Appendix 5

Treasury management activities 2006/07

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 2006/07 and in particular sets out:

· The Council's external borrowing requirement in 2007/08

· The economic background

· Types of borrowing used

· A comparison of the composition of the Capital Financing Requirement at 31 March 2007 with that for the previous year.

2 External borrowing requirement in 2006/07

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

· The level of borrowing required to finance capital expenditure

· Less the availability of internal balances.

2.2 The level of borrowing required for capital expenditure amounted to £61.9m in 2006/07 which was determined as follows:

2.3 As a result, bringing into account an increase in internal funds of £19.5m and a reduction in the level of transferred debt of £2.1m (see table at paragraph 5.2), the level of net external borrowing increased by £14.4m as the following table shows:

3 External borrowing

3.1 At its meeting in February 2006 the County Council set authorised and operational prudential limits on total external debt of £580m and £490m respectively. External borrowing stayed within these limits throughout the year, reaching a maximum level of £485m in January 2007.

Long-term borrowing

3.2 The Cabinet approved a treasury management strategy for 2006/07 in February 2006. At that time, base rates had been very stable at 4.5% since August 2005. Market commentators were split on prospects for base rates for the remainder of 2006 and into 2007. The majority were expecting further reductions, possibly to levels around 4% by March 2007, but there was no clear consensus, with some voicing fears over inflation and possible rises to around 5%. The latter view turned out to be correct. There were three 0.25% base rate rises during 2006/07 as fears about overheating in the UK economy increased. By March 2007 they stood at 5.25%, and there has been one further rise since to 5.5% in May.

3.3 Longer-term rates had continued on a consistent downward trend in the six months to February 2006. Public Works Loan Board (PWLB) rates stood then at 4.35% for shorter maturities and extremely low at 3.85% for loans maturing in 30 years. This was a reflection of a high demand for long-dated bonds, as pension funds continued to move away from equities into bonds to reduce their risk profiles. The yield curve had remained relatively flat, suggesting that the markets expected any movements in long-term rates to be very small for the foreseeable future. PWLB rates stayed below the agreed borrowing trigger rate of 4.5% until the end of 2006, although rates chargeable on the shorter maturities did rise reflecting the rises in base and other short-term rates. However, at the start of 2007, rates on the longer maturities also started to rise, and moved above the 4.5% trigger. Rates on 30-year PWLB loans stood at 4.65% at 31 March 2007.

3.4 The Cabinet agreed the following strategy in February 2006:

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

· Long-term fixed-rate borrowing to be considered if long-term rates stand at 4.5% 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 2006/07 of £22m to maintain the balance between fixed and variable-rate debt. In practice only £10m was taken, reflecting the fact that rates rose unexpectedly above the trigger in early 2007. It should also be borne in mind that in the previous year the long-term borrowing guideline figure of £24m was exceeded by £8m, so over the two years long-term fixed-rate borrowing has been close to target. 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 5.9% to just under 5.8%. The current PWLB rate for over 25-30 years is 4.85%.

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 Many LOBOs will enable borrowers to take 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. There are also `one-rate-only' LOBOs, where the rate offered during the primary period matches that for the remaining period.

3.9 The main advantages of LOBOs are as follows:

· Very cheap initial rates can be obtained (sometimes below 1%) on many LOBOs, 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 has the option to change the rate at the end of the primary period, normally every six months or year - 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 are now 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 2006 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 2006/07, it was possible to comply with these conditions, and two `one rate only loans' were taken, totalling £8m 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 £116.3m and £39.1m 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 4.85%.

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 2006/07 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 4.86%.

5 Consolidated Loans Pool ( 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 2006 and 31 March 2007: