Room151 Think Tank: Coming to terms with capital loss, resources and reputations

The latest Room151 Treasury Think Tank, sponsored by J.P.Morgan Asset Management, tackled resourcing issues, reputational fears, changing attitudes to capital loss and the culture of zero default risk.

 

Gavin Hinks: What are the pressures faced by treasury managers?

Bridget Uku: Some of the internal pressures we face centre around resources. The looking for credible counterparties to place investments with. Some other pressures are that running down investments can prove difficult at a time when you are trying to build up reserves for long term-resilience.

We are quite risk averse which invariably means some investments are placed with the DMO. Our current strategy is to run down investments – making more on savings from not borrowing than we would make from taking additional counterparty risk placing investments.

In other words we want to minimise the cost of carry, i.e. borrowing at higher rates but investing those borrowed funds at lower rates before they are required.

The world is still beset by a number of global and financial imbalances so we are still concerned about counterparty risk. Also – looking for alternative investments that will  diversify our exposure to banks in light of bail-in. One obstacle is coming to terms with being able to take a capital loss.

Gavin Hinks: Tell us about coming to terms with capital loss.

Bridget Uku: Well, the cornerstone of our treasury function is to ensure our capital

remains secure and to be able to pay bills as they fall due. It is whether, and how, we migrate to a mind-set where we search for yield, on the basis that we move up the risk spectrum and maybe take some capital loss but still make money across the piece.

I think it’s just getting all our stakeholders on board with that mindset. We still are not there yet.

Gavin Hinks: Is changing mindsets a familiar experience?

Stephen Bevis: Absolutely. One of our main external pressures is shared services. That’s always at the forefront. Great if you are asked to run a tripartite arrangement but I’d be reluctant to give up some or all our funds. We’ve got quite a high investment portfolio. We’re very risk-averse.

Some of our internal pressures, for example: we’re looking at other ways and other products, currently looking at some enhanced cash funds, which are fairly liquid. We’re looking at trade plus two, so you get your money back. Admittedly, variable NAVs, but I think the risk is quite minuscule of losing any capital and they give you a good yield, currently around 90 basis points, which is quite a good rate of return.

Our only debt really is on the HRA self financing. We’re looking at repaying that early, perhaps, and looking at some repayments versus any premiums we have to pay.

So quite a challenging environment and we do the best with our portfolio. But, I think the biggest external pressure is probably shared services and how we manage that.

Gavin Hinks: Can you tell us a little bit more about that, the shared services issue?

Stephen Bevis: Well, we’re in collaboration with South Cams District Council City and Huntington District Council. With our expertise hopefully we would run the service, if we needed to, get the good return and that causes quite a bit of external pressure.

An interesting phenomenon really is pooled funds and how they would work. Would we have the autonomy to invest someone else’s funds? Can we put that down in our strategies, for example, and be transparent with members? That’s quite key. And I’d be interested to hear, if others have similar experiences, similar concerns. Do they work from a practical position. It’s quite in its infancy where I come from.

Andrew Lovegrove: The pressure on staff resource is significant, pressure for people in the team. Can they do something else?

The expectation of return has changed, certainly in Warwickshire. After

the crash the expectation was that there will be minimal return because we have a very risk-averse approach. So, people and colleagues and the councils expected very little return.  That has now changed. There is the expectation: can we get more yield? Can we get more return? But please no more risks.

That’s an interesting dilemma. Like others, we’re backing away from exposure to banks. We quite like to see who’s got our money so a line of sight as to where that money is going, and who the counter party is, is quite attractive for us because we want to have that visibility. When you’re asked the question “where’s the money?” at least you’ve got a coherent answer to give to people.

Gavin Hinks:  Does the pressure to produce yield fit with demands to avoid any risks?

Luke Webster: No, in the sense that your return doesn’t come about without some acceptance of risk.

The key conceptual difficulty is the one that Bridget articulated, and it’s a perfectly rational position for authorities to take. They want to have zero default risk and that’s fine.

That’s a perfectly legitimate position for members to come to. But there’s a very limited number of solutions that one can offer in that circumstance and essentially buying government securities is it.

I think what we’ve tried to do is to rationalise the risk appetite. That’s really the most challenging thing that we do at the strategic level, is try and encourage members to converge on a rational risk appetite.

The way that we frame it internally is: “What’s the riskiest investment that you would be comfortable with?” And then present the universe of other investment options that are consistent with that risk.

We’re very rigorous about pointing out that there is a default risk present in our portfolio. Indeed, there are risks set with certain instruments.

We need to get to a position where we look at the portfolios as a whole and if we’re comfortable that the overwhelming probability is a positive net return, it doesn’t matter necessarily if a particular investment goes the wrong way.

