Appendix 11

Treasury Management Strategy for 2005/06

1 Introduction

1.1 This Appendix:

· outlines a proposed strategy for the management of the Council's long-term debt portfolio in the light of forecast trends in long and short-term interest rates over the next year and beyond.

· sets out an Annual Investment Strategy for the investment of the Council's surplus funds, subject to the County Council's approval (see below).

· sets out a revised Treasury Policy Statement for the County Council's consideration, to reflect new guidance issued by the Government in March 2004 on local authority investments under Section 15(1)(a) of the Local Government Act 2003. This places responsibility for approving an Annual Investment Strategy for the Council's surplus funds on the full County Council.

1.2 The Prudential Code requires authorities to set a number of limits, some of which relate to borrowing and other aspects of treasury management. The requirements of the Code are dealt with in Appendix 12 to this report.

2 The Medium-term Position

2.1 The following table sets out a forecast of the capital financing requirement as defined for Prudential Indicators purposes for each year until March 2008 (including debt managed on behalf of the Police Authority, Portsmouth and Southampton City Councils and the Higher Education Funding Council):

2.2 The table shows that over the three-year period to March 2008 an increase in the capital financing requirement of £80.7m from £505.6m to £586.3m is forecast based on the current and proposed capital programme.

2.3 A balance needs to be drawn in the debt portfolio between long-term debt at fixed interest rates from the Public Works Loan Board (PWLB) and other sources and debt where interest is payable at variable rates. Fixed-rate long-term debt means that interest costs are more stable and less vulnerable to changes in interest rates. Short-term debt is sensitive to changes in interest rates and enables savings to be made when interest rates fall but means higher costs when they rise.

2.4 If no further fixed-rate long-term borrowing takes place between now and the end of March 2005, some 58.3% of the capital financing requirement will be held at variable interest rates. If further long-term borrowing were not to take place by March 2008, this proportion would increase to around 67%. To maintain the target variable/fixed rate ratio of 55%/45%, around £73m would need to be borrowed long-term at fixed rates between now and March 2008, implying a target of around £24m a year.

3 Interest rate trends

3.1 At the time of last year's report base rates stood at 4% and were on a rising trend. Forecasters were saying then that prospects for UK economic growth were improving and that rates were likely to rise slowly over the following 12 months to levels around 5% by the end of 2004/05.

3.2 These forecasts have proved to be largely correct. There have been three further rises in base rates in May, June and August of 2004, and they now stand at 4.75%.

3.3 Prospects for substantial further increases in base rates seem to have receded recently. Most commentators expect base rates to peak at around 5%, and some predict that a downward trend will re-emerge later this year.

3.4 Prior to last year's report, long-term rates had also been on a slight rising trend, but had stabilised, fluctuating gently between 4.8% and 5.1%. Forecasters were expecting gilt yields to rise over the following 12 months by between 0.25% and 0.5%, as a result of an increasing supply of gilts to finance the borrowing requirements of central government.

3.5 In practice, these rising yields have not materialised. Long-term rates have instead been on a downward trend for the last six months or so and PWLB rates now stand at just above 4.5% for virtually all maturities.

3.6 There is no clear consensus about how long-term rates will move over the next year. The yield curve is currently very flat, suggesting that any movements will be small, so it seems reasonable to expect fairly stable rates over the period to March 2006.

3.7 The following borrowing strategy was agreed for 2004/05:

· That long and short-term rates be closely monitored.

· That long-term fixed-rate borrowing be considered if long-term rates stand at 5% or below.

· That long-term fixed-rate borrowing be considered at rates higher than this if clear signs of a rising trend in rates occur.

3.8 Since February 2004, a further 13 long-term fixed-rate loans from the PWLB have been taken totalling £27m at rates ranging between 4.5% and 4.95%, averaging 4.68%. The Council's established policy of taking loans in small tranches has continued. This is for two main reasons:

· The Council has been further protected against any risk of rising short-term rates.

· The Council's scope to borrow has been preserved in case long-term rates fall to even lower levels.

4 Lender's option/borrower's option loans (LOBOs)

4.1 Over the last three years, the commercial money market has been increasingly competitive with the PWLB. Since June 2002, lender's option/borrower's option loans (LOBOs) have been of particular interest as an additional form of borrowing.

4.2 A standard LOBO means taking a loan for a primary period at a relatively beneficial interest rate fixed for the whole period, followed by a higher rate for the remaining period which can be changed by the lender every six months. The Council, as a borrower, would be able to opt to repay the loan at the end of the primary period and every six months thereafter, but only if the lender chooses to change the quoted rates.

