Panic over?

It’s been a cold winter for local authority investment returns.  As the storm clouds gathered over the Eurozone, many treasurers battened down the hatches and adopted emergency measures with their investment strategies, raising credit rating criteria and reducing time limits for commercial banks – even to overnight deposits only.

In the aftermath of the Icelandic bank failures, local authorities were criticised for focusing too much on credit ratings and ignoring the other signals available in the market.  This time round, with CDS spreads rising to record highs for many banks, treasury managers have been forced to take notice, even if their gut instincts told them that the big UK banks were safe.  After all, to miss the signs you didn’t know about in 2008 might be unfortunate, but to ignore the man waving a big red flag and be caught out again would be unforgiveable.

However, pressing the panic button is the easy step; knowing when to sound the all-clear is a more difficult decision.  Keeping the investment portfolio in special measures unnecessarily will be a big hit to interest income, at a time when local authority budgets are under all sorts of other pressures.  And there are some signs that the clouds are breaking, with the blue sky maybe not too far behind.

The iTraxx index of 25 leading European banks CDS spreads is now back down at 213, having reached 339 in November as the crisis in Greece escalated.  However, given that the index was below 100 just two years ago, it still has some way to go.  And LIBOR rates for bank to bank lending remain surprisingly elevated compared with credit risk-free rates such as Treasury bill yields.

So what options are there for the local authority treasury manager needing to boost investment income to prevent another round of job cuts?  Those stuck with millions in the DMO earning 0.25% because they are not in a position to accept any credit risk can look to buy government gilts.  Locking in for five years at 1% might not sound particularly attractive, but quadrupling investment income sounds much better.  And my guess is that DMO rates won’t be above 1% for a long time to come yet.

Authorities able and willing to accept a small level of credit risk shouldn’t be looking for one or two big names to bet on as being safe.  Governments around the world are doing all they can to ensure that they never rescue a bank again, and none of them are exempt from going bust.  So diversification is the key – spread your money around a wide range of high quality names, so that if you are unlucky enough to suffer a default, it’s a manageable sum.

Since most of the quality overseas banks are only interested in a foreign currency like sterling in large amounts, diversification is best achieved by using professional fund managers, either appointing them to manage a segregated portfolio, or more easily via AAA-rated money market funds and similar pooled structures.  With an impressive array of investment options, and a strong incentive to be very careful with your money, fund managers are an ideal way for local authorities to emerge slowly from the panic room.

David Green is the 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.