Appendix 8

Treasury Management and Investment Strategies, Prudential and Financial Health Indicators

1 Summary

1.1 This Appendix:-

· outlines a proposed strategy for the management of the Council's debt portfolio;

· sets an Annual Investment Strategy for the investment of the Council's surplus funds; and

· in accordance with the Chartered Institute of Public Finance and Accountancy (CIPFA) Prudential Code, sets the Council's prudential indicators for next year and beyond which relate to borrowing and other aspects of treasury management, together with a number of other financial health indicators.

1.2 This Appendix recommends that:

· the borrowing strategy for 2008/09 be approved;

· lender's option/borrower's option loans (LOBOs) will be considered as an alternative and supplementary form of borrowing in order to generate short-term savings in interest costs;

· guideline annual targets of up to £14m and £7m be set for 2008/09 to 2010/11 for new long-term fixed-rate borrowing and variable-rate LOBOs respectively, which can be exceeded if circumstances are appropriate;

· the County Treasurer is given delegated authority to repay Public Works Loan Board (PWLB) loans held at high coupon rates prematurely, replace with longer term loans at lower rates and amortise the early termination penalties over the outstanding periods of those replacement loans;

· it be a recommendation to the County Council that the Annual Investment Strategy be approved; and

· the Cabinet approve the prudential and financial health indicators for submission to the County Council.

2 Planned capital expenditure and capital financing requirement 2008/09 to 2010/11

2.1 Table 1 sets out actual capital expenditure incurred in 2006/07 and estimated capital expenditure in the current and future years to 2010/11, based on the capital programme submitted to the Cabinet for approval. The table also identifies the extent to which capital expenditure is planned to be financed from supported and unsupported borrowing.

Table 1: Capital Expenditure and Resources

2.2 Based on the capital expenditure plans set out in Table 1, the capital financing requirement is forecast to increase from £587.5m at 1 April 2008 to £627.0m at 31 March 2011, as set out in Table 2 below.

2.3 The capital financing requirement represents capital expenditure which has not been financed from capital receipts, the revenue budget, capital grants or external contributions. This can be financed either from external borrowing or by borrowing from internal balances.

2.4 Provision for the repayment of debt is charged to the revenue account based on a minimum revenue provision, in most cases based on 4% of the capital financing requirement. Communities and Local Government (CLG) has consulted on draft changes to the regulations governing the minimum revenue provision. The new regulation is likely to be based on a general requirement to make prudent provision and would be supported by more detailed guidance from the Secretary of State. One of the proposals in the draft guidance was that local authorities should prepare before the start of each financial year a statement on its policy for making minimum revenue provision, for approval by the full authority. The regulations and accompanying guidance are not expected to be finalised until March 2008 and, once they are enacted, a policy statement will be submitted to the County Council. It is not anticipated that implementation of the new regulations will have a material impact on the County Council's capital financing costs.

Table 2: Capital financing requirement

2.5 Table 3 analyses the capital financing requirement between borrowing supported by the Government through the formula grant system and unsupported borrowing. In normal circumstances, the focus of the County Council's consideration of the affordability of borrowing for capital purposes would be focussed on the level of unsupported borrowing, as increases in the cost of supported borrowing from additional Government borrowing allocations would be matched by additional formula grant. However, this is not currently the case as the County Council's grant is determined by the criteria for setting a `grant floor' rather than the formula itself.

2.6 The County Council's current policy on the take up of supported borrowing in setting the base budget is to limit the increase in the capital financing requirement relating to supported borrowing to 2.5% per annum, with any additional take up of supported borrowing being subject to a review of priorities within the overall budget strategy.

Table 3: Capital financing requirement between supported and unsupported borrowing

2.7 Table 4 analyses the unsupported element of the capital financing requirement between projects.

Table 4: Analysis of the unsupported element of the capital financing requirement between projects

2.8 Transitional costs from the 1997 Local Government reorganisation of £4.2m were funded from Government approvals which were issued on an unsupported basis so that whilst the financing costs were not supported by Government grant, local authorities were able to defer the impact on the revenue budget. Full provision for the repayment of this borrowing will have been made by March 2008.