4.3 The main advantages of LOBOs are as follows:

· Very cheap initial rates can be obtained (occasionally below 1%), which cannot be matched either by long or short-term loans available elsewhere.

· Quoted rates for the remaining periods to maturity are also relatively attractive, being similar to those available from the PWLB, although the lender can change the rate periodically, normally either every six months or annually - at which point the Council can repay.

4.4 The main disadvantages are:

· There is a lack of certainty - the lender can change the rate every six months after the end of the primary period.

· If the rate isn't changed the Council cannot repay.

· The minimum principal sum for a LOBO is £4m, higher than the normal £2m tranches being taken from the PWLB.

4.5 LOBOs cannot provide guaranteed long-term interest rate stability, but can be an attractive option bearing in mind the opportunities for very low interest rates in the primary period and competitive indicative rates thereafter.

4.6 It is suggested that LOBOs be taken on two main conditions:

· That they would generate short-term savings over their primary periods compared with standard short and long-term interest rates.

· That their indicative rates for their remaining periods would be no higher than the trigger rate used for fixed-rate long-term borrowing.

4.7 The LOBO market has matured significantly over the last three years. It is suggested that, in view of the attractive initial rates, scope should be provided for increased use of this market. It is suggested that in future a limit of 15% of the Council's capital financing requirement should be set on LOBO loans outstanding, forming part of the variable rate target of 55% (see paragraph 2.4). This would provide headroom for a target of £45m of LOBOs to be taken in 2005/06, or, over the longer term, £52m to be taken by March 2008, based on the current forecast of the Council's capital financing requirement.

5 Borrowing strategy

5.1 Interest rates generally are expected to be relatively stable over the period to March 2006.

5.2 It is suggested that the basic strategy for borrowing at long-term fixed rates as set out in paragraph 3.7 should remain unchanged. However, the LOBO target should be increased as explained in paragraph 4.7.

6 Investment of surplus funds - Annual Investment Strategy

6.1 This proposed Annual Investment Strategy has been prepared in accordance with guidance issued under section 15(1)(a) of the Local Government 2003.

6.2 When investing its surplus funds, the County Council's policy is to continue to treat security and liquidity as paramount. Accordingly, only `specified investments' will be used in 2005/06. These categories of investment are defined in the Government's guidance as offering both high security and liquidity.

6.3 In particular, the Council's surplus funds will either be invested in:

· fixed-term deposits for periods of up to three months with local authorities, the Government's Debt Management Office, or banks rated at least AA3 by Moody's (a Government-recognised credit rating agency) that are included on the Council's lending list.

· call deposits with the Bank of Scotland (rated AA2)

· call deposits in four managed AAA-rated money market funds included on the Council's lending list.

6.4 The `call deposits' may be recalled by the County Council at any time. The Council's cashflow position will be monitored on a daily basis and adjustments made as necessary to the funds placed on call.

6.5 The Council's lending list includes the major clearing banks, four highly-rated European banks and all UK local authorities.

6.6 The lending list is reviewed monthly using Moody's ratings. Institutions will be removed immediately from the list if any doubt is cast on their credit worthiness, pending confirmation of the position by Moody's.

6.7 Limits are placed on levels of total deposits made with individual institutions.

6.8 An overall review of the lending list, including the money market funds, and the investment limits will be undertaken annually.

6.9 Changes to the lending list and the limits on investments will be subject to the approval of the County Treasurer.

6.10 Other, or `non-specified', investments will not be used.

6.11 Treasury management staff operate within detailed parameters set out in an internal code of practice, which takes account of the Code of Practice on Treasury Management and other guidance issued by the Chartered Institute of Public Finance and Accountancy. They are fully trained before participating in investment work.

7 Treasury management budget for 2005/06

7.1 The following table summarises the interest budget to finance the Council's capital financing requirement in 2005/06:

7.2 £2.7m of the total interest payable to finance the capital financing requirement is chargeable to other bodies for transferred services, for example the Higher Education Funding Council, Southampton and Portsmouth, the Police Authority and the Probation board, leaving £23.6m payable by the County Council.

Recommendations

1 That the following strategy be approved for 2005/06:

· Long-term and short-term interest rates to be closely monitored.

· Long-term fixed-rate borrowing be considered if long-term rates stand at 5% or below.

· Long-term fixed-rate borrowing be considered at rates higher than this if clear signs of a rising trend in rates occur.

