Anyone in need of redemption?

OK, so perhaps I don’t mean that question quite as broadly as it sounds – I am of course not referring to the theological use of the term – perhaps worth clarifying before you all rush to confess your sins to me!  I am of course referring to the potential for debt redemption.  Before you click off this article having already discounted the idea of reducing your debt on the basis of it being too expensive, I would like to provide some words of comfort that repayment may not be as crazy as it sounds.

Granted, discount rates for calculating premiums are not as favourable as they once – but before we berate HM Treasury too much for not being kinder with these rates, it is worth remembering that whilst we may feel a little injured following the changes in margins for new borrowing, the margins on redemption rates have not altered – there have been no moving goal posts on that side of the pitch.  It is the macroeconomic environment that has hurt us here.

So is there still value to be had in redeeming debt?  Is it worth our while to consider it?  Depending on your own situation (and the size of the carry trade you have on) in my opinion, in many cases – most definitely, and if I was still a practitioner I would be rushing to undertake an immediate review.  After all, I imagine (after a brief trawl around TM strategies in the public domain) that most strategies contain an intention to consider undertaking some debt rescheduling if it is beneficial.

The next question therefore must be “How can we evaluate such opportunities?”

Traditionally, we have been conditioned to think that no evaluation is complete without a discounted cash flow calculation – without wanting to alienate my fellow accountants too much, I am not entirely sure this is the best way of determining the viability of this particular decision.  Where there is uncertainty about the future cash flows (i.e. the rate at which investment income will be lost by repaying debt) guessing these revenues in order to discount them to provide a Net Present Value over which redemption will pass or fail does seem arbitrary to say the least.  Me, I prefer a more risk based approach – which fully takes account of the uncertainty around future rates and can provide a probability of redemption (or any restructuring for that matter) being beneficial in terms of Net Interest Costs.

My example portfolio below tries to illustrate this point.  This authority has a large and long-dated portfolio of approximately £500m at an average rate of 4.78%.  In addition to an investment portfolio of around £130m (not all required for liquidity purposes) yielding a return well below 1%.

Having looked at its portfolio in the context of its liability benchmark, my LA has determined that it has more loan debt than is desirable and is much too long dated.  £50m loans have been identified for possible redemption in order to bring the portfolio closer in line with the benchmark.   At current rates, the premiums are not cheap (around £41m), and may well have dissuaded this authority from wanting to take this exercise any further.

However, by taking a risk-based approach to determining the potential benefits and recognising the key unknown of future investment rates, the results are somewhat surprising.

This chart shows the distribution of potential outcomes for Net Interest Costs including amortised premiums based on over 1000 potential interest rate scenarios.  The red curves show the pre-restructuring range of outcomes demonstrating a fair bit of uncertainty in the next 3 years and 5 years.  The green curves show the outcomes following the restructuring; reflecting not only a higher degree of certainty (demonstrated by the narrower and higher peaks), but also a significant shift to the left – showing a very strong likelihood of significantly lower Net Interest Costs.

So from undertaking this restructuring, not only does my LA end up with a more balanced portfolio which is more closely aligned to its benchmark, but the expected net interest costs are lower, and risk has also reduced.  Of course, on the flip side, this authority’s ability to participate in upside potential if investment rates rise particularly rapidly is diminished (shown by the tail events in red on the left hand side) – but I for one, would gladly sell the upside potential in favour of reducing the downside risk.  I should also point out that this illustration has just been shown for 3 and 5 years, but clearly looking at this over a range of time horizons will give the depth required to evaluate the opportunity appropriately.

Of course redemption is not just applicable for PWLB loans, it is equally relevant for any market loans – however the inherent lack of a formulaic approach to calculating breakage costs on those loans means that without dialogue with your lenders, they are trickier to estimate.  However, be aware that right now the value of those options are incredibly low (as the likelihood of them being exercised is pretty remote!) therefore it may not be a bad idea to get some of those discussions going – but I can’t promise it will be as compelling a case as my PWLB example above.

I would therefore sum up that if you have sinned, and borrowed too much long dated money in the past that was not necessarily needed, it’s not too late for redemption – it could be your salvation!

Jackie Shute is the Co-founder of Public Sector Live a company specialising in Local Authority treasury risk analytics and the TreasuryLive treasury platform.