Borrowing short-term and waiting for the PWLB consultation to finish may not be much of a borrowing strategy for local authorities. Jackie Shute looks at the risks involved.
Has there ever been such a time when s151 officers face such headwinds?
A £6bn aggregate hole in revenue budgets so far this year as a result of the pandemic, and who knows how this will grow as the “second hump of the dromedary” hits largely falling at the feet of local authorities; short-term interest rates falling to close to zero, with murmurs of negative rates being minuted by the MPC; the shock of last year’s increases in PWLB spreads giving way to excitement of an imminent cut, with few LAs believing they will face restrictions from accessing them in future.
Reasons
So, what does all this mean for your borrowing strategy?
To many, the strategy may look something like this: Borrow short-term from other local authorities and await the outcome of the PWLB consultation—and the subsequent reductions in spreads—then lock in 1-3 years time at lower rates.
This strategy appears good for a number of reasons:
- Short-term rates are significantly lower than long term rates—an immediate revenue saving;
- PWLB stated it would be prepared to reduce spreads if market conditions allowed;
- Capital strategy only has “regeneration” projects that would earn a yield so not commercial;
- Advisers’ forecasts suggest that gilt yields are expected to remain broadly flat.
Great. So, decision made, let’s move on to the next pressing urgency in the s151’s in-tray. Not so fast.
As we all know, the prime objective of the CIPFA code of practice on treasury management is to manage risk, so let’s examine which risks, if any, there are to this strategy.
This strategy works if the following requirements are met:
- Short-term rates remain low from now until you lock in, and
- Other LAs will be there to lend to fulfil the short-term need, and
- Gilt yields will not increase before you lock into long-term financing, and
- PWLB spreads will reduce following the outcome of the consultation, and
- PWLB will not restrict access for your authority following the outcome of the consultation, or
- If PWLB does restrict access, other investors will be there to fulfil the long-term need.
You may consider that each of these individually seem likely, but you need all of these to happen for the strategy to be one which does not result in higher borrowing costs. And, of course, risk management isn’t about positioning your portfolios to take advantage of a potential upside, even if considered highly likely. It is about limiting the downside potential, especially at a time when revenue pressures are particularly unwelcome.
Digging deep
So, let’s take each of these requirements in turn and dig a bit deeper into the risks to determine whether the likelihood is something that should be readily dismissed.
Is there a risk of short-term rates increasing?
While there is much talk of rates remaining low, and even discussion of negative rates, this is by no means a certainty. How would they change if a vaccine is released? And what rate is relevant anyway? Perhaps, it’s not base rate but something credit related? A wave of corporate defaults with inflation finally materialising (especially given recent Fed comments) could be quite disruptive. And let’s not forget how a lack of liquidity would push rates up, as was seen just a few months ago in March.
Is there a risk that the Inter-local authority market won’t always be there?
It may seem that many LAs are awash with cash now, to fulfil any short-term borrowing need from their peers, but is this certain to continue? Many authorities are sitting on Covid-19 support grants to be distributed to local business, for one thing, which will ultimately need to be distributed or repaid. MHCLG data showed, admittedly before Covid, that during 2020-21, a net £17.7bn of cash would be walking out of English local authorities’ doors and net debt would therefore increase by this much.
The latest stats, however, show that at the end of June there was a net debt reduction of £2.7bn. September data will be interesting. Of course, reductions in capital programmes should be factored in as the uncertainty of balancing budgets still remains. But, even if the initial expectation was halved, that still leaves £11.5bn cash to reduce from the sector before the end of March. Surely, most treasury managers can’t bank on this market given it had less liquidity in March than the Sahara.
Is there a risk that gilt yields will increase?
This is the most sensitive factor, due to the long-term nature of the borrowing decision. The gilt yield, which influences the fixed rate, at the time long-term borrowing is locked down, will be felt for decades to come. By not locking into currently affordable levels now, you are making a very bold statement that you do not believe gilt yields will rise between now and when you lock it down.