2.9 The proposals for unsupported borrowing in 2008/09 and subsequent years are the result of the application of the County Council's policy on the use of unsupported borrowing under the Prudential Code. Projects fall within four categories contained in the policy:-

· borrowing over a period of up to 10 years on an `invest to save' basis where the project is expected to generate cash savings, increased income or the avoidance of otherwise unavoidable costs, which will enable the service's revenue cash limit to be reduced in order to accommodate the financing costs within the budget. Unsupported borrowing for the Nursing Care project, Calshot Activities Centre and to provide funding for the set up costs of Hantsdirect has been approved in accordance with this policy;

· unsupported borrowing to fund additional spending on highways structural maintenance, which is to be met from savings elsewhere within the Environment Department's locally resourced capital programme;

· temporary unsupported borrowing pending the availability of capital receipts, grants or contributions, which will enable the borrowing to be repaid, including any interest costs not met from within the service revenue budget. Unsupported borrowing for a number of school projects in advance of capital receipts or developer contributions and the Ashburton Court refurbishment have been agreed or are proposed in the 2008/09 to 2010/11 capital programme in accordance with this policy. The timing of capital receipts associated with the Andover Children's Centre and Winchester Discovery Centre project is also likely to require the use of temporary unsupported borrowing. Since 2006/07 the County Council's policy requires service budgets to cover interest costs and minimum revenue provision from the revenue budget rather than rolling it up to be financed from the eventual capital receipt;

· use of unsupported borrowing to finance business unit capital expenditure where the financing costs will be recovered in charges made to users and met from their existing budgets. IT Services' use of unsupported borrowing was approved in accordance with this policy.

2.10 In addition to the use of temporary unsupported borrowing to fund specific projects, as a result primarily of slippage in the general programme of capital receipts or other external sources of funding, some additional temporary unsupported borrowing is also forecast to be required during 2009/10 and 2010/11.

3 Further long-term borrowing

3.1 Table 2 shows that over the three-year period to March 2011, an increase in the capital financing requirement of £39.5m from £587.5m to £627.0m is forecast based on the current and proposed capital programme.

3.2 A balance needs to be drawn in the debt portfolio between long-term debt at fixed interest rates from the 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.

3.3 If no further fixed-rate long-term borrowing takes place between now and the end of March 2008, some 57.3% of the capital financing requirement will be held at variable interest rates. If no further long-term borrowing were to take place by March 2011, this proportion would increase to around 61.9%. To maintain the target variable/fixed rate ratio of 55%/45%, just over £43m would need to be borrowed long-term at fixed rates between now and March 2011, implying a target of around £14m a year.

4 Interest rate trends

4.1 After a series of 0.25% increases commencing on 3 August 2006, the base rate reached a peak of 5.75% on 5 July 2007 before seeing its first cut in more than two years when it was reduced to 5.5% on 6 December 2007. The consensus market view is for further reductions, with an average forecasted base rate of 5% by December 2008. The Monetary Policy Committee (MPC) Inflation Report for November 2007 indicated that rates might have to fall to 5%.

4.2 Whilst the latest figures released in January 2008 showed that Consumer Price Index (CPI) inflation at 2.1% has remained above the Bank of England's target for the third month in a row, predictions of weak growth in the UK economy for both 2008 and 2009 have led certain market commentators to suggest that interest rates could eventually fall as low as 4%.

4.3 However, a 12-month money market rate of around 5.2% at the end of January 2008 indicated that the general market sentiment seemed to be rather more cautious.

4.4 If there are any base rate movements over the next year, these would therefore seem to be more likely to be down than up.

4.5 However, lingering inflation concerns could limit the scope and pace of further rate cuts. In particular, energy prices are likely to push the CPI rate significantly higher to around 3% over the coming months as more gas and electricity suppliers respond to recent sharp rises in wholesale prices.

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

5.1 Over recent years, the commercial money market has endeavoured to offer loan products to local authorities which are competitive with those available from the PWLB. Since June 2002, lender's option/borrower's option loans (LOBOs) have been of particular interest as an alternative form of borrowing in order to generate short-term savings in interest costs.

5.2 A standard LOBO means taking out a long-term loan for an initial primary period (normally between one and three years) at a preferential fixed interest rate, followed by a higher rate for the remaining period of the loan. `Single-rate only' LOBOs are also available, where the rate over the primary period is the same as that for the remaining period. In both instances, the lender can choose to increase the rate at the end of the primary period and every six months or annually thereafter. If the lender increases the rate, the Council as a borrower can choose to repay the loan.

5.3 LOBO loans can generate short-term savings in borrowing costs over the initial primary periods. However, such loans will track any upward movement in long-term interest rates and may therefore equate to higher future long-term borrowing costs. Unlike long-term fixed rate PWLB loans, LOBOs cannot provide guaranteed long-term interest rate stability. Whilst the Council has a choice over repaying the LOBO loan when the lender opts to increase the relevant interest rate, it will ultimately need to re-finance this by taking out a replacement loan at prevailing borrowing rates.

