Appendix 11

Treasury Management and Annual Investment Strategies for 2006/07

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.

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 2009 (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 2009 an increase in the capital financing requirement of £87.4m from £548.1m to £635.5m is forecast based on the current and proposed capital programme. Changes to the revenue support grant formula require a review of the County Council's policy on the use of supported borrowing and may result in the Government modifying its approach to the provision of support for capital expenditure. No account of the possible outcome of these reviews is allowed for in estimating future capital financing requirements.

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 2006, some 56.4% of the capital financing requirement will be held at variable interest rates. If further long-term borrowing were not to take place by March 2009, this proportion would increase to around 65.5%. To maintain the target variable/fixed rate ratio of 55%/45%, around £67m would need to be borrowed long-term at fixed rates between now and March 2009, implying a target of around £22m a year.

3 Interest rate trends

3.1 At the time of last year's report, base rates had been on a rising trend and stood at 4.75%. Most commentators then were expecting base rates to peak at 5%, but some were predicting that a downward trend would re-emerge later in 2005.

3.2 Since then, there has been only one base rate change - a drop of 0.25% in August 2005 to 4.5%. There are differing opinions about the likely course of base rates over the period to March 2007. The majority of market commentators seem to expect further reductions, possibly to levels around 4% by March 2007. However, sentiment could change rapidly.

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 At the time of last year's report, there was no clear consensus on the likely trend in long-term rates. The yield curve then was very flat, implying relative stability over the foreseeable future.

3.5 In practice, long-term rates have been on a downward trend, particularly over the last six months, and PWLB rates now stand at 4.35% for the shorter maturities, and as low as 3.85% for loans maturing in 30 years. These declines in long-term rates seem to be a reflection of a high demand for long-dated bonds from institutional investors, as pension funds move away from equities into bonds to reduce their risk profiles.

3.6 The yield curve remains relatively flat, suggesting that any movements will be small in the foreseeable future, so it seems reasonable to expect fairly stable rates over the period to March 2007.

3.7 The following borrowing strategy was agreed for 2005/06:

· 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 2005, a further 14 long-term fixed-rate loans from the PWLB have been taken totalling £32m at rates ranging between 3.85% and 4.75%, averaging 4.38%. 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 four 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 rates for fixed initial periods can be obtained if required (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 and sometimes below 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.

· `Single-rate only' LOBOs are also available at rates which cannot be matched by the PWLB. As with other LOBOs their rates are fixed for a primary period, but can be varied by the lender at six-monthly or annual intervals - 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 in either or both of the following circumstances:

· 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 four years. Last year a limit was agreed of 15% on the proportion of the Council's capital financing requirement financed from LOBOs. This would form part of the variable rate target of 55% (see paragraph 2.4). This would provide headroom for a target of £31m of LOBOs to be taken in 2006/07, or, over the longer term, £39m to be taken by March 2009, implying an annual target of £13m, based on the current forecast of the Council's capital financing requirement.

4.8 £20m worth of `single rate only' LOBOs have been taken in line with this strategy since it was first agreed last year, at fixed initial rates ranging between 3.5% and 4.25% for initial periods between one and three years.

5 Borrowing strategy

5.1 Interest rates generally are expected to be relatively stable over the period to March 2007.

5.2 It is suggested that, in view of the current historically low level of long-term interest rates, the strategy for borrowing at long-term fixed rates as set out in paragraph 3.7 should be amended with a new trigger rate of 4.5%, at or below which long-term fixed-rate borrowing should be considered.

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 and building societies rated at least A2 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 three 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, six UK building societies, one highly-rated European bank, the Government's Debt Management Office, 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 is 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 2006/07

7.1 The following table summarises the interest budget to finance the Council's capital financing requirement in 2006/07:

7.2 £2.4m 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 £25.4m payable by the County Council.

Recommendations

1 That the following strategy be approved for 2006/07:

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

· Long-term fixed-rate borrowing be considered if long-term rates stand at 4.5% 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 £22m and £13m be set for 2006/07 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.

Annex 1

1 PWLB fixed-rate debt as at 31 March 2006 by interest rate

Interest rate	Principal outstanding
%	£m
3 - 3.99	4.0
4 - 4.99	142.0
5 - 5.99	14.0
6 - 6.99	8.0
7 - 7.99	17.0
8 - 8.99	5.0
9 - 9.99	49.0
Total	239.0

2 PWLB debt by year of maturity

Year	Interest rates (range)	Principal repayable
	%	£m
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 - 4.5	8.0
2031/32	4.25 - 4.95	14.0
2032/33	4.55 - 4.85	8.0
2033/34	4.5 - 4.75	8.0
2034/35	4.35 - 4.75	6.0
2035/36	3.85 - 4.65	14.0
2036/37	4.1	2.0
Total		239.0