No fix required?

David Blake is a client director with Arlingclose

Members of the Monetary Policy Committee have been falling over themselves to tell us that the Bank Rate could be going up sooner than expected. Markets are pricing in a rate rise before Christmas. PWLB variable rates have started to tick up, as have bank deposit rates, particularly those beyond six months.
With the cost of borrowing on the rise many treasury managers will be considering their interest rate exposure and monitoring opportunities to lock in fixed rate debt.
However, there is still a strong argument for maintaining a reasonable proportion of variable rate or temporary funding in the portfolio, even in a rising interest rate environment.

Below are five reasons why:-

1. Funding Margin
At 0.80% above gilt yields PWLB fixed rate funding is relatively expensive. Consider that typically short-term “local to local” deals, say up to 3 months, are often benchmarked against DMADF levels. As a result those rolling over temporary funding can do so at effectively gilts flat (no margin) or better. Savings are significant.

2. Flexible Funding
Some flexibility in the portfolio should be maintained through the use of short-term or variable rate debt. Long-term debt is not just for Christmas. If it is subsequently no longer required it can incur a considerable cost, either via an on-going cost of carry or expensive premature redemption costs, particularly given the PWLB’s huge borrowing / repayment spread.

3. Cash Flow Cycle
In many cases cash borrowing may only be required in the last few months of the financial year. In this scenario temporary borrowing will be more suitable than long-dated debt. Will “LA to LA” deals dry up? The level of cash invested by LAs was £36bn at March 2014, with no signs of this falling. And with “bail in” increasing the risk associated with bank deposits, appetite for “LA to LA” investments will continue to be strong.

4. Liquidity Hedge
Although local authorities have excellent access to liquidity, some authorities will feel more comfortable maintaining a minimum level of cash close to hand. This will generally be placed in call accounts or money market funds.  It therefore makes sense to match these liquid investments against variable rate or temporary borrowing (perhaps with an average maturity of, say, 6 months). This will ensure the cost of funding this is always closely correlated to investment returns, whatever happens to interest rates in the future, minimising both cost and interest rate risk.

5. Interest Rate Expectations – is 3% the new 5%?

The market consensus view on interest rates, currently priced into interest rate markets, is shown below:-

The MPC has consistently stated that when the Committee does start to raise the Bank Rate, it expects to do so only gradually and to a level materially below its pre-crisis average.
In a recent interview MPC member David Miles suggested that a return to a 5% rate was “wildly unlikely”. Pre-crisis mortgages used to be lent at margins very close to 0% over the Bank Rate. However, this margin has now increased to about 2% on average. All things being equal, the Bank Rate would only need to go to 3% to equate to mortgage rates of 5% and consequently it may peak at a much lower level than previous cycles.
Either way most commentators are agreed that rates will rise slowly, with the Bank Rate not expected to hit 2.5% until well in to 2017.
Against this backdrop long-term fixed rate PWLB loans at 4% and above look expensive. Of course, it would be unwise to expose the entire portfolio to variable rates; a core proportion of the portfolio should be fixed to provide budget certainty. So consider your existing portfolio and current exposure and combine this with sensible risk and scenario analysis.
It may also be sensible to secure fixed funding costs for particular projects, particularly when the financial viability of a certain project is sensitive to relatively small movements in interest rates.
But for many, a positive exposure to interest risk may be very manageable and perfectly sensible, even with rates expected to rise.