5.4 In 2006/07, it was agreed to set a 15% limit on the proportion of the Council's capital financing requirement to be financed from LOBOs. This would form part of the variable rate target of 55% (see paragraph 3.3). This would provide headroom for a target of £15m of LOBOs to be taken in 2008/09, or, over the longer term, £21m to be taken by March 2011, implying an annual target of £7m, based on the current forecast of the Council's capital financing requirement.

5.5 For information, the Council currently has a total of £73m LOBOs at interest rates ranging between 3.5% and 5.0% and an average overall rate of 4.41%. Of this total, £21m has been taken out since April 2007 at fixed initial rates ranging between 3.89% and 4.77%, averaging 4.30%.

6 Fixed-rate borrowing strategy

6.1 Based on PWLB loans maturing between 30-35 years, long-term borrowing rates initially rose from 4.4% in early January 2007 and peaked at just above 5.0% in June 2007 before gradually returning back to their previous rate of 4.4% in early January 2008.

6.2 In line with the Council's established policy of taking loans in small tranches, a total of 14 new long-term fixed-rate £2m loans have been taken out from the PWLB since April 2007. Of this £28m total, £10m relates to a debt restructuring exercise the details of which are covered in section 7. The fixed rates ranged between 4.39% and 5.0%, averaging 4.67%.

6.3 It is envisaged that longer-term interest rates will remain on a stable path over the next year at around 4.5%, although the most recent downward trend could indicate the possibility of marginally lower rates becoming available during 2008.

6.4 Subject to the close monitoring of interest rates, the strategy will be to take out new long-term fixed-rate borrowing of up to £15m in 2008/09 at rates of 4.5% or less, although such borrowing may be considered at rates higher than this if clear signs of a rising trend in rates occur. Additionally, this £15m limit can be exceeded if circumstances are appropriate.

7 Debt restructuring

7.1 Local authorities may choose to repay loans earlier than required by the original agreement. In those circumstances, they may be liable either to pay a premium or to receive a discount. A premium is an extra payment required on top of the principal repayment. A discount is a reduction in the principal repayment. Whether a premium or discount applies, and its amount, depends upon the relationship between current interest rates at the time of repayment and the interest being charged on the loan.

7.2 Whilst premiums have to be charged to the revenue account, local authorities are allowed to spread these charges over either the outstanding period of the loan repaid or (where applicable) the outstanding period of any replacement loan, whichever is the greater.

7.3 Discounts should be treated in a broadly similar way to premiums and credited to the revenue account over either the unexpired term of the repaid loan or 10 years, whichever is the lesser.

7.4 The Council's ability to restructure its debt by repaying loans taken out at relatively high interest rates, replacing these with later maturity dates at significantly lower interest rates and spreading the premiums over this extended maturity term can achieve savings in the annual budget requirement for Council Tax setting purposes in the short term.

7.5 However, such debt restructuring increases the annual budget requirement for Council Tax setting purposes in the longer term to the extent of the amortised premiums being incurred beyond the original outstanding periods of the loans being repaid.

7.6 Such a strategy also increases the average maturity profile of the Council's outstanding debt portfolio, which would impact on its longer term ability to take advantage of low or falling short and long-term interest rates.

7.7 In 2007/08, the Council prematurely repaid a £10m PWLB loan at 9.875% which was originally due for repayment in 2018, incurring a premium of £3.9m. Replacement loans of £10m in total were taken out at an average interest rate of 4.74% maturing between 2035 and 2037. This was done in order to achieve savings in the annual budget requirement for Council Tax setting purposes in the short term.

7.8 From 1 November 2007, the PWLB introduced a separate set of rates applicable to early repayments. Hitherto, the same set of rates had applied to loan advances and to calculating the premium or discount due on an early repayment. The rates used to calculate the premium/discount due on the early repayment of a loan are now lower than those applying to advances. This has had the effect of increasing the premiums payable in respect of the early repayment of loans.

7.9 Nevertheless, it is proposed that the County Treasurer be given the authority to continue to apply such a debt restructuring strategy where there would seem to be financial advantage in doing so, whilst 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.

8 Treasury management budget for 2008/09 to 2010/11

8.1 Table 5 summarises the interest budget to finance the Council's capital financing requirement for 2008/09 to 2010/11, inclusive of interest recovered from other external bodies in respect of transferred debt.

Table 5: Interest budgets for 2008/09 to 2010/11

9 Prudential indicators for affordability

9.1 The Prudential Code prescribes two indicators of the affordability of borrowing for capital purposes.

Ratio of financing costs to net revenue stream

9.2 The ratio of financing costs to the net revenue stream shows the estimated annual revenue costs of borrowing (interest payable on debt plus the minimum revenue provision for repaying the principal less interest on balances) as a percentage of the amount in the draft revenue budget to be met from central government grants and local taxpayers. Actual figures for 2006/07 and estimates for 2007/08 to 2010/11 are set out in the Table 6 below. It excludes past capital expenditure being financed by external bodies following the transfer of services away from the County Council. The relative stability of the ratio reflects the County Council's decision under the current grant floor arrangements not to take up supported borrowing in full.

Table 6: Ratio of financing costs to net revenue stream

Estimated incremental impact on council tax of draft capital programme

9.3 Table 7 sets out estimates of the incremental impact on the Band D council tax which will result if the Cabinet approves the new draft capital programme.

Table 7: Incremental impact on council tax

9.4 This indicator has been calculated as if the impact of financing new capital investment by borrowing falls entirely on the council tax. However, in practice the cost of financing additional Government supported borrowing is normally matched by additional revenue support grant, although this does not currently apply to authorities such as Hampshire who are well below the grant floor. The new unsupported borrowing proposed will be matched by an equivalent reduction in current expenditure within the relevant service or will be covered from future capital receipts, grants or contributions.

10 Prudential indicators for external debt

Medium term borrowing not to exceed capital financing requirement

10.1 The Prudential Code requires that, as a key indicator of prudence, net borrowing over the medium term should not exceed the total of the capital financing requirement in the preceding year plus the estimates of any additional capital financing requirement for the current and next two years. The County Treasurer will ensure that this limit is not breached.

Actual external debt

10.2 Actual external debt at 31 March 2007 was £393.4m.

Authorised limits for external debt

10.3 The Code also requires authorities to set authorised limits for external debt, defined as the sum of external borrowing and other long-term liabilities. It is recommended that the following limits be approved for the period 2008/09 to 2010/11.

10.4 These recommended limits are based on the estimated capital financing requirements (as per Table 3) in order to enable these to be financed entirely from external borrowing should the Council's internal reserves become depleted. The limits also include an allowance for temporary borrowing to cover normal revenue cash flow requirements and unexpected outflows or delays in receiving cash. The 2008/09 limit is also the statutory limit for the purposes of Section 3(1) of the Local Government Act 2003. It should be borne in mind that the limits for 2009/10 and 2010/11 are indicative only and can be revised next year if necessary.

Operational boundaries for external debt

10.5 The Cabinet also needs to approve operational boundaries for external debt over the same periods. These should reflect the most likely scenario and be consistent with the Council's capital plans and treasury management strategy. Temporary breaches of the 2008/09 operational boundary can take place for cashflow reasons, but any sustained breach will lead to further investigation. The Cabinet is asked to recommend the following operational boundaries for 2008/09, 2009/10 and 2010/11.

10.6 The operational boundary for 2008/09 allows for new external borrowing of £21m, based on the guideline figures for new external long-term borrowing as outlined in paragraphs 3.3 and 5.4. The indicative boundaries for 2009/10 and 2010/11 reflect the changes in the predicted capital financing requirement in those two years.

11 Prudential indicators for Treasury Management

Adoption of the CIPFA Code of Practice for Treasury Management in the Public Services

11.1 The Prudential Code requires local authorities to have adopted the CIPFA Code of Practice for Treasury Management in the Public Services. This was agreed by the Cabinet in February 2003 and has been incorporated in the County Council's financial regulations.

Upper limits on fixed interest rate exposure

11.2 The Council also has to set an upper limit on its fixed interest exposure. The table below sets out limits recommended for approval. They are expressed in terms of the maximum long-term fixed-rate principal sums which can be outstanding on any day in each year. The limits suggested for 2009/10 and 2010/11 are indicative only and subject to revision next year.

11.3 Long-term fixed-rate debt outstanding is currently £253m, although is scheduled to reduce to £251m by 31 March 2008. This appendix recommends an annual maximum guideline target for new long-term fixed-rate borrowing of £14m over three years. However, the above limits make allowance for fixed-rate borrowing of up to a further £30m in each of the next three years, as it might be prudent to borrow up to these levels if rates are particularly advantageous or show signs of a prolonged upward trend.

