Annual Report on the Treasury Management Service



HERTFORDSHIRE COUNTY COUNCIL

AUDIT COMMITTEE

WEDNESDAY 25 JUNE 2008 AT 10.00AM

|Agenda Item No:

9 | |

ANNUAL REPORT ON THE TREASURY MANAGEMENT SERVICE AND PRUDENTIAL INDICATORS 2007/08

Report of the Director of Finance, Information & Commercial Services

Executive Member: David Lloyd

Authors of the report: James Morgan (Tel: 01992 555334) and Nicola Webb (Tel: 01992 555394)

1. Purpose of Report

The Annual Treasury Report is a requirement of the CIPFA Prudential Code and covers the treasury activity for 2007/08, and reviews the prudential indicators specified in the County Council report of 27th February 2007, in accordance with the requirements of the Prudential Code.

2. Summary

The County Council has complied with all statutory and regulatory requirements for Treasury Management during the year and the guidance of CIPFA’s Code of Practice for Treasury Management was applied to the Treasury service.

The level of long term borrowing increased during the year from £345.3m to £377.2m. The average interest rate of the portfolio reduced to 4.59% to 4.58%.

£19.1m of interest was earned during 2007/08 at a rate of 5.92% - 0.34% over the key benchmark – the 7 day LIBID rate.

The County Council’s capital financing and borrowing positions complied with the Prudential Code indicators set in February 2007 throughout 2007/08.

3. Conclusions

Capital Financing and Treasury Management were carried out in accordance with statutory requirements, good practice and in compliance with the major Prudential Code indicators during 2007/08. The loan and investment portfolios were actively managed to minimise cost and maximise interest earned, whilst maintaining a low level of risk.

4. Suggested Resolution

That the Annual Report on the Treasury Management Service and Prudential Indicators 2007/8 be approved.

5. Background

The CIPFA Prudential Code requires the Council to set Prudential Indicators for its capital expenditure and treasury management activities and to report on them at the end of the financial year. In addition the indicators are monitored on a quarterly basis as part of the quarterly budget monitor report to Cabinet.

This Council has adopted the CIPFA Code of Practice for Treasury Management in the Public Sector and operates its treasury management service in compliance with this Code. The Code requires as a minimum the regular reporting of treasury management activities to:

• Review actual activity for the proceeding year (this report) ; and

• Forecast the likely activity for the forthcoming year (in the Annual Treasury Strategy Report).

6. Prudential Indicators

6.1 The Council is required by the Prudential Code to report the actual prudential indicators after the year end. Appendix A provides a schedule of all the mandatory prudential indicators.

6.2 The first of these is the amount of capital expenditure in the year on long term assets. The table below shows this and the ways it has been financed.

Table 1: Capital Expenditure

| |2007/08 |2007/08 Original Indicator |

| |Actual |(£000s) |

| |(£000s) | |

|Total Capital Expenditure |186,139 |163,855 |

|Resourced by: | | |

|Capital Receipts |29,716 |27,915 |

|Capital Grants |62,552 |66,248 |

|Revenue |16,877 |28,126 |

|Other Contributions |11,086 |7,566 |

|Unfinanced Capital Expenditure | | |

|(additional need to borrow) |65,908 |34,000 |

6.3 The amount to be funded from borrowing is higher than expected partly due to needing to fund self-financing schemes before the necessary receipts come in. The most significant example is the receipt for the Wheathampsted site, which is to fund the TW3 project. This receipt is now expected later in 2008/09. The other major reason for the higher borrowing figure is the reduction in slippage between 2006/07 and 2007/08.

6.4 The Council’s underlying need to borrow is called the Capital Financing Requirement (CFR). This figure is a gauge of the Council’s debt position and represents capital expenditure up to the end of 2007/08 which has not yet been charged to revenue. The process of charging the capital expenditure to revenue is a statutory requirement and is done by means of the Minimum Revenue Provision (MRP). The Council’s CFR is shown below and is a key prudential indicator.

Table 2: Capital Financing Requirement (CFR)

| |31 March 2008 |31 March 2008 |

| |Actual |Original Indicator |

| |(£000s) |(£000s) |

|Opening Balance 1 April 07 | 390,688 | 388,972 |

|Plus unfinanced capital expenditure | 65,908 | 34,000 |

|Less MRP | 15,627 | (15,708) |

|Closing Balance 31 March 08 | 440,969 | 407,264  |

6.5 While the Council’s gauge of its underlying need to borrow is the CFR, the Finance Director can manage the Council’s actual borrowing position by either borrowing to the CFR, choosing to utilise some temporary cash flow funds instead of borrowing (under borrowing) or borrowing for future increases in the CFR (borrowing in advance of need). The County Council began 2007/08 in a slightly underborrowed position. This underborrowed position increased during 2007/08 because additional borrowing was not sufficient to cover the increase in the CFR. Further details of the borrowing transactions in 2007/08 are in section 7 below. The overall treasury position at 31 March 2008 is in the table overleaf compared with the previous year.

