• Home
  • About
  • Subscribe
  • LATIF
  • Conferences
  • Dashboard
  • Edit My Profile
  • Log In
  • Logout
  • Register
  • Edit this post

Room 151

  • 151 BRIEF

    What's New?

  • Slough welcomes commitment that Office for Local Government ‘will not be a burden’

    June 30, 2022

  • Homes England agrees strategic partnership with two authorities

    June 29, 2022

  • Soaring inflation and pay pressures to add £3.6bn to council budgets

    June 28, 2022

  • Underfunded social care reforms could ‘exacerbate workforce pressures’

    June 27, 2022

  • Nottingham City Council leader labels proposed intervention as ‘disappointing’

    June 27, 2022

  • Government preparing to intervene in Nottingham City Council

    June 23, 2022

  • Treasury
  • Technical
  • Funding
  • Resources
  • LGPS
  • Development
  • 151 News
  • Blogs
    • David Green
    • Agent 151
    • Dan Bates
    • Richard Harbord
    • Stephen Sheen
    • James Bevan
    • Steve Bishop
    • Cllr John Clancy
    • David Crum
    • Graham Liddell
    • Ian O’Donnell
    • Jackie Shute
  • Interviews
  • Briefs

To boldly go…

1
  • by Jackie Shute
  • in Blogs · Jackie Shute · Treasury
  • — 1 Jul, 2013

jackieshute-banner-blue

Don’t get me wrong, I am not a Trekkie, so as much as some of you may like the idea of this blog being about Spock and co., you may have to look elsewhere. But I would like to talk about frontiers; not the final one but some frontiers that colleagues and I have been working on to raise some interesting concepts about treasury investment performance.  I’d like to share some thoughts with you about efficient frontiers – a reflection of the best returns that can be achieved for various levels of risk, and the role that these could play in a risk-based treasury management strategy.

Before I get going, caveats do apply.  I am not an investment manager, but I am someone who has a keen interest in assisting authorities in squeezing slightly better returns out of their cash without being at the expense of risk.  Everyone needs their assets to sweat harder, and I worry that this increased desperation for higher yield may be pushing the boundaries a little too far out of traditional treasury management in some cases – so I’d like to take a step back and think of more conventional ways in which higher returns can be achieved in a framework which you should be comfortable with and demonstrate how your risk appetite can assist in governing the kind of returns you could be expected to achieve.

I would strongly argue that, for authorities with debt, the starting point for determining your investment strategy should be to quantify the impact of debt repayment; you need to know the impact of putting your surplus funds to use in this risk-free way before you can ascertain how the risks and rewards of various investment strategies can provide opportunities.  Perhaps the IRR is the starting point for this, and targeting loans that get you closer to your liability benchmark. This can effectively provide a rate representing the benefit of investing in buying back your own debt.  Only then should alternative uses for surplus cash be considered; effectively using this IRR as a benchmark.

So, once you have this, the next step is to ascertain whether this target investment rate is likely to be achievable – and with that, it is necessary to think about risk.  The two main investment risks to a local authority treasurer are credit and interest rate risk.  And, as I have blogged about previously, just because the mantra of Security, Liquidity and Yield leads us to focus on the former ahead of yield, this does not mean that the impact of interest rate risk should be a lesser concern.  In fact, in terms of quantum, based on current LA behaviour, it can dwarf credit risk exposures.  Exceptionally low credit risk is being achieved at the expense of protection against adverse interest rates, and over time this has been very costly and is likely to continue to be unless there is a change in the way we approach this dichotomy.  There needs to be an effective balance between the two.

This is where the efficient frontier can comes into play. Those of you involved in pensions are probably familiar with the concept; and it can equally be applied to your treasury investment portfolios, with risk in the treasury context could be taken as a combination of credit and interest rate risk. Of course the methodology of combining these two factors carries with it a fair degree of subjectivity but this alone should not be a reason for starting to look at more holistic approaches.

The chart below illustrates this with an example of two efficient frontiers measured over a ten year duration.  The red line shows a strategy allowing investments in A rated financial institutions for periods up to 5 years.  There is a restriction that no more than 10% of the portfolio can be with any single counterparty, with the exception of gilts and cash (e.g. liquidity funds).  The blue line shows the frontier for the same strategy except allowing up to 10 year duration of individual instruments.

JS4

This shows that the longer duration strategy is able to achieve higher expected returns over the 10 years shown here, than is possible under a strategy with more restricted duration. All this without increasing total portfolio risk.  Rather interesting, when we have all been conditioned to think that short duration = lower risk.