Upper limits on variable interest rate exposure

11.4 The Council also has to set limits on its variable interest rate exposure. The limits recommended for approval are shown in the table below. They are calculated simply as the difference between the recommended authorised borrowing limits and the fixed-rate borrowing outstanding at the end of each year if no further such borrowing is undertaken.

11.5 These recommended limits provide full flexibility for the prudent management of the Council's debt portfolio and mean that there will be no need for enforced fixed-rate borrowing at high interest rates as long as total external borrowing remains within the authorised limits.

Upper and lower percentage limits on the maturity structure of long-term fixed-rate borrowing outstanding in 2008/09

11.6 The Code also requires the Council to set upper and lower percentage limits on the maturity structure of its long-term fixed-rate borrowing during 2008/09. The following table shows recommended limits. These have been set in order to allow maximum flexibility in managing the debt portfolio and are consistent with the existing portfolio and the treasury management strategy as outlined earlier.

Upper limits on investments with maturities longer than one year

11.7 The Council has not made any investments for periods longer than one year and has no plans to do so. Therefore, an upper limit of nil on such investments is recommended for 2008/09 and the following two years.

12 Financial Health indicators

12.1 Annex 3 contains a summary of the prudential indicators and a series of additional financial health indicators relating to budget and capital programme management and income collection. These are monitored quarterly as one element of the County Council's budget monitoring.

13 Investment of surplus funds

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

13.2 When investing its surplus funds, the Council's investment priority is to continue to maintain the security of capital and maintain policy flexibility through liquidity of its investments. The Council will aim to achieve the optimum return on its investments commensurate with the proper levels of security and liquidity.

13.3 Accordingly, only `specified investments' will be used in 2008/09. These categories of investment are defined in the Government's guidance as offering both high security and liquidity.

13.4 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 both the Bank of Scotland (rated AA2) and NatWest Bank (rated AAA); and

· call / 7-day notice deposits with three managed AAA-rated money market funds included on the Council's lending list.

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

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

13.7 The lending list is reviewed quarterly 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.

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

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

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

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

13.12 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 CIPFA.

Annex 1

PWLB fixed-rate debt as at 31 March 2008 by interest rate

Interest rate	Principal outstanding
%	£m
3 - 3.99	2
4 - 4.99	174
5 - 5.99	16
6 - 6.99	6
7 - 7.99	14
8 - 8.99	5
9 - 9.99	34
Total	251

PWLB fixed-rate debt by year of maturity

Year	Interest rates (range)	Principal repayable
	%	£m
2008/09	4.2 - 9.25	4
2009/10	7.875	4
2010/11	4.35 - 4.625	4
2011/12	8.5	5
2012/13	4.2 - 6	4
2013/14	4.25 - 4.625	6
2014/15	9.375	10
2015/16	9.125 - 9.25	7
2016/17	4.4 - 9.875	8
2017/18	9.375 - 9.875	9
2019/20	4.625 - 4.875	6
2020/21	4.45 - 4.875	8
2021/22	4.5 - 7.375	8
2022/23	4.5 - 7.5	8
2023/24	4.625 - 7.25	8
2024/25	4.5 - 7.25	10
Year	Interest rates (range)	Principal repayable
	%	£m
2025/26	4.5 - 7.125	9
2026/27	4.4 - 6.25	10
2027/28	5 - 5.875	8
2028/29	4.5 - 4.875	8
2029/30	4.5 - 4.95	9
2030/31	4.25 - 4.5	8
2031/32	4.25 - 4.95	14
2032/33	4.25 - 4.85	10
2033/34	4.2 - 4.75	10
2034/35	4.35 - 4.75	6
2035/36	3.85 - 4.85	22
2036/37	4.1 - 4.7	10
2037/38	4.75 - 5	6
2038/39	4.7	2
2039/40	4.6	2
2041/42	4.43 - 4.48	4
2042/43	4.39 - 4.51	4
Total		251

Annex 2

LOBO debt as at 31 March 2008 by interest rate

Interest rate	Principal outstanding
%	£m
3 - 3.99	20
4 - 4.99	49
5 - 5.99	4
Total	73

LOBO debt by year of maturity

Year	Interest rates (range)	Principal repayable
	%	£m
2027/28	4.99	4
2028/29	4.80	4
2030/31	5.00	4
2034/35	4.75 - 4.95	8
2036/37	3.89 - 3.95	8
2037/38	4.42 - 4.45	9
2040/41	4.77 - 4.85	8
2042/43	3.89 - 3.94	8
2043/44	4.50	4
2045/46	3.50 - 4.25	10
2055/56	4.25	6
Total		73