Is there any risk you could be wrong? What drives the gilt market? Long-term views of inflation, what’s happening to US Treasuries, confidence in equity markets … I don’t know about you, but I’m certainly not expert enough to have a view on these things, so I would struggle trying to convince my authority that we should bet the next 40 years of revenue budget on the expectation that a Covid vaccine won’t be successful, which would boost equitie, resulting in a sell-off of gilts and an increase in my borrowing costs above what I could have achieved.
Putting this into context, long-term gilt yields only need to increase by six bps (basis points) in order for any short-term benefit gained for a year to be completely eroded in the longer term. Is there, therefore, a risk that gilt yields may rise by more than six bps over the next year?
Is there a risk that the PWLB will not reduce spreads before long-term borrowing is required?
And a risk that they may restrict access to LAs?
I wouldn’t fancy a game of poker with the PWLB. This is what they said: “The government intends to cut the interest on all new loans from the PWLB, subject to market conditions, following the development and implementation of a robust lending framework co-designed with the sector through this consultation.”
It sounds positive. They will cut interest rates on loans. But it is subject to a) market conditions, and b) a robust framework which fulfils their objectives. Let’s not forget that it was market conditions that led to an increase in the PWLB margin as, following long-term rates hitting historical lows, PWLB lending volumes increased significantly resulting in the 100bp increase to “restore interest rates to levels available in 2018”.
It may, therefore, be some time before market conditions are satisfied enough to reverse or reduce this and, if logic prevails, it will be when gilt yields are at significantly higher levels than they currently are.
Secondly, there’s the robust framework condition. The perceived heavy-handed proposals to restrict access to authorities pursuing a commercial investment agenda was seen by many as unduly penal. There are challenges in re-writing the framework that has provided the main lending source to all LAs for decades, if not centuries. Many think it unlikely that the changes will be implemented in their proposed form, and therefore all will continue to have access, at lower rates than now. But it is hard to see how that would meet the consultation objectives.
With the autumn statement having been cancelled to concentrate on the here and now, the appetite at HM Treasury to embark on wholesale changes to PWLB lending may not be as urgent as it once was. Anyone banking on a swift outcome in order to dive into cheap lending, may have a long and tense wait on their hands. As gilt yields creep up, and PWLB still does not show its hand, the risks and the costs go up.
Is there a risk that, if PWLB access is restricted, other long-term investors will not be there to fulfil the need?
The alternative options to the PWLB have been widely known: Public, Bond Agency issue, private placements. While you may be led to believe these are either unavailable to your authority, or require huge resource, this isn’t necessarily the case.
Some investors may be twitchy about commercial activities and significant reliance on alternative income streams, but others may be able to price these perceived additional risks accordingly. Smaller LAs with commercial activities may not be able to obtain funds quite as readily as larger LAs with credit ratings.
If you haven’t explored all your options, you could be exposed. The other point to bear in mind, which all investors have in common, is the need to ascertain your relative credit quality within the sector. The approach taken by the rating agencies, as well as implied ratings determined by investors, takes into account the dependency that borrowers have on the short-term markets. We’ve done the maths, and an increase in your short-term borrowing ratio could result in a one-notch downgrade to your implied rating, materially impacting on your borrowing costs.
Lock-in
In summary, if you have a known long-term borrowing need and think there is a chance that short term rates might go up, or there’s a chance short-term liquidity may dry up, or you think gilt yields could go up, or that the PWLB aren’t in any hurry to reduce spreads, or that they may restrict access, then maybe this strategy isn’t for you. If you can lock into borrowing now, on a forward, or spot basis, that is within your budget, this would take considerable risk off the table.
no-brainer [noh-brey-ner]; noun. informal.
An easy or obvious conclusion, decision, solution, task etc.; something requiring little or no thought.
No treasury decision requires just a little or no thought, particularly when public money is at stake in such dire economic times. Every decision needs full consideration of the risks involved, especially those extending decades into the future. An active decision not to reduce risk is one thing but giving no thought to the risks is something else.
Jackie Shute is co-founder and director at Public Sector Live.
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