If you’re not comfortable with that, then you shouldn’t be taking any risk at all. Everything should be in government securities. And that’s a choice.

Victoria Worsfold: We’re quite lucky. We’ve had a good engagement with our lead councillors in the past. They attend our strategy meetings with advisors, so they understand the decisions that we’re making.

When we’re putting the strategy together, we’ve got a treasury management panel, cross-party representation, so we try to get them involved.

Moving on, we have got some external funds that have been in our

portfolio for a while and they do take a capital loss, and we have seen that in the last 12 months.

So we have, in a way, got acceptance that that is the case because we view them over three to five year periods. … It’s a small percentage of our overall portfolio. We reiterate that message … .

We’ve got multi asset, equities, FTSE 100. A wide range and property. We haven’t got all our eggs in one basket in terms of funds. We’ve got say, one or two million each to spread in the hope that if one down up, one will go up. It’s a wide-ranging external fund portfolio. They’re income dividend paying as well so, while they may be making a capital loss, we’re getting, in some cases, a 7% return even though it’s made quite a capital loss. So, it’s still bolstering our income receipts.

Gavin Hinks: How do you engage with councillors on this subject? Do you have to describe a narrative of seeing the portfolio as a whole?

Victoria Worsfold: That’s what we try to do. They are obviously focused when they see a capital loss, but then we show them the capital position, the income return and then the position of both over the year and since its inception.

We try to show the whole picture as opposed to over a month’s time because, obviously, they can go up and down in a month. We’re trying to give them the best picture of the whole thing and tie it in with the whole portfolio.

We do try to get that message across, that it is a longer term investment, you haven’t to worry about one month. You only have to worry about that if you’re going to take the money out. But if you’re getting a capital loss, why would you with an income return… ?

Quite rightly they’ll [councillors] ask questions and we’ll keep giving the same response … that you need to look at the portfolio as a whole. That kind of helps with the risk and the return as well.

David Dickinson: We don’t invest in equities or anything like that. We’ve just got deposits, CDs, and we do other investments in property, pre-payments in a pension fund, that sort of thing. We do try to de-risk a lot of investments with local authorities as well.

We’ve got a target return that has been agreed over a three-year period, quite low and progressively higher. Again, a little bit higher, but the target return you can get either from an increase in an average yield or by having a bigger cash balance. Sometimes, doing a bit of short-term borrowing to get to that position. But it is fairly risk averse.

Gavin Hinks: Do you find yourself under a lot of pressure to reach that target?

David Dickinson: I found this year… quite exciting, quite interesting. There’s been key moments this year where there’s been opportunities on both the investment side and the borrowing side.

We don’t have much borrowing as a council, but we’ve got ambitions to borrow quite a bit because we’ve got quite a large regeneration strategy.

From both sides, if yields are quite low and there are some good opportunities then we’ve tried to lock in those rates in borrowing. Equally, especially with local authorities cash flow, and just generally with the banks as well, there’s been some quite good opportunities throughout the year to meet that target. We try to have most of our investment quite long term, as far as up to two to three years, and have the short-term on the borrowing side, using the short term to manage the cash flow.

You mentioned pre-payment of the pension fund?

David Dickinson: On a small basis last year, we just prepaid the deficit. From treasury cash and then the pension fund pays back and there’s an actuarial calculation of that.

We effectively just pay, on 1^st April, one year in advance and then each month the pension fund pays back and then at the end they pay interest.

From a pension fund point of view, we’ve had to get the pension panel members involved and so there has to be a strategic view of why the pension fund need this money … We’ve got quite a lot of calls on large infrastructure investments so that’s used to fund infrastructure. It worked well last year. There was only about £5m. This year it’s £22m.

Gavin Hinks: What are the pressures as seen from outside the treasury departments?

Olivia Maguire: One of the things that you need to think about when you want to invest in risk assets is, do you have the resources to look into them and analyse them properly?

Or, do you have access to those resources to ensure that you’re understanding exactly the asset classes that you’re getting into, the credits that you want to buy and that you fully understand the risks.

You need to be very careful with your analysis of the investments that you’re buying. What country are they in? What is the bank’s approach to the regulations? How are they looking at their structure of issuance? Is it single point of entry, multiple point of entry? It’s very complex, more so than it used to be.

It’s important to ensure – it’s always been very important – to rely not just  on rating agencies ratings and to look at, and try to understand yourself more clearly, what you’re investing in, and use resources around you to do that.

Gavin Hinks: Where are resource issues cropping up?

Bridget Uku: It is about retaining skilled talent. We all need more resources but it’s difficult to get an allocation for additional resources given the pressures local authorities are under.

Since the Icelandic bank debacle we all are aware that you are responsible for your own decisions so you have to stay on top of things rather than just call an adviser to get the answer. You have to construct your own risk appetite and look at all the issues.

