Jackie Shute, Director, Public Sector Live (PSL)
Carry Cost is a widespread issue amongst many local authorities and mainly takes the form of borrowings having been undertaken on a long term fixed rate basis, and surplus funds being lent out on a short term or variable basis thus being exposed to fluctuations in prevailing rates. The Cost of Carry therefore arises when investment rates fall below the rates at which the funds have been borrowed at.
Treat and prevent carry cost using the 'carry cost clinic' advice below:
Carry Cost Clinic
Symptoms
The main symptoms that occur are:
- high net interest costs
- greater sensitivity to unfavourable economic conditions
- significant and costly exposure to interest rate risk
- resource intensive portfolio churning
Other symptoms that may occur include:
- desire to take additional credit risk to enhance returns
- difficult conversations with senior officers and elected members
- crossed fingers and sweaty palms hoping for short term rates to bounce back.
Causes
Carry costs are reasonably widespread and can affect over 80% of authorities with indebtedness, to a greater or lesser extent. Historically carry trades were thought to benefit local authorities who were able to borrow long and cheap and lend out at higher rates of interest. Greater acceptance of risk management has challenged this widely held belief and as a result carry trades are now recognised as not always being beneficial.
Other causes can be put down to:
- poor long term cashflow forecasting and failure to recognise the impact that notional repayments of principal have on the net indebtedness of the authority
- constantly borrowing long term maturity debt structures.
There are of course varying degrees of carry cost ranging from acute cases where cash balances are held purely for liquidity purposes and are inherently needing to be kept short and consequentially exposed to variable market conditions – up to more severe cases where significant balances are held for reasons other than liquidity.
Treatment
There are some cures available for carry costs, although these may lead to undesirable side-effects in some cases. These treatments include:
- redemption of debt using surplus investment balances
- switching fixed rate debt to floating rate debt
- extending duration of investment balance to reduce interest rate risk.
Before any of these treatments are undertaken, it is advisable to fully ascertain the risks of each approach and understand the side effects at portfolio level.
Prevention
For those authorities concerned about this issue, or only showing light symptoms, it is advisable to take preventative action now. This includes:
- undertaking long term cash flow projections
- Following the recommendations of CIPFA’s Treasury Risk Management Toolkit Active consideration of annuity & EIP loan structures
- Questioning why indeed you have to borrow at all if you have cash balances
Remember, you don’t need to suffer in silence, no matter how far progressed the problem is, it’s not too late to take action. Public Sector Live can provide you with a confidential independent examination and provide objective quantification and analysis for further discussion.