Andrew Hardingham explains how an interest rate swap enables Plymouth to “lock into a known, fixed rate for an agreed term, while retaining the flexibility to continue borrowing at lower, short-term rates.”
Plymouth, Britain’s Ocean City, faces huge demands on its resources. A naval city with a long and illustrious history and one of the most bombed cities after Coventry during second world war, now faces the challenge of rising once more after pandemic.
This is a city with a population of over 270,000 people who live in properties of which 86% fall in bands A to C for council tax purposes, and around 80 of 326 of the local authority districts having indices linked with deprivation places.
And, in keeping with the national trend, people in Plymouth are living longer with one in three residents aged over 50. Demand for services continues to rise whilst resources diminish. More than 70% of the net budget is spent on care services for the elderly, children and families and the homeless.
The pandemic hurts. £50m of business grants have been pumped into the local economy and more than 3,000 extra council tax payers are seeking support from the council tax support scheme.
The council has pursued a “growth dividend”; a strategic and structured approach to grow and to invest in city regeneration.
Such growth was designed to generate much needed, sustainable local income streams in terms of council tax, business rates and the new homes bonus scheme.
This is exemplified by the recent opening of the latest UK cultural offering, The Box, a capital investment of more than £42m reflecting the ambitious investment in the city for growth, culture and innovation. In addition, the Resurgam programme (local investment in local providers) has been launched.
Swap
Managing such capital investment requires careful and prudent management of its borrowing.
The Council’s borrowing as at 31 March 2020 was £570m of which 78% (>£400m) was from short-term loans (usually less than three months) through the inter-local authority market.
This was considered a strategy to minimise borrowing costs to enable growth and fund service demand, but with an eye to ensuring the prudent approach extends beyond the life of the current medium term financial strategy.
Backed by a leading QC’s opinion, the council agreed its first interest rate swap of £75m in April which effectively gives a fixed cost of borrowing of 0.56% for the next 20 years.
The swap is, in essence, a contract with a bank (in Plymouth’s case Santander) to fix the borrowing rates against SONIA (Sterling Over Night Indexed Average) which is scheduled to replace LIBOR.
The deal was 12 months in the making and has paved the way for the council to consider a further swap.
Whilst we make use of fixed-rate debt from the PWLB as part of a diversified funding portfolio, the lower rates available from other local authorities presented a dilemma. While we valued the certainty fixed-rate debt provides, the cheaper short-term rates available would keep our interest costs lower, meaning less tax payer money was spent on servicing debt and enabling us to invest a greater proportion into local services.
But this comes at the expense of being exposed to fluctuating interest rates as we roll these short term contracts over.
The swap, allows us to lock into a known, fixed rate for an agreed term, while retaining the flexibility to continue borrowing at lower, short-term rates.
Simply put, each quarter, should the fixed rate be above SONIA, we pay the bank a cash settlement representing the difference. Whereas, should floating SONIA be higher than the fixed rate, the bank settles the difference to us; the net result being we are locked into the fixed rate.
When compared to the fixed rates available from the PWLB, the swap also offered a saving of around 2% on a like-for-like basis.
Balance
It is of course important that we continue to run a balanced portfolio, using a combination of funding options, hence we ‘swapped’ only part of the borrowing.
Such a strategy means that while we are protected against rate rises on part of our funding, should rates fall further, we retain the ability to benefit on the part which remains unhedged.
We discussed in detail with both the bank and our adviser, how the swap would work in a number of scenarios, examining the risks and benefits. We concluded this was a prudent means to manage the interest rate risk associated with our short-term borrowing.
Mark Swallow, strategic director at treasury adviser Arlingclose, explains it this way: “Local authorities which fund their borrowing requirements from either internal borrowing (using their own balances and reserves) or short-term variable rate borrowing from other local authorities, are exposed to the risk of interest rates rising, thereby increasing the cost of their borrowing in the future. A swap is one way of managing this risk as it converts, or ‘swaps’, a floating interest rate to a fixed rate.”
As Arlingclose points out, up until now, there have been few alternatives for local authorities to “lock out” the risk of rates increasing, except by turning to the PWLB. But with its rates some 20-times the equivalent short-term rates, this has been an expensive alternative
Localism Act
Of course, local authorities have had dealings with interest rate swaps before. In 1992 the High Court case of Hazell v Hammersmith and Fulham concluded in a ruling that local authorities had no power to engage in interest rate swap agreements. This, the ruling went, was because swaps were beyond a council’s borrowing powers, and all contracts were void as their actions were said to contravene the Local Government Act 1972.
Since then things have changed. The Localism Act 2011 gave councils in England a “general power of competence”. Section 1 of the act says: “A local authority has power to do anything that individuals generally may do.” The legislation has enabled Plymouth to go through with the swap transaction.
As Arlingclose points out, Plymouth’s swap is an innovative transaction, which took much work by all parties to conclude.
This involved ensuring the council had fully understood the reasons for going through with the transaction; both counter parties ensuring that Plymouth possessed the “necessary” capabilities, legal/regulatory powers to trade; and the council demonstrating that all its internal governance needs had been met.
Our advisor’s analysis and recommendations were a central part of Plymouth being able to demonstrate to Santander that the swap was a “suitable product” to reduce interest rate risk in the council short-term debt portfolio.
Support from the advisor came through the approval and contractual processes agreeing the International Swaps and Derivatives Association Credit Support Annex.
Further support will follow in the form of valuing the swap as well as help with the necessary hedge accounting that comes at year end.
I expect the debate will rumble on over the not too distant future as to whether Plymouth should, or should not, have enetered into this transaction, and questions will be asked as to whether the council has the power to do this.
What needs to be said is that this will not be the solution for every council. It was only after a close examination of treasury policy, thorough due diligence, the careful consideration of advice and legal opinion that the decision was taken to proceed.
Andrew Hardingham is service director for finance, Plymouth City Council.
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*Photo by NICHOLAS CAPPELLO on Unsplash.
