Opportunity knocks for debt managers

In recent years Leeds has remodeled its loan book to significantly improve its cost of debt. Bhupinder Chana, principle finance officer at Leeds City Council explains how they’ve done it.

Since the Icelandic crisis the mantra security, liquidity and yield has been drilled into every treasury manager’s mind if it wasn’t already branded on their forehead.

This principle must be upheld but in the face of ultra-low rates for the vast majority of councils it is the cost of maintaining debt that is the bigger burden.  If this is managed by taking advantage of the market opportunities then you can generate significant year on year savings.

To illustrate the point Leeds has loans currently totalling £1.4bn at an average rate of 3.93%. If these were at the average of metropolitan districts (4.64% in 2012/13 as per those authorities that responded to Cipfa) then that would add £10m to the debt budget.  Over a 25 year period that would equate to a staggering £250m.

It wasn’t always the case that Leeds’ borrowing rate was so low.  Back in 2006 our average borrowing rate was 5.65%.  It was around this time that we began to see rescheduling opportunities in the market.  Ultra-long rates had dropped in response to pension fund and insurance demand leading to an inversion of the yield curve.  This gave us the opportunity to reschedule PWLB debt, achieve a discount and put our debt into the long grass.  This was in the days when the margins applied to new loans and repayment loans were similar.  The decision to reschedule debt was taken after consideration of:

• npv analysis of the option to reschedule against continuing with the existing loan
• impact on volatility
• impact on the maturity profile
• impact on the HRA account
• accounting implications
• fees payable

Examples include: rescheduling PWLB into market debt that involved the repayment of PWLB £95m at an average rate of 3.8%. Re-borrow LOBOs at an average rate of 3.79% generating a large cash discount taken straight to revenue; and repayment of £360m at an average rate of 5.15% of PWLB loans, and re-borrowing at an average rate of 4.6% generating annual savings of £3.2m after effects of premiums and discounts.

In 2006/07 the strategy produced £22m of in-year savings.  This involved repaying more than £600m of loans and taking on new borrowing of more than £800m. The table below shows our rescheduling activity in the following years.  It has reduced in recent years as our strategy has shifted to fund borrowing from our balance sheet and short-term money markets. The increase in the margin above gilts has also affected the number of opportunities to reschedule debt.

The effect of overhauling virtually our entire loan book has been to reduce the average borrowing rate and provide substantial in-year budgetary savings.  The only loan we have now that pre-dated 2007 is one at 7.35% (£14.1m taken out in 1997).  This will probably remain on our books now until it matures in 2058.

What has this done for our portfolio maturity?  Have we put too many loans into a particular period?  We do not match our maturities to our MRP profile but look for maturity periods that offer good value whilst still achieving a manageable maturity profile.

A number of loans have been put into 2051 and beyond, but based upon past experience there will be opportunities in the future to reschedule these loans into different periods. If not inflation will also have a bearing on the capital outstanding in real terms.

To help smooth our volatility profile we have £445m of market debt mainly in the form of LOBOs.  These are instruments that have a fixed period of paying a fixed interest rate. After that period the lender has the option to vary the rate and if exercised the borrower can pay the new rate until the next option date or repay the debt outstanding, with a penalty. During this time we have more or less structured our LOBO portfolio so that they have options every three, five and six years.  When we embarked on the use of LOBO’s  we had seen a piece of work that pointed to an average LOBO life of 17 years before the loan was collapsed, but we were prepared for a shorter life span.

However, as the market has moved to an era of ultra-low rates our LOBOs have been very stable.  From the lenders perspective they have provided a good return for an investment in a stable name.

Whilst the costs of establishing a LOBO are higher than the PWLB, they have proved efficient vehicles to raising finance as the documentation is light touch. There is no need for expensive credit rating valuations and there is no dependency on market fluctuations/movements once you have confirmed the rate.  Additionally, both parties have the option to walk away from the deal if the market moves detrimentally.

We’ve also considered bond options both as a single issuance and as part of a consortium.  Whilst we remain open to these routes of securing finance they present some important issues that have yet to be resolved:

• There are considerable costs in getting a rating and costs in maintaining it
• Uncertainty of the rate that will be achieved
• Market movements mean that any gain to comparable PWLB loans could be quickly lost
• Documentation is particularly onerous and requires detailed examination
• Taxation issues on paying interest gross can cause investor nervousness
• Cross guarantees – are local authorities happy to cross guarantee the debt of other locals? Even if the likelihood of default is low? Is this legal?

Perhaps we have become too comfortable with raising finance from the PWLB.  But they have been around since1793; they are our lender of last resort and have no intention of moving away from providing funds.  The PWLB recently increased the limit of the amount of loans that they are prepared to lend councils from £70bn to £95bn.

Their process of awarding loans is efficient, the costs are low, and funding is available based upon real-time gilt prices, plus a margin, which arrives in your bank account in two days.  Simple, efficient and transparent.

But what about volatility? Whilst the average borrowing rate has continued to fall it is important to note the average maturity profile of the council’s debt.  The average length of all loans to final maturity including temporary loans is 37.6 years.   The average length of all loans to the next option date including temporary loans is 20.8 years.  This provides a large degree of funding certainty within the overall debt portfolio.

So, the rescheduling that we undertook has introduced significant certainty in our costs of funding and furthermore has now allowed us to fund our capex requirements from ultra-low short term rates.  One of the anomalies that we see is that despite significant reductions in funding (between 2010 and 2016 our funding will have reduced by £170m, or about 43%) our balance sheet strength is funding around £350m of our requirements.

At some point we’ll have to convert that into longer-term funding.  So we’ll continue to watch the markets and when there are signs that the economy starts to normalise we’ll look to secure longer-term funding.  Principally that will be from the PWLB and market loans but we are not averse to looking at credible alternatives that offer real value.

In terms of investments its simple security liquidity and yield – that’s one constant in a changing world.