute basis). We remain excited by some of the developments of fund managers that have developed a good knowledge of the local authority market and we have worked with them to develop their products so that they embrace longer term strategies within cash plus, absolute return, commercial property, equity and commodity investment disciplines.

We anchor investment strategies around cash and near cash assets in order to deliver a secure level of income on the capital employed. For some clients we will diversify smaller amounts of capital away from cash, usually via fund managers, into non-cash assets. The objective being that even when returns from non-cash assets are poor they do not erase the positive returns from the cash element of the portfolio. At Arlingclose, we develop a whole portfolio approach. What is interesting is the debate that we go through with clients in determining their specific requirements and tolerances. It is not uniform or standard but developed with and bespoke to each client.

R151: It’s difficult to argue against the benefits of diversification – so why then are we seeing so much concentration in sterling?

MH: We agree – we like diversification. The question whether it is better to have, say, 5 x £1m deposits with 5 institutions or £5m with a single institution is one that is open to debate and usually it is concerned with who that single institution should be. The concentration in sterling is due to the pretty simple fact that almost all the liabilities and cash flows of local authorities are sterling denominated so it makes sense to match that with sterling operations as well. As for concentration, it is a reflection of the deterioration in credit characteristics. If investment strategies are working at the current time then they should, in our view, be responding to the deterioration in credit indicators. The outcome is a more defensive position which we believe is more than justified.

R151: On the debt side, do you see much appetite for borrowing from outside the PWLB?

MH: I would say there is very little appetite for borrowing outside the PWLB for as long as the PWLB continues to operate as it does now. We can, of course, see some benefits from bonds but the evidence so far suggests to us that the benefits do not compare favourably to what the PWLB currently offers. We were reasonably well advanced with some of our clients in relation to non-PWLB borrowing for the forthcoming HRA Self Financing transaction but any numbers of investment banks now appreciate how government can change the game very quickly indeed. It works both ways, however, so I would never say never!

R151: What do you think will become the popular financing options for local authorities in the years ahead (e.g. bank loans, single issue bonds, pooled bond, retail bonds, EIB, etc)

MH: The PWLB is the key to all this but in a world where it did not exist, then I would see all of the facilities outlined above to be open for more than just consideration as is the case now. The issue is that developing a market in bonds is expensive and liquidity (demand and supply) is required to bring down pricing to levels deemed to be attractive i.e. below those available from the PWLB. The financial markets are extremely cautious about risk and demand quite high premiums for any degree of uncertainty and quasi-sovereign debt issued in or after a sovereign debt crisis has an implicit high hurdle to clear.

I guess a word about the EIB is worthy given it issued 3 year bonds a week or so ago priced at over +150bp over gilts. The EIB was placed on rating watch with negative implications by the rating agencies towards the end of last year. S&P announced that it had affirmed its AAA rating this week albeit with a negative outlook. The problems in Europe have understandably had an impact on the EIB’s cost of funds and this pressure is reflected in the rates offered under its lending programme. We have spent some time with the EIB looking at borrowing for some of our client’s requirements and the relative attraction in borrowing costs compared to other available sources has all but disappeared. It will continue to do so until the Eurozone crisis is resolved.

Finally, the revised Code of Practice and a lot of debate concerns the use of derivatives by local authorities. Whilst we do not detect a great deal of firm appetite we think that is mostly to do with there being enough pressures elsewhere and the debate for the use of derivatives remains undeveloped. What is required is clarity on what ones can be used and what benefits they will bring. Until that case is clearly made, then they will remain largely a sideshow.

R151: How will S&P’s Eurozone downgrades impact local authority reserves?

MH: I do not believe that it will have any direct impact on local authority reserves. The downgrades have not significantly altered our advice since we recommended an incrementally more defensive position throughout 2011. The key downgrade in terms of the headlines was, of course, France, but in a wider context it is the sustained deterioration in credit outlook that reflects the problems in the Eurozone and beyond (Hungary being the latest example of a non-Euro member adversely affecting Euro members and Austria in particular).

The subsequent downgrade of the European Financial Stability Facility (EFSF) adds further unhelpful pressure into a struggling system. We are mindful that on 20th March 2012 Greece has €14bn of debt redemptions due and this is viewed as another crunch date. It falls just one week before the HRA Self Financing Settlement.

R151: What other challenges do you think you’ll be focussed on with your local authority clients in 2012?

MH: Our focus remains on supporting all our clients in what we expect will remain extremely challenging times. A lot of our focus is currently on the HRA Self Financing transaction where we are moving towards the end game of actually funding the settlements. Whilst the Treasury has restricted the PWLB borrowing window, the structure and extent of the borrowing is where we are continuing to work very closely with clients.

Taking all these together, Arlingclose will remain focussed on delivering the best, bespoke advice to our clients in order to help them through what will be another challenging year.