David Green: To borrow or not to borrow

To borrow or not to borrow – that is the question:
Whether ‘tis nobler in the long-term to suffer
the slings and arrows of outrageous interest rates;
Or to take arms against a sea of investments
And by opposing end them.

Following the EU referendum result, PWLB rates are at an historic low. Again. And so, many treasurers are grappling with a financial version of Hamlet’s famous indecision.

Some didn’t grapple for long though – 62 local authorities borrowed a total of £1.3 billion in June at an average rate of 2.54%. One even said it would be ridiculous not to take advantage. But the inconvenient truth is that PWLB rates have hit all-time lows in 36 out of the last 300 months. And while many people have said many times that the only way is up, the long-term trend for the past 25 years has been decidedly down.

Before committing to long-term loans, there are three main questions to be answered:

First of all, do we actually need to borrow in the first place? After all, that half-price pair of shoes is only a bargain if we actually need some footwear, otherwise they risk sitting on the shoe rack looking pretty. It’s the same with money – if you borrow some that you don’t need it just will sit in your investment balance, earning next to no interest. The low risk treasurer will take arms against the sea of investments, with its waves of credit risk, and seek to end it. Many local authorities regularly plan to spend cash, only to see balances rising rather than falling each year. Some more realistic cash flow forecasting, including a long-term liability benchmark that takes inflation and minimum revenue provision into account will help answer to this question.

Then, if we do need some money, does it need to come from long-term fixed rate loans? PWLB fixed rates are broadly calculated as the average expected base rate over the full term plus 0.8%. But local to local short-term loan rates are somewhere around base rate minus 0.2%. So for the long-term rate to be better value, the interest rate has to be wrong by more than 1.0% on average. It’s not going to be out much at all in the near-term, so it needs to be very wrong in the later years. OK, the market doesn’t have a great record of forecasting interest rates, but so far it has consistently forecast them too high. Given where rates are in the Eurozone now, it’s not inconceivable that rates might turn out more than 1% below forecasts, rather than above.

Rolling short-term loans have a similar interest rate risk profile to a long-term variable rate loan. And it has been common for local authorities to treat this as a high risk – after all, rates can go up and up with no ceiling. It’s now becoming apparent that there might not be a floor either.

But even if we ignore the likely cost savings, there are good risk management reasons for holding a portfolio of short-term or variable rate loans.  Consider the circumstances when the Bank of England is going to ensure that short-term interest rates are low. This will be when the economy is in a downturn, and therefore when benefit payments are rising and council tax and business rates receipts are falling. Now that these have all been localised, wouldn’t it be preferable for your interest payments to be falling at this time, to offset some of the pain? Unfortunately most local authority treasuries are set up so that interest income receivable falls faster than interest payable, meaning that treasury management adds to the problem, instead of alleviating it.

Finally, if both those points have been covered off, then the third question is whether the PWLB is the best source of funds. On the plus side, it’s very fast and administratively simple to arrange a loan, but it is very inflexible. You can’t negotiate a better rate, or a forward start, or a tailored repayment profile. And PWLB loans are very expensive to repay early if you find later that you have more cash than you expected.

Alternative sources, including bonds, public and private sector banks, pension funds and other local authorities can all offer advantages including lower interest rates and greater flexibility. They may not be quite so easy to arrange, but if a few days of staff time and a few thousand pounds of fees saves you a million pounds in interest, that should be a price worth paying.

The UK may be heading for an economic winter of discontent made glorious summer by the sun of near-zero interest rates. Short-term borrowers and long-term investors will be able to bask in the ensuing warmth. But those that have filled their boots with PWLB loans at 2.5% may be feeling a little sunburnt.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.

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