Table 3: Treasury Position at 31 March 2008

| |31 March 2008 |31 March 2007 |

| |Principal |Average |Principal |Average |

| |(£000s) |Rate (%) |(£000s) |Rate (%) |

|Total Debt |377,222 |4.58 |345,278 |4.59 |

|Total Investments |309,949 |5.92 |238,142 |4.87 |

| | | | | |

|Net Borrowing |67,273 | |107,136 | |

6.6 In order to ensure that borrowing levels are prudent over the medium term, the Council’s external borrowing, net of investments, must only be for a capital purpose. Net borrowing should not therefore, except in the short term, exceed the CFR for 2007/08 plus the expected changes to the CFR over 2008/09 and 2009/10. The table below shows that the Council has complied with this requirement.

Table 4: CFR compared to Net Borrowing Position

| |31 March 2008 |31 March 2008 |

| |Actual |Original Indicator |

| |(£000s) |(£000s) |

|Net borrowing position |67,273 |107,136 |

|Capital Financing Requirement |440,969 |407,264 |

6.7 In addition to ensuring that the net borrowing position is lower than the CFR, the Council is required to set gross borrowing limits. These are detailed overleaf with the actual positions during the year.

Table 5: Borrowing limits

| |2007/08 |

| |(£000s) |

|Original Indicator - Authorised Limit |447,000 |

|Maximum gross borrowing position during the year |377,222 |

|Original Indicator - Operational Boundary |414,000 |

| | |

|Average gross borrowing position during the year |357,485 |

| | |

|Financing costs as a proportion of net revenue stream |-0.45% |

6.8 The Authorised Limit is the “Affordable Borrowing Limit” required by section 3 of the Local Government Act 2003. The table above demonstrates that during 2007/08 the Council has maintained gross borrowing within its Authorised Limit.

6.9 The Operational Boundary is the expected borrowing position of the Council during the year, and periods where the actual position is either below or over the Boundary are acceptable subject to the Authorised Limit not being breached. The Council has maintained borrowing within the boundary throughout 2007/08.

6.10 The indicator “financing costs as a proportion of net revenue stream” identifies the cost of capital (borrowing costs net of investment income) as a proportion of the Council’s total budget. The actual figure in 2007/08 was -0.45% and this is lower than the original indicator estimated in February 2006 of -0.04%. The ratio returns a negative value in 2007/08 because investment income was greater than the cost of borrowing. Reasons for this are outlined in more detail in sections 7 and 8.

7. Treasury Management Strategy

7.1 During 2007/08 the Council complied with all of the relevant statutory and regulatory requirements which limit the levels of risk associated with its treasury management activities. In particular its adoption and implementation of the Code of Practice for Treasury Management means its treasury practices demonstrate a low risk approach.

7.2 The Council is aware of the risks of passive management of the treasury portfolio and has proactively managed the debt and investments over the year with the support of its treasury management advisers.

7.3 Shorter-term variable rates and likely future movements in these rates predominantly determine the Council’s investment return. These returns can therefore be volatile and, whilst the risk of loss of principal is minimised through the annual investment strategy, accurately forecasting future returns can be difficult.

7.4 The rising trend in UK interest rates continued in the first half of 2007/08. Base rate was raised to 5.5% in May and 5.75% in July in response to the deteriorating inflation outlook.

7.5 The credit crunch which hit the markets in late August led to inter bank rates rising to over 6.5% as financial organisations’ reluctance to lend money to counterparties caused a severe shortage of funds in the market. This widened the margin between official bank rate and market rates which continued through to the year end.

7.6 Fears of an economic slowdown as a result of the tightening of liquidity and the consequent rise in borrowing rates across the entire economy prompted a change in the Bank of England’s assessment of UK economic prospects over the medium term. This prompted quarter point rate cuts in December and February to end the year at 5.25%

7.7 Long term interest (PWLB) rates fluctuated throughout 2007/08 in response to economic events. Generally, the trend was upward until June with 50 year PWLB rate peaking at 4.80%. From then, rates tended to fall with 50 year PWLB ending the year at 4.43%.

8. Borrowing

8.1 At the beginning of the financial year, the total level of long term borrowing was £345.3m and the average rate of interest being paid on the portfolio was 4.59%.

