Appendix 5

Treasury management activities 2005/06

1 Introduction

1.1 The County Council's Treasury Management Policy Statement requires an annual report on the exercise of the treasury management function to be presented at the end of each year.

1.2 This report summarises the main aspects of the management of the Council's debt and lending in 2005/06 and in particular sets out:

· The Council's external borrowing requirement in 2005/06

· The economic background

· Types of borrowing used

· A comparison of the composition of the Capital Financing Requirement at 31 March 2006 with that for the previous year.

2 External borrowing requirement in 2005/06

2.1 The Council's external net borrowing requirement depends on:

· The level of borrowing required

· Less the availability of internal balances.

2.2 The level of borrowing required for capital expenditure amounted to £34.6m in 2005/06 which was determined as follows:

2.3 As a result, bringing into account an increase in internal funds of £6.1m and a reduction in the level of transferred debt of £4.7m (see table at paragraph 5.2), the level of net external borrowing increased by £36.0m as the following table shows:

3 External borrowing

3.1 At its meeting in February 2005 the County Council set authorised and operational prudential limits on total external debt of £550m and £400m respectively. By June 2005 it had become apparent that the operational limit had become insufficient to accommodate the Council's borrowing requirements, and the limit was increased to £450m accordingly. This arose partly from the level of surplus Pension Fund and Police Authority cash lent temporarily to the County Council and partly from the favourable opportunities for long term borrowing. External borrowing stayed within these limits throughout the year.

Long-term borrowing

3.2 The Cabinet approved a treasury management strategy for 2005/06 in February 2005. At that time, base rates had been on a rising trend and stood at 4.75%. Market commentators were expecting base rates to peak at 5% during the first half of 2005, after which a re-emergence of a downward trend was possible. 4.75% turned out to be the peak, and there has since been only one small reduction in base rates to 4.5% in August 2005. They have remained stable ever since.

3.3 Longer-term rates had been on a downward trend in the six months prior to February 2005 and stood then at levels between 4.5% and 4.65%. The yield curve was very flat, and forecasters were expecting long rates to remain relatively stable to March 2006. However, the downward trend in long yields, continued, particularly in the second half of the financial year. By January 2006 rates on 30-year loans fell briefly as low as 3.85%. This was a reflection of a high demand for long-dated bonds, as pension funds moved away from equities into bonds to reduce their risk profiles.

3.4 The Cabinet agreed the following strategy in February 2005:

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

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

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

3.5 The Cabinet agreed a guideline figure for long-term borrowing in 2005/06 of £24m to maintain the balance between fixed and variable-rate debt. However, long-term rates were below the agreed borrowing trigger rate of 5% for virtually the whole year, and fell in the second half of the year to unexpectedly low levels. Hence, in practice, long-term loans totalling £32m were taken from the Public Works Loan Board (PWLB) in line with the agreed strategy. This meant that the £24m guideline was exceeded, but full advantage was taken of historically low levels of long-term interest rates. All the loans taken were for periods of 26 years or more. The new loans taken are listed below:

3.6 The average rate payable on the long-term fixed-rate portfolio fell during the year from 6.2% to 5.9%. The current PWLB rate for over 20 years is 4.5%.

Lender's option/borrower's option loans

3.7 Lender's option/borrower's option loans (LOBOs) have become increasingly attractive, with rates matching or sometimes below PWLB rates.

3.8 A typical LOBO means taking a loan for a primary period at a relatively beneficial interest rate fixed for that period, followed by a higher rate for the remaining period which can be changed by the lender every six months. The Council, as 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.

3.9 As stated in previous reports, the main advantages of LOBOs are as follows:

· Very cheap initial rates can be obtained (sometimes 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 every six months - at which point the Council can repay.

3.10 There are also disadvantages, which are:

· There is a lack of certainty - the lender can change the rate every six months at 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 normally taken from the PWLB.

3.11 LOBOs do not provide the guaranteed long-term interest rate stability provided by the PWLB's fixed-rate loans, but they are an attractive option when they offer very low interest rates for the primary period, and competitive rates thereafter. `One rate only' loans have also become available at increasingly attractive rates, where the initial rate is the same as the indicative secondary rates applying after the first option date. The Cabinet agreed in February 2005 that a limit should be placed on total LOBOs outstanding at 15% of the County Council's capital financing requirement. They would normally only be taken on two 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.

3.12 In 2005/06, it was possible to comply with these conditions, even though four `one rate only loans' were taken, totalling £20m as follows:

Temporary borrowing

3.13 Temporary external debt consists mainly of borrowing from the Pension Fund and Hampshire Police Authority. Borrowing from these two sources reached peaks of £73.9m and £37.0m respectively. Interest to the Pension Fund and Police Authority was paid based on the monthly average seven-day notice rate, which over the year averaged 4.56%.

4 External lending

4.1 Surplus cash balances were lent out during the year to borrowers on the Council's approved list. The list is kept under continuous review to avoid the possibility of any capital loss. In 2005/06 it included the major clearing banks, six top building societies, two highly rated European banks, and also three money market funds (MMFs), which were made available to local authorities from April 2002. MMFs are large pooled funds (most are over £1bn) that are able to invest in a whole range of money market instruments with maturities up to 13 months. Investors benefit when higher rates are available on longer-term deposits, but suffer no loss of liquidity. Funds can also be lent to other local authorities.

4.2 The weighted average rate achieved on funds lent out temporarily was 4.67%.

5 CLP debt outstanding

5.1 CLP debt outstanding represents the total indebtedness of the County Council on the acquisition, creation and capitalised maintenance of fixed assets not yet charged to the annual revenue accounts.

5.2 The following table sets out the balance of total indebtedness between long and short-term external borrowing and internal resources both at 1 April 2005 and 31 March 2006: