Appendix 11

Treasury Management and Annual Investment Strategies for 2007/08

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 2010 (including debt managed on behalf of the Police Authority, Portsmouth and Southampton City Councils and the Learning and Skills Council):

2.2 The table shows that over the three-year period to March 2010 an increase in the capital financing requirement of £24.3m from £580.7m to £605.0m is forecast based on the current and proposed capital programme, though reaching a peak of £622.9m at 31 March 2009 due to the profile of temporary unsupported borrowing.

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 2007, some 58.5% of the capital financing requirement will be held at variable interest rates. If further long-term borrowing were not to take place by March 2010, this proportion would increase to around 62.8%. To maintain the target variable/fixed rate ratio of 55%/45%, just under £50m would need to be borrowed long-term at fixed rates between now and March 2010, implying a target of around £16m a year. In view of the projected peak in the capital financing requirement at the end of 2008/09, it is proposed that the option of taking all or most of the additional long-term borrowing in the next two years should be considered if conditions are appropriate.

3 Interest rate trends

3.1 At the time of last year's report, base rates stood at 4.5%, and had been on a slow but falling trend. There were differing opinions about the likely course of base rates to March 2007. The majority of market commentators then were expecting further reductions, possibly to levels as low as 4% by March 2007.

3.2 These forecasts proved incorrect, as concerns grew that inflationary pressures in the UK economy have been mounting. There have been three 0.25% increases since then in base rates in August and November 2006 and January 2007, and they now stand at 5.25%. Commentators currently suggest that base rates may reach their peak at 5.5% in the spring of this year, although, with 12-month money market rates standing at over 5.7%, general market sentiment seems rather more cautious. However, it could change rapidly.

3.3 Last year long-term rates were expected to remain relatively stable. The yield curve then was very flat, implying relative stability over the foreseeable future.

3.4 In practice, long-term rates have been on a very slow upward trend over the past year, particularly for loans with shorter maturities, and Public Works Loan Board (PWLB) rates now stand at over 5% for the shorter maturities, but still relatively low at 4.65% for 25-30 year maturities.

3.5 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 4.5% 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.

3.6 Since February 2006, a further five long-term fixed-rate loans from the PWLB have been taken totalling £10m at rates ranging between 4.2% and 4.4%, averaging 4.27%. 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 five 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 (normally between one and three years), sometimes, but not always, at a relatively beneficial interest rate fixed for the whole of that primary period, followed by a higher rate for the remaining period which can be changed by the lender every six months. `Single-rate only' LOBOs are also available, where the rate over the primary period is the same as that for the remaining period. 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 advantages of LOBOs include:

· 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 borrowing using LOBOs should be considered when their primary and indicative rates for their remaining periods are no higher than the trigger rate used for fixed-rate long-term borrowing.

4.7 The LOBO market has matured significantly over the last five 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 £24m of LOBOs to be taken in 2007/08, or, over the longer term, £27m to be taken by March 2010, implying an annual target of £9m, based on the current forecast of the Council's capital financing requirement.

4.8 £28m worth of `single rate only' LOBOs have been taken in line with this strategy since it was first agreed two years ago, 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 2008.

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 3.5 should be left unchanged.

6 Draft Local Authorities (Capital Finance and Accounting) (England) Regulations 2007

6.1 Local authorities can opt to repay a loan from the PWLB prematurely, on condition that they pay a premium or discount to reflect the difference between the interest rate payable on the repaid loan, and the rate the PWLB would charge on a replacement loan. For example, there is a loan in the County Council's portfolio of £7m taken in 1989 at 9.25% that does not mature until March 2016. A decision to repay this loan prematurely now would mean incurring a premium in excess of £3m.

6.2 Standard accounting practice stipulates that such a premium would have to be charged to the County Council's revenue account when paid, which would mean that budgetary constraints would rule it out as an option.

6.3 These draft regulations were published in November and are expected to take effect by 31 March 2007. As drafted the regulations would enable English local authorities to repay PWLB loans prematurely, and amortise the premiums over the longer of the outstanding period of the loans repaid or the lives of any replacement loans, for council tax setting purposes.

6.4 Calculations by the County Treasurer on a selection of eight PWLB loans taken at relatively high interest rates in the 1980s show that, if they were replaced by loans with later maturity dates, savings in the budget requirement in excess of £800,000 per year could be generated.

6.5 The main disadvantage of such a strategy is that it would increase the average period to maturity of the Council's fixed-rate long-term debt portfolio, in effect reducing the council's long-term ability to take advantage of low or falling short and long-term interest rates. A balance would therefore need to be drawn between the need to generate savings over the short term and the need to preserve flexibility in managing the Council's debt portfolio over the long term.

6.6 Nonetheless, it is suggested that the County Treasurer be given the authority to undertake such a strategy, paying due regard to the need to maintain the Council's ability to continue to take full advantage of falling interest rates by avoiding a heavily skewed maturity profile.

7 Investment of surplus funds - Annual Investment Strategy

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

7.2 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 2007/08. These categories of investment are defined in the Government's guidance as offering both high security and liquidity.

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

· fixed-term deposits for periods of up to 364 days 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.

7.4 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.

7.5 The Council's lending list includes the major clearing banks, six UK building societies, two highly-rated European banks, the Government's Debt Management Office, and all UK local authorities.

7.6 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.

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

7.8 An overall review of the lending list, including the money market funds, and the investment limits is undertaken annually.

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

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

7.11 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.

8 Treasury management budget for 2007/08

8.1 The following table summarises the interest budget to finance the Council's capital financing requirement in 2007/08:

8.2 £2.4m of the total interest payable to finance the capital financing requirement is chargeable to other bodies for transferred services, for example the Learning and Skills Council, Southampton and Portsmouth City Councils, the Police Authority and the Probation Board, leaving £29.4m payable by the County Council.

Recommendations

1 That the following strategy be approved for 2007/08:

· 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 £16m and £9m be set for 2007/08 to 2009/10 for long-term fixed-rate borrowing and LOBOs respectively, which can be exceeded if circumstances are appropriate, particularly in view of the projected peak in the capital financing requirement at 31 March 2009.

4 That, on condition that the draft Local Authorities (Capital Finance and Accounting) (England) Regulations 2007 are implemented, the County Treasurer be given authority to repay PWLB loans held at high coupon rates prematurely, replace with longer term loans at lower rates, and amortise over the outstanding periods of those replacement loans.

5 That it be a recommendation to the County Council that the Annual Investment Strategy set out in section 7 of this report be approved.

Annex 1

1 PWLB fixed-rate debt as at 31 March 2007 by interest rate

Interest rate	Principal outstanding
%	£m
3 - 3.99	4.0
4 - 4.99	152.0
5 - 5.99	14.0
6 - 6.99	8.0
7 - 7.99	14.0
8 - 8.99	5.0
9 - 9.99	44.0
Total	241.0

2 PWLB debt by year of maturity

Year	Interest rates (range)	Principal repayable
	%	£m
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	4.25 - 4.85	10.0
2033/34	4.2 - 4.75	10.0
2034/35	4.35 - 4.75	6.0
2035/36	3.85 - 4.65	14.0
2036/37	4.1 - 4.4	8.0
Total		241.0