We have a risk board that meets monthly and they discuss and distil the facts surrounding risks/return and agree the strategy. There is therefore a necessity to stay on top of things, remain cognisant of market developments and how they impact your portfolio, but with so many conflicting priorities that can be a constant battle.

Most local authorities have experienced the loss of skilled staff either through career progression which is inevitable, or from uncertainty brought on by restructuring. As soon as staff are operating at full, or near, full capacity they can move on. So, we need to look at ways to retain skilled staff within this complex area.

Gavin Hinks: Do resource issue affect treasury management strategies?

Andrew Lovegrove: It had a direct impact. … There was pressure to come off the bottom, in terms of the return, and I was able to put forward an argument that there’s a relationship between the staff resource we have, the skill set, and our ability to go out and seek better returns.

I was able to argue that we would increase the return by having a better staff resource. I won that argument.

There is a pressure to retain staff, train them. We have to do that. But I took advantage of the fact the mood was changing from: “We can accept no return because we don’t want any default risk.”

That was softened because risk appetite was moving. I was just lucky to be at the right place, at the right time, to put that argument on the table.

We have a much more diverse portfolio now. We were heavy users of the DMO before, because of the no default risk. That has changed quite significantly in the spread of our portfolio.

Amir Mota: I think a lot of what we discuss goes down to segmentation. We’ve been speaking to institutional cash investors for decades on segmentation and some types of sectors have been doing it for a long time.

Again, as Luke says, when you look at a portfolio I think you should look at the liquidity component – have a credit view, and an interest rate view. Anything that doesn’t need to be liquid or same day, you should view as reserves and that can have a totally different view on credit and interest rate, and so on.

When you hear the industry talking about not having resources and not having expertise, it’s worth bearing in mind many of you have relationships with asset managers today.

And those asset managers have solutions that can give you access to corporate credit and other instruments.

In many ways, as investors in MMFs for the past 10 years, there is not a massive difference in jumping from MMFs to ultra-short duration bond funds.

You are outsourcing your cash management to a fiduciary. They will have a fiduciary responsibility to manage your liquidity whether through a money market fund or an ultra-short bond duration fund.”

Dom Piper: One point I want to make here is that the challenges that have been described today are not unique to local authorities by any stretch of the imagination.

Going back to the kind of portfolio that you discussed earlier, a gilt portfolio: from a default perspective that works very well, assuming you have a good forward view on your own liquidity profile, that you can buy the duration that you want in those gilt’s and they’re available to you.

Also, you’re not being pushed from a yield perspective. I think that’s a good starting place for a conversation and it’s where we will often start with local authorities, or any other client type.

But when you suddenly step away from that, you go back to looking at price risk, marked to market risk, if you’re looking at other instruments.I think that takes us back to: “What is the initial discussion you need to have?”

Quite often we will start with: “What’s an investor’s tolerance to risk, from a mark to market perspective, and over what period of time?” Once you’ve identified that, you can look at various different portfolio types that might support that [view], be they pooled vehicles, separately managed accounts or direct investments.

Luke Webster: In our case we’ve also felt the resource pressure very acutely and we solved it by constructing a very large shared service.

When I marketed that idea it was very much not about staff savings, it was about improved outcome. We essentially captured the staffing resources of each authority that we consolidated and built a much bigger team.

But what that meant was that rather than having five [times] one and a half generalists we could have a treasury team with senior managers, trainees, experienced operational middle managers, and set up career progressions, succession planning, that sort of thing, which enables us to do many things directly that we otherwise perhaps wouldn’t.

For instance, we do run our own ultra  short-dated bond fund, we do almost all the cash operations ourselves.

But nevertheless we certainly do look to external partners when that’s the most efficient solution. In many cases it is. For instance, we’re just in the process of awarding a mandate for residential mortgage backed securities.

Although we work in a very short-dated space and they’re [residential mortgage backed securities] not very complicated instruments, the monitoring load is heavy and it makes much more sense to have somebody with the market connections and the daily view of the portfolio doing that.

I think those partnerships can be very valuable. But what I think is difficult for local authorities to outsource is the strategic risk management.  There must be somebody in the authority who properly understands the risks that are being run, whatever the investment solution is.

If you discharge your fiduciary duties properly you need to have some in-house resource who can explain to members and senior officers.

That could be a section 151 officer, but it is unrealistic for every section 151 officer to be an investment specialist. So, they have to be able to recruit those sorts of people.

Gavin Hinks: What knowledge strategic risk do you need to asses whether your investments are being managed satisfactorily?

Luke Webster: Well, it’s a different set of challenges. A bank’s chief risk officer would have a much broader range of things to be concerned about, but even for a relatively simple authority, as soon as you have a borrowing portfolio there’s the interplay between the balance sheet, the assets and the liabilities.