2 That lender's option/borrower's option loans (LOBOs) also be considered using the same trigger rates as above, with a view to generating short-term savings in interest costs.

3 That guideline targets of up to £24m and £45m be set for 2005/06 for long-term fixed-rate borrowing and LOBOs respectively, which can be exceeded if circumstances are appropriate.

4 That it be a recommendation to the County Council that the Annual Investment Strategy set out in section 6 of this report be approved.

5 That it be a recommendation to the County Council that the revised Treasury Policy Statement at Annex 2 be approved.

Annex 1

1 PWLB fixed-rate debt as at 31 March 2005 by interest rate

Interest rate	Principal outstanding
%	£m
3 - 3.99	2.0
4 - 4.99	112.0
5 - 5.99	14.0
6 - 6.99	8.0
7 - 7.99	17.0
8 - 8.99	5.0
9 - 9.99	53.0
Total	211.0

2 PWLB debt by year of maturity

Year	Interest rates (range)	Principal repayable
	%	£m
2005/06	9.25	4.0
2006/07	7.5 - 9.375	8.0
2007/08	3.8 - 6.375	8.0
2008/09	4.2 - 9.25	4.0
2009/10	7.875	4.0
2010/11	4.35 - 4.625	4.0
2011/12	8.5	5.0
2012/13	4.2 - 6	4.0
2013/14	4.25 - 4.625	6.0
2014/15	9.375	10.0
2015/16	9.125 - 9.25	7.0
2016/17	4.4 - 9.875	8.0
2017/18	9.375 - 9.875	9.0
2018/19	9.875	10.0
2019/20	4.625 - 4.875	6.0
2020/21	4.45 - 4.875	8.0
2021/22	4.5 - 7.375	8.0
Year	Interest rates (range)	Principal repayable
	%	£m
2022/23	4.5 - 7.5	8.0
2023/24	4.625 - 7.25	8.0
2024/25	4.5 - 7.25	10.0
2025/26	4.5 - 7.125	9.0
2026/27	4.4 - 6.25	10.0
2027/28	5 - 5.875	8.0
2028/29	4.5 - 4.875	8.0
2029/30	4.5 - 4.95	9.0
2030/31	4.25	4.0
2031/32	4.6 - 4.95	8.0
2032/33	4.55 - 4.85	8.0
2033/34	4.5 - 4.75	8.0
Total		211.0

Annex 2

Revised treasury management policy statement

Policies and objectives

The Council defines its treasury management activities as:

· The management of the Council's cash flows, its banking, money market and capital market transactions; the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent with those risks.

The Council regards the successful identification, monitoring and control of risk to be the prime criteria by which the effectiveness of its treasury management activities will be measured. Accordingly, the analysis and reporting of treasury management activities will focus on their risk implications for the Council.

The Council acknowledges that effective treasury management will provide support towards the achievement of its business and service objectives. It is therefore committed to the principles of achieving best value in treasury management, and to employing suitable performance measurement techniques, within the context of effective risk management.

Responsibilities

The responsible committee for most treasury management matters will be the County Council's Cabinet. It will consider all reports submitted by the County Treasurer and have specific responsibility for:

· Approving an annual borrowing strategy at its annual budget meeting; this strategy will cover the raising of capital finance and the management of the Council's long-term debt portfolio, and will focus on the minimisation of risk.

· Considering at the same time the County Council's Annual Investment Strategy, and making recommendations accordingly to the County Council.

· Considering and approving the annual report by the County Treasurer on the exercise of the borrowing and investment powers delegated to him.

· The policy on the appointment of external managers or contractors for the management of the treasury function.

The full County Council will be ultimately responsible for the consideration and approval of its Annual Investment Strategy, and will receive recommendations accordingly from the Cabinet.

The Cabinet will delegate authority to the County Treasurer for the determination of operating parameters, monitoring procedures and reporting arrangements for all treasury management matters. In particular, the County Treasurer will have delegated responsibility for:

· The formulation of borrowing and investment strategies for the approval of the Cabinet and County Council respectively.

· The day to day management of the Council's bank balances.

· The determination of approved methods of raising capital finance.

· The determination of criteria for, and the maintenance and monitoring of, an approved list of organisations to which the Council can lend. Limits are to be maintained on investments outstanding at any one time with organisations on the approved list.

· The formulation and maintenance of treasury management practice notes (TMPs), as recommended in CIPFA's Code of Practice for Treasury Management in the Public Services.