Why carry out analysis on local authorities, is it worth the time and effort? Well, on one hand it could be argued that there are no cases of a local authority defaulting in over 200 years. Alongside this there are various creditor protections available plus a high probability of government support.
On the other hand, we know that some authorities have counterparty restrictions on several of their peers, usually due to negative media reports and reputational risk. We also receive requests for detailed forward looking due diligence on individual authorities, which we do undertake but this can be resource intensive and has an associated cost. So where do you strike the balance?
What do professional investors think? There are many banks, pension and insurance funds that invest in local authorities, all of these will undertake detailed due diligence, both before lending money and at regular intervals throughout the life of the loan. Also consider, for local authority bonds that have been issued in the capital markets, there is a clear credit spread over gilts, indicating investors do not believe that the risk is the same as lending to the UK government. It is important to know your counterparty when transacting and the FSRs help to demonstrate that level of analysis taken when constructing your investment portfolio.
The Prudential Code states that ‘‘Local authorities are reminded that the prime policy objective of their treasury management investment activities is the security of funds, and they should avoid exposing public funds to unnecessary or unquantified risk’’ and that it is important that ‘‘authorities adopt an appropriate approach to risk management with regard to their investment activities.’’ The aforementioned two quotes demonstrate that there needs to be a prudent approach when investing and that there is a suitable approach taken to help mitigate unnecessary risks. In the Treasury Management Code, it suggests under ‘Credit and counterparty risk Management’ that each ‘‘organisation will ensure that its counterparty lists and limits reflect a prudent attitude towards organisations with whom funds may be deposited or investments made’’, again reiterating the point that each local authority needs to know who they are dealing with. The FSRs allow this analysis to be done effectively and iDealTrade takes this one step further by offering a clear paper trail of completed deals.
A decade of austerity and funding cuts have continued to exert pressure on local government finance. Combined with an increased emphasis on commercialisation, this has produced a significant divergence in financial strength across local authorities. While the probability of loss remains low, many believe the risk of default has increased for some. Arlingclose has developed a set of Financial Strength Ratings (FSRs) which help to identify differences across local authorities in five key categories (Debt, Interest Burden, Income, Use of Reserves & Budgetary Control).
The data for the ratings is sourced from DLUHC. It is important to note that the published data is inevitably backward looking, whereas risk is forward looking. We have attempted to manage this by using quarterly and budget data, rather than relying solely out last year’s outturn. But even quarterly data is published several months late, while budgets and capital programmes are amended mid-year without being reported to government.
FSRs are not expected to prohibit an authority’s ability to borrow in the money market as the underlying credit quality of all authorities is strong, due to the aforementioned creditor protections. Nor are the ratings expected to be a definitive guide to financial strength, rather an indication of underlying relative risk, based on publicly available information, that highlights where further due diligence might be appropriate.
To conclude, one of the main points of this insight is that if the data is available for consumption and easy to process then why not use it? The analysis that Arlingclose carries out on each local authority is free too, available at iDealtrade.net when placing deposits. It will also help you meet your obligations under regulatory codes and guidance, ensure best practice and provide a reference point if the rationale for an individual investment is questioned at a later stage.
Arlingclose have recently discussed this topic on their weekly webcast, Trending Treasury. For Arlingclose clients, this can be viewed here.
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