Jackie Shute: A glance back in time through the CIPFA Treasury Management Risk Study
0CIPFA’s 2016 Treasury Management Risk Study returned this year, with a two-tiered approach to capturing and analysing local authority treasury related risks. Registration for the risk study is ongoing.
The Lite Risk Study captured portfolio positions at 30th September and provided a series of charts and analysis to each of the circa 150 respondents, and the Professional Risk Study coupled that with spending plans to produce the more familiar forward looking projections and full risk analysis that has been enjoyed by participants in previous years.
This is the first of a series of articles honing in on some of the key findings and thought-provoking outcomes from the study, and has a nostalgic glance towards the 2012 study as we look at the evolution of the economic environment and portfolio positionings.
You obviously don’t need me to tell you that back in June 2012, we faced a different economic environment, but what’s interesting is the way in which local authorities have responded to these changes, and how big a part risk management has played in their strategies.
The chart below shows the history of 1 month LIBOR going back a decade (red line), and the blue line shows the expected future path at the 2012 risk study. The shaded area shows, using Monte Carlo risk simulations, where 98% of the potential outcomes could have been (indicating the uncertainty, and risk). What is clear from this, and unsurprising perhaps, is that short term rates have achieved significantly lower rates than have been achieved.
1 month libor
The benefit of hindsight shows very clearly that extending investment duration, where possible, and locking into the market’s expected increases at that time, would have been of benefit by offering protection against the lowering interest rate scenarios.
Sadly, the flattening of the yield curve between the risk study dates shows significantly less opportunity to benefit from extending duration this time round.
Evolution
So, how have local authorities been evolving in these 4 years? Just taking the authorities that participated in both 2012 and 2016 (the core universe) shows an increase in investment balances of 20% over the period, which is not insignificant. We will look further into this aspect in later articles.
As expected, the rates in our snapshot comparisons, show a reduction from a weighted average of 1.04% to 0.67% in 2016. While reductions were suffered by the majority of authorities in our core universe, 24% managed to show an increase in their returns, despite the challenging environment.
Which, perhaps, nicely brings us on to thinking how credit risk has evolved: one thing is clear from looking at the chart below (showing the credit default swap (CDS) Spreads for some familiar UK banks) the market believes there is a significantly lower probability of these banks defaulting, than there was back in 2012 (shown by the dotted lines).
So, if the credit backdrop is more comfortable now, than back in 2012, how have local authorities responded to this in the context of their credit risk budget?
Well, most significantly perhaps, our core universe showed a reduction of 82% in deposits with the Debt Management Office, although, around 32% of this reduction was represented by an increase in T-bills.
Exposure to money market funds reduced by 20%, which possibly accounted for the similar increase in enhanced funds with variable net asset value features is showing changes in the way authorities are approaching investment opportunities.
A, perhaps surprising, 31% increase in exposure to building societies has been seen by the group, as well as a more modest 19% increase to banks, reducing their share of exposure from 52% to 51%.
But the elephant in the room is, of course, inter-local authority deposits, which has seen a 131% increase and makes up 13% of the current position.
The final chart compares the credit risk & return of each of our core universe participants, measured using the outstanding rate on the relevant date and the calculated probability of default for each trade outstanding on that date.
Two key points spring to my mind, looking at that chart. 1) A significant reduction in credit risk for the vast majority of participants, and 2) A much more “bunched” effect with less diverse credit strategies.
The questions that may be asked therefore is whether local authorities have decisively chosen to reduce their credit risk exposure? Whether they were aware that, in many cases, they could afford to take on more credit risk? And the extent to which this is acknowledged in forthcoming investment strategies.
It would be remiss of me not to mention liquidity. money market funds and call accounts have seen a 19% reduction and now only comprise 28% rather than 41% in 2012 of the investment balances held by councils. Consequently, duration has increased from 95 days to 105 days.
These observations give some initial pointers to how the sector is evolving, but this is barely scratching the surface. For those local authorities that did participate, hopefully you found your individual analysis useful. If you weren’t able to participate in September, fear not: CIPFA is now running the Lite Risk Study on a monthly basis, so there are plenty of opportunities to join the universe and understand more about your own evolving treasury risks.
Jackie Shute is the Co-founder of Public Sector Live a company specialising in local authority treasury risk analytics and the TreasuryLive treasury platform.
