Short-term thinking: reacting to recent bond market movements

Council treasurers should be wary of 50-year loans from the Public Works Loan Board, despite the impact of recent movements in the bond market, says David Blake.

Something strange is going on in the bond market.

The 50-year gilt yield has traded below 1% dragging Public Works Loan Board (PWLB) rates with it, with the 50-year PWLB certainty hitting a new low of 1.67% in recent days.

Time to fill your boots on low cost, long-term debt? Not necessarily.

The reason for the sharp fall in bond yields is the gloomy economic outlook and increasing prospects of global recession.

Economic data and forward-looking surveys suggest a downturn is likely, with international trade barriers between China and the USA seen as the main culprit, with a side serving of Brexit concerns in the UK too.

Bond investors are putting their tin hats on and preparing for the worst.

The following chart tells part of the story on why we are saying don’t go “all in” on 50-year PWLB rates, despite new record lows.

LIBOR (black line) represents current interbank rates and is positively sloping, due to bank funding requirements and credit risk considerations. Sterling Overnight Index Average (SONIA) swaps (blue line) do not involve an exchange of principal so are a useful guide to the markets expectations for “risk free” rates; here we observe a negative curve, implying the market expects a reduction in bank rate. The suggested short-term “LA to LA” rates (pink shaded area) are compiled by iDealTrade using these market metrics and adjusted for demand / supply factors observed in the LA to LA market.

PWLB certainty rate loans continue to incorporate a margin of approximately 0.80%, so rates currently remain above 1%.

Meanwhile, short term local authority loans are available at well below bank rate, with some rates nudging 0.50%.

The market is now fully pricing in at least one rate cut over the next few months, while the gilt curve is inverted out to seven years, suggesting the market is expecting low rates to be a feature for some time to come.

We are also mindful that UK gilt yields did turn negative for a brief period at the end of 2016 – 0% is clearly not the lower boundary and has been a consistent feature of bond markets in Europe and Japan.

With “LA to LA” rates at half the cost of the cheapest PWLB certainty rate and a reasonable chance they head lower still, it is sensible to retain some exposure to short-term rates.

Arlingclose is advising clients adopt a balanced approach to funding.

Caution needed

Whilst short-term loans have their advantages, the uncertainty that global economic conditions and Brexit create suggest exposures should be carefully quantified and monitored.

On the flip side, there is also an opportunity to lock in PWLB rates at well below the levels anticipated in most treasury manager’s budget projections; these savings will be hard to ignore.

But don’t go overboard on fixed rates, particularly 50-year maturity loans, and don’t borrow just because rates “look good”.

While 50-year loans can make sense in some circumstances, including debt rescheduling scenarios, most projects will include a provision to repay debt, favouring equal instalments of principal and annuity loan structures.

Ultra-long maturity loans can prove incredibly costly to unwind and remove the flexibility to adjust debt levels or refinance at lower rates.

A perfectionist could argue that anyone borrowing 50-year loans over the last few years has shot their bolt too early, although nailing the lowest rate for all funding requirement is clearly an unrealistic expectation.

A blended approach to funding is one way to manage uncertainty – use existing cash resources in the first instance, incorporate a prudent exposure to flexible, low margin local authority funding and borrow an element of fixed rate PWLB debt.

Where fixed rate funding is required, borrowing in smaller instalments, when rates fall to predefined trigger levels, can help manage rate volatility.

Alternatives

We also prefer the flexibility and value offered in mid-term amortising PWLB loan rates – the repayment profiles are generally a much better fit for our clients and are lower cost too.

For investors, low bond yields and deposit rates continue to make the investment environment difficult, with deeply negative real rates of return on cash and high-quality bonds.

For clients with strategic investment positions we continue to recommend they explore the use of alternative asset classes via pooled funds, where approved treasury strategies permit.

While capital values may prove more volatile, investment returns of 4% to 5% are still a realistic target and are regularly achieved.

We estimate this approach to risk management has helped clients generate average savings of over £2m per year.

While lower funding cost may help with the viability of certain council projects, the gloomy set of global economic conditions that have caused this could weigh on council finances in the future.

Treasurers that see low rates as on opportunity to lever up and take speculative treasury positions, either with a view to generate future pre-payment discounts, or create a positive carry through investments in higher yielding assets, will need to tread carefully.

The Chartered Institute of Public Finance and Accountancy and central government will continue to take a dim view of activity that is at odds with formal guidance – with the global economy seemingly balanced on the edge and Brexit looming, there is clearly a greater risk to some financial and property assets.

Acting prudently to achieve a real rate of return on current reserves and balances is all well and good and should be encouraged.

Aggressively levering up, using cheap debt to buy volatile assets with storm clouds looming and regulators threatening to bare their teeth, is probably asking for trouble.

David Blake is strategic director at treasury adviser Arlingclose