David Green: Taking a ‘balanced view’ of borrowing

Long-term fixed rate loans may be low risk but, argues David Green, the lowest risk comes with a portfolio including a “decent proportion” of short-term borrowing.

A recent Room 151 article sensibly advises that local authorities should take a risk management approach to their borrowing decisions, with long-term loans or bonds likely to be the lowest risk solution, even though they come at a higher cost.

Looking at a single loan in isolation, I think we can all agree that long-term fixed rate is the lowest risk. But many local authorities already have large portfolios of long-term fixed rate loans, often coupled with large variable rate investment portfolios. These are leveraged one-way bets that interest rates can only go up from here, despite evidence from the last 30 years that interest rates keep going down. The last thing these local authorities need is more long-term fixed rate debt.

Much better, in our view, to take a more balanced view. Yes, 2020 may be the turning point with interest rates climbing in the years ahead. But maybe we will stay on this 0% floor, or maybe even the Bank of England will open the trapdoor and take us down to negative rates. For organisations that are net borrowers, a balanced portfolio has some fixed rate debt to protect against rate rises but also some short-term or variable rate loans to take advantage of rate falls.

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Balance

Finding the appropriate balance between the two is one of the most important treasury management decisions to make. There are a few key considerations. Firstly, short-term and variable rate investments should be netted off short-term borrowing, as the cost of a rate rise on the borrowing will be offset by the additional income on investments.

Secondly, build in the authority’s exposure to economic risks. In a recession, all sorts of income streams dry up while costs rise in other areas. The localisation of business rates and council tax support, coupled with increasing commercialisation, means that local government shoulders a larger economic burden these days than it did a decade ago.

But short-term interest rates always fall in a recession, and a portfolio of short-term borrowing can help alleviate the financial impact. The old approach of long-term fixed rate borrowing combined with short-term investments exacerbates the problem instead.

Consideration must also be given to the authority’s ability to absorb the cost of interest rate rises within its reserves. It would be wasteful to budget every year for a large interest rate rise, a slew of by-elections and the roof blowing off the town hall, but it is prudent financial management to budget a little bit each year to build up a reserve against one of those happening.

If half of the savings from short-term borrowing are placed in an earmarked reserve each year, you can get a virtuous circle where reserves grow and so the authority’ ability to continue making the savings through short-term borrowing grows.

Cash flow

Finally, just as no-one has a crystal ball when it comes to interest rates, neither do you have one when it comes to your cash flow forecast. Flexibility and the ability to repay loans early is therefore important.

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The PWLB is the most expensive and most inflexible lender in this regard; their repayment premiums are exceptionally high and they will not negotiate. Private placements are an improvement and with public bonds you can buy them back on the stock exchange. But short-term borrowing is free to repay early—you just don’t reborrow when it matures.

Taken together, these mean that the lowest risk portfolio often includes a decent proportion of short-term borrowing. When that proportion gets uncomfortably high, its time to lock into long-term fixed rates. Loans and bonds are the traditional ways to achieve that, but you will pay a margin to the lenders to compensate them for tying up their cash for many years. PWLB currently charges a margin of 1.80% above gilts or 2.25% above overnight rates (SONIA). The recent Municipal Bond Agency issues have been at 1.00% above gilts and 0.80% above SONIA.

Short-term borrowing is currently available at no margin to SONIA, a total cost of 0.05%. You can then take an interest rate swap which allows you to lock into long-term rates without paying such a high margin. With 20-year swap rates at 0.40% compared with PWLB at 2.65% and bonds around 1.20% to 1.85%, there are substantial savings to be made, even after allowing for the additional costs involved.

Interest rate swaps will be new to many local authority treasurers, so shouldn’t be entered into without due process. But they are a powerful tool for managing interest rate and shouldn’t be dismissed just because they are new.

David Green is strategic director at Arlingclose Limited.