8.2 At the end of the financial year, the total level of long term borrowing was £377.2m comprising £224.7m from the PWLB and £152.5m from major banks. The average interest rate being paid on the portfolio fell to 4.58%. The table below summarises the position as at the end of 2007/08:

Table 6: Debt position at 31 March 2008

| |31 March 2008 |31 March 2007 |

| |Principal |Average Rate (%) |Principal (£000s) |Average Rate (%) |

| |(£000s) | | | |

|Fixed Interest Rate Debt | | | | |

|-PWLB |224,722 |4.99 |213,778 |5.03 |

|-market |134,500 |4.03 |131,500 |3.81 |

|Variable Interest Debt | | | | |

|-PWLB |- | |- | |

|-market |18,000 |4.13 |- | |

|Total Debt |377,222 |4.58 |345,278 |4.59 |

8.3 The table overleaf provides a summary of all the borrowing transactions during 2007/08:

Table 7: 2007/08 borrowing transactions

| |New loans (£000s) |Loans repaid (£000s) |Balance (£000s) |

|Balance at 31/3/07 | | |345,278 |

|Loans matured | | (56) | |

|New borrowing |32,000 | | |

|Rescheduling |39,000 |(39,000) | |

|Balance at 31/3/08 | | |377,222 |

8.4 As shown in the above table £32m of new borrowing was undertaken in 2007/08. The Council did not borrow up to the CFR by the end of 2007/08 and so ended the year in a slightly underborrowed position. Unfinanced capital expenditure was effectively funded out of cash balances made possible by the high levels of cash balances held throughout 2007/08. New borrowing was taken when rates reached low points as shown in the table below which compares the interest rate on new borrowing with the average rate for 2007/08. The additional borrowing required for 2007/08 capital expenditure will be taken in 2008/09 if interest rates are favourable.

Table 8: New borrowing in 2007/08

|Month |Lender |Principal (£m) |Interest Rate (%) |Loan period (yrs) |Average for 2007/08|

| | | | | |(%) |

|Aug |PWLB |5 |4.45 |45 1/2 |4.60 |

|Jan |PWLB |5 |4.42 |30 |4.73 |

|Feb |PWLB |7 |4.29 |4 |5.12 |

|Mar |PWLB |5 |3.90 |3 |5.14 |

8.5 In addition to this, £21m of PWLB debt was restructured and replaced by a 70 year market loan. The net effect of the restructuring did not incur either a discount or a premium. The purpose of the restructuring was to create annual savings of £73,500 by stretching the terms of the loans and taking advantage of movements in interest rates.

8.6 In November 2007, without warning, the PWLB changed its structure of interest rates so that any repayment of PWLB debt will have a higher repayment rate applied. No more PWLB restructuring was carried out in 2007/08 due to the higher cost of PWLB repayments.

8.7 £18m of market debt was refinanced during the year. The lender exercised a right to increase the rate on the original loan from 3.8% to 4.5%. As a result, it was decided to repay the existing loan and the loan taken to replace it accrued interest at 4.13% in 2007/08.

8.8 The total interest payments during the year were £16.330m, compared to the original budget of £18.862m. The original budget assumed the prudent position that the Council would borrow up to its CFR in 2007/08. As the total borrowed in 2007/08 did not take the Council up to its CFR this led to an underspend on the interest payments budget.

9. Investments

9.1 The table below summarises the Council’s investment position at the end of 2007/08:

Table 9: Investment position at 31 March 2008

| |31 March 2008 |31 March 2007 |

| |Principal (£000s) |Average Rate (%) |Principal (£000s) |Average Rate (%) |

|Fixed interest investments |294,949 |5.98 |230,642 |4.87 |

|Variable rate investments |15,500 |4.09 |7,500 |4.79 |

|Total investments |309,949 |5.92 |238,142 |4.87 |

9.2 The actual rate on investments earned in 2006/07 was 5.92% as opposed to a forecast of 5.30% which was included in the budget. This forecast was based on the best estimates of future interest rates provided by the County Council’s treasury management advisors at the time the budget was set. As a result of the credit crunch rates available on the market exceeded initial forecasts significantly. The rate earned on variable investments fell because the Council has two investments which perform better in low interest rate environments. These investments were taken out to protect against the risk of interest rates falling by offering higher returns if this occurred. In a high interest rate environment the lower return on these investments is offset by the increase in rates achieved on the remainder of the Council’s investment portfolio.

9.3 The County Council earned a total of £19.1m of interest through the investment of surplus funds on the money market. The interest earned was £1.61m higher than the budgeted figure of £17.49m. This additional interest was due to achieving a higher than forecasted interest rate (£2m additional interest) partially offset by lower than expected cash balances (£0.39m reduction in interest). The average balance of cash was £322m as opposed to a budgeted figure of £330m.

9.4 The Council’s investment policy is governed by central government guidance, which has been implemented in the annual investment strategy approved by the County Council on 27th February 2007. The investment activity during the year conformed to the approved strategy, and the Council had no liquidity difficulties.

9.5 The majority of the cash balances held by the County Council are required to meet short term cash flow requirements and therefore throughout the year 345 fixed term deals for periods of less than one year were placed. The average amount invested was £5m and the average term was 62 days using a weighted average. The credit crunch which began in the summer of 2007 led to rising interest rates due to an increased demand for liquidity from banks and this had the effect of widening the gap between base rate and rates achievable on the market. Advantage was taken of higher one year rates by taking small amounts (typically £1m to £2m) as and when rates improved. The table below shows the most used counterparties overall and the countries in which they are based. All deals are in sterling despite the country the counterparties are based in.

Table 10: Counterparties used

| |Country |No. of Deals |Value of Deals (£m) |

|Dexia Bank Belgium |Belgium |36 |255 |

|EBS |Ireland |25 |81 |

|DEPFA Bank |Ireland |24 |141 |

|HSH Nordbank |Germany |20 |132 |

|Alliance and Leicester |UK |17 |113 |

|Anglo Irish Bank |Ireland |15 |31 |

9.6 In addition to specific fixed term deals, use was also made of call accounts during the year, because they provide instant access to funds while paying base rate or better. This meant that funds were available for unexpected cash flow events to avoid having to pay higher rates to borrow from the market. During 2007/08 an average of £24.9m was held in such accounts. The onset of the credit crunch in August 2007 pushed LIBOR rates over 6.5% and more funds were switched from call accounts to fixed rate deposits in order to take advantage of these higher available rates.

9.7 When the Prudential Code was introduced, the restriction on the length of time funds could be lent out was removed, so now it is possible to lend for more than 364 days. In February 2007 a new limit of £50m was agreed for deals of one year or more for 2007/08 up from £20m the previous year. During the year 10 new long term deals were taken taking the total invested for more than 364 days to £39m by the end of 2007/08. A mix of fixed, callable and variable longer term deposits was taken for different lengths of time in order to spread risk. Investments of this nature were taken in small amounts when the opportunity to earn attractive rates arose. There is the scope to increase the level of long term investments to £50m in 2008/09 if further attractive opportunities arise in the market.

9.8 The performance during the year is compared to two benchmarks: the average 7 day LIBID (London Inter Bank Deposit) rate and the average 1 month LIBID rate. The graph below shows the County Council’s performance month by month compared to these benchmarks and base rate.

Graph1: Investment performance compared to benchmarks

[pic]

9.9 The bold line shows the County Council performance during the year. Overall, performance was 0.34% over the average 7 day LIBID rate for the year, 0.14% over the 1 month LIBID and 0.38% above average base rate for the year.

9.10 From April to July, the Council’s performance tracked its benchmarks and base rate. The credit crunch which started in August brought about a sudden increase in the rates available on the market and a widening of the gap between base rate and market rates. As a result the return on the Council’s investments improved but due to the fact that existing investments were achieved at lower rates the Council’s performance lagged behind 7 day LIBID and 1 month LIBID for a period. Once these higher rates fed through into the Council’s investment portfolio, performance rose above all benchmarks for the remainder of the year, except for a blip in December 07 caused by a further worsening of credit conditions in the markets.

Appendix A

Estimated and Actual Treasury Position and Prudential Indicators

| |Figures are for the financial year unless otherwise titled in |2007/08 |2007/08 |

| |italics |Actual |Original |

| | | |Indicator |

|1 |Capital Expenditure |£186,139k |£163,855k |

|2 |Capital Financing Requirement (CFR) |£440,969k |£407,264k |

|3 |Treasury Position at 31 March | | |

| |Borrowing |£377,222k |£409,000k |

| |Investments |£309,949k |£330,000k |

| |Net Borrowing |£67,273k |£79,000k |

|4 |Authorised Limit (against maximum position) |£377,222k |£447,000k |

|5 |Operational Boundary |£377,222k |£414,000k |

|6 |Ratio of financing costs to net revenue stream |-0.45% |-0.04% |

|7 |Incremental impact of capital investment decisions on the Band|+£33.87 |+£29.04 |

| |D council tax | | |

|8a |Upper limits on fixed interest rates (against maximum |95.13% |100% |

| |position) | | |

|8b |Upper limits on variable interest rates (against maximum |4.87% |30% |

| |position) | | |

|9 |Maturity structure of fixed rate borrowing (against maximum |

| |position) |

| |Under 12 months |0.01% |25% |

| |12 months to 2 years |0.01% |40% |

| |2 years to 5 years |3.18% |60% |

| |5 years to 10 years |0.00% |80% |

| |10 years and above |96.80% |100% |

|10 |Investments greater than 364 days (Maximum limit) |£39m |£50m |

In addition to the above the Council is required as a Prudential Indicator to:

• Adopt the CIPFA Code of Practice.

• Ensure that over the medium term borrowing will only be for a capital purpose (i.e. net external borrowing is less than the CFR).

The compliance for these indicators are highlighted in the body of the report.

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