So, going back to my starting point, knowing the return I have to achieve to justify not repaying debt, is this possible? And if so, what kind if strategy should be presumed in order to provide me with these expected returns and what risk profile is required?

What I haven’t mentioned so far of course is alpha.  There is value to be added by tactical and executional decisions which may enable returns to considerably exceed the expectations implied by the markets, and the ability for this to be generated should not be underestimated whether that is by the use of external fund managers, or internally with support of consultants or brokers.

So in a nutshell, using a framework such as this to ascertain the returns that could be achieved for a given level of risk, and removing the arbitrary duration constraints can provide significant benefit in the medium term.  So perhaps consider boldly going into longer instruments in a managed credit framework.  Lend long and prosper!

The writer wishes to apologise unreservedly to all Star Trek fans who may have been offended by the inappropriate references in this article.

Jackie Shute is the Co-founder of Public Sector Live a company specialising in local authority treasury risk analytics and the TreasuryLive treasury platform.

Share

You may also like...

  • How best to respond to local audit delays? 7th Feb, 2022
  • Pensions code of practice represents intensified scrutiny for LGPS Pensions code of practice represents intensified scrutiny for LGPS 22nd Jul, 2021
  • Making sense of climate risk reporting for LGPS 2nd Mar, 2021
  • Impact Awards: The winners are revealed 1st Jul, 2021

1 Comment

  1. dblake@arlingclose.com says:
    2013/07/02 at 14:29

    Good call on debt repayment, particularly pertinent given the recent increase in discount rates.

    Log in to Reply

Leave a Reply Cancel reply

You must be logged in to post a comment.

  • 151 BRIEFS – WHAT’s NEW?

    • Homes England agrees strategic partnership with two authorities
    • Soaring inflation and pay pressures to add £3.6bn to council budgets
    • Underfunded social care reforms could ‘exacerbate workforce pressures’
    • Nottingham City Council leader labels proposed intervention as ‘disappointing’
    • Government preparing to intervene in Nottingham City Council
  • Room151’s LGPS Roundtables

    Biodiversity
    Valuations & Risk
    LGPS Women

  • Room151’s LGPS Roundtables

    Biodiversity
    LGPS Women
    Valuations & Risk
  • Latest tweets

    Room151 9 hours ago

    Hillier confirmed as keynote speaker for LATIF/FDs’ Summit: Dame Meg Hillier, chair of the Public Accounts Committee, has been confirmed as a keynote speaker for Room151’s combined Local Authority Treasurers Investment Forum (LATIF) and FDs Summit. The… dlvr.it/ST70F7 pic.twitter.com/hxV676Iley

    Room151 9 hours ago

    Councils’ funding at risk due to ‘undercounting’ in census data: Population estimates in London and Manchester may have been significantly underestimated in the 2021 census potentially threatening government funding for frontline services in these… dlvr.it/ST707J pic.twitter.com/VncIyaXa01

    Room151 2 days ago

    Gove at LGA: councils to receive two-year financial settlement: Michael Gove has announced that councils will receive a two-year financial settlement from next year to provide authorities with “financial certainty” and allow them to plan ahead. The… dlvr.it/ST0kSV pic.twitter.com/wxL3UM4sGO

    Room151 2 days ago

    LGPS valuations: the digital journey: Rob Bilton explains how technology is helping to deliver one of the most complex data exercises in the world of public sector pensions. The 2022 valuations for LGPS funds in[...] dlvr.it/ST0kMq pic.twitter.com/VxjSPC2Uvo

    Room151 6 days ago

    Conrad Hall: ‘more sophisticated’ regulation needed for local government: The chair of the CIPFA/LASAAC Code Board has questioned the sophistication of financial regulation in local government and the continuing focus of the Department for Levelling Up,… dlvr.it/SSnPBV pic.twitter.com/G5d7JCWF8c

    Room151 1 week ago

    Slough Council approves plans to restructure finance department: Slough Borough Council has approved plans to restructure its finance department to enhance capacity and capability and to address a “significant weakness” in the function. The local… dlvr.it/SSf8DG pic.twitter.com/l5lmyHmkBg

  • Register to become a Room151 user

  • Previous story Spending Review, Manchester homes, Highlands infrastructure, Buss suggests CIV, GLA rating
  • Next story Central banks in focus

© Copyright 2022 Room 151. Typegrid Theme by WPBandit.

0 shares