It’s complex and managing the risks that arise is a non-trivial problem at whatever scale, frankly.

I think local authorities do need people who have a good grounding in technical risk issues and it’s an issue that the sector has to confront. With very hidebound – in many cases – approaches to grade structures and pay, it’s very hard to get that expertise and, as Bridget says, retain it.

I’m lucky to work in a corporately supportive environment. I still sometimes fear I might lose some of my best and brightest trainees because the local authority framework for pay doesn’t compete for that particular skill set.

Bridget Uku:  It is not just what you invest in today. It is trying to look at the implications in five years’ time. Reputational risk comes into play.

As an example LOBOs seemed a rational common sense and affordable way to borrow when many were taken out, but there is a lot of scrutiny of that now.

We will not enter into a transaction if we don’t fully understand the risks, and need to be sure how it will play out when market conditions change so stress testing.

Something what can look like a no brainer today can turn out to be not so good in five years’ time. It is not just understanding the effect today, but also establishing how it will impact your portfolio for the long term.

Gavin Hinks: Does potential publicity deter you from any level of default risk and are treasury managers supported?

Bridget Uku: Yes, reputational risk is a major consideration in everything you do as a local authority steward.

Sometimes it is not just about the bottom line but how your reputation is going to be impacted if the decision results in a less than favourable outcome later on.

Exaggerated reporting can misrepresent a course of action that was quite rational at the time when the decision was taken.

Yes, we are internally supported, as long as one can establish the decision was considered and rational at the time when it was taken. But it doesn’t mean that the stakeholders or public reporting will be proportionate

But the other thing is, whatever decision you take has got to be your decision. Don’t follow the herd because you could just herd into the slaughterhouse. I think that’s one thing that we’re conscious of. Just because everybody else is doing it doesn’t make it right for you.

Andrew Lovegrove: 

I agree. You need to own your decisions. You then have to own your research and you can use other parties, which is great, but ultimately it’s your neck on the line.

To answer the question about support from senior officers and politicians: yes, but I think they operate in different arenas. When they’ve got the local paper knocking on the door for a quote, that puts them in a difficult position because newspapers like sensational headlines.

Gavin Hinks: What other external pressures do we see day to day? Is reputation an issue for external advisors?

Olivia Maguire: In terms of the other external pressures, supply is an issue for us in terms of short-dated investments. With a lot of the regulation coming in on banks, reducing the short-dated funding that they want, trying to get invested over key periods such as month end, quarter end … has been quite difficult.

It’s not even about finding quality. It’s about finding counter parties that will actually take the cash at certain times of the month.

Obviously, banks are not supposed to window dress, and take it [cash] every day of the month until the day they get measured, but you will find that liquidity is easier to come by on certain days than others. That has been a struggle. If you just go back to year end 2013, a lot of the money market funds struggled to get invested on that last day of the year and a lot of us had uninvested cash.

We’ve been looking at ways since then to try to minimise the impact going forward. In 2014 we closed our funds early on the last day of the year. We had less cash going into that by spending it down, ironically, by increasing our exposure to T-bills and to the DMO … not to reduce risk, but just to use it as a very liquid alternative to time deposits, because T-bills can be sold on the day, very easily, in very large sizes as well.

A time deposit isn’t breakable. For a CD, or a CP, you need to find a secondary market for that, but T- bills are very liquid. We’ve been using those as an alternative to try to invest some of our excess cash.

The Bank of England talks with a lot of money market funds and were very interested in the pressures we were feeling at year end, and at certain times of the calendar. They’ve had open dialogue with us [the money market fund industry] and also the DMO has had open dialogue.

We found that there’s been more support in the market over the last few months. If you look back to the Budget the DMO had the announcement that they could issue T-bills for more than just managing the finances. We’ve seen that there’s been more reverse enquiries from the DMO to issue short-dated bills just ahead of month end. That’s been very useful.

Participants

Victoria Worsfold, senior accountant (treasury management & capital) Guildford Borough Council

Bridget Uku, group manager treasury and Investments, London Borough of Ealing

Andrew Lovegrove, head of corporate financial services, Warwickshire County Council

David Dickinson, group manager (treasury), London Borough of Barking and Dagenham

Adrian Goddon, chief technical accountant, Reading Borough Council

Stephen Bevis, accountant (strategic VAT & treasury management), Cambridge City Council

Luke Webster, chief investment officer, GLA

 

From J.P. Morgan Asset Management

Olivia Maguire, sterling liquidity fund manager

Amir Mota, vice president, global liquidity

Dom Piper, managing director, global liquidity

From Room151

Gavin Hinks, editor

Peter Findlay, publisher

 

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