Pdf effective management of debt finance for local government

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Title: Effective Management of Debt Finance for Local Government
Keywords: Local government debt
Author: Richard McKenzie
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PDF Effective Management of Debt Finance for Local Government

EFFECTIVE MANAGEMENT OF DEBT FINANCE
FOR LOCAL GOVERNMENT
This information circular aims to provide an overview of the appropriate use of debt finance for
local government and the requirement for a market valuation when refinancing or making
unscheduled repayments on fixed interest rate loans, to assist in making informed decisions
when considering debt finance from WATC.
The majority of Western Australian Local the loan are subjecting themselves, and ultimately
Government Authorities (LGAs) maintain a portfolio their rate payers, to a higher degree of financial risk.
of fixed-interest rate loans with Western Australian This arises as the alternate income streams expected
Treasury Corporation (WATC). These are generally to support such loans are generally subject to a degree
long-term amortising loans (e.g. 10 years or longer) of uncertainty in comparison to an LGA's core sources
where the interest rate was fixed at the time the loan of income (i.e. rates and regular grants).
was taken out. Payments of interest and capital for the
life of the loan are determined at the time the loan is To assist our LGA clients in considering the
drawn. appropriate use of debt as a possible source of finance
for the future development of community
Fixed-interest rate loans provide the benefit of infrastructure, WATC has developed the Indicative
certainty of financing costs over the long term, which Additional Borrowing Capacity Calculator. This
assists with project costing and budgeting for future calculator is designed to be inserted within an LGA's
repayment obligations. It also protects the borrower long-term financial planning model and, based on
from increases in the general level of interest rates. prudent debt-servicing assumptions, provides an
However, if interest rates fall over time, the borrower indication of the likely capacity of an LGA to use debt
will be left with a financing commitment at a higher for future capital projects.
interest rate than the rate currently available.
Refinancing and Unscheduled
Appropriate Use of Debt Finance Repayments of Fixed Interest Rate Loans
LGAs primarily borrow from WATC to fund With market interest rates currently at record lows,
infrastructure development for the communities they WATC's LGA clients often enquire about the possibility
support. Long-term loans are raised for the of restructuring (i.e. refinancing) existing fixed-interest
development of specific community assets with rate loans that have significantly higher interest rates
repayment being tied to the primary sources of income with a replacement loan at the current market interest
for LGAs - principally rates. rate which is considerably lower.
However, some councils direct their LGAs to have a Often at the request of council, LGAs enquire about
no-debt policy or a policy whereby a loan can only be the possibility of repaying loans early to take
raised on the basis that it is expected to be repaid by advantage of low interest rates, as is frequently
an independent source of revenue, for example, portrayed in the media where householders are doing
property development projects. so to get ahead on their mortgages. However,
household mortgages are predominantly variable-rate
An LGA with a no-debt policy may regard itself as loans and therefore unscheduled repayments are not
financially conservative or not wanting to burden its subject to a market valuation adjustment as explained
constituents with debt. However, such a policy is not below.
consistent with achieving an appropriate balance in
intergenerational equity. As such, it may negatively Market Valuation Adjustment
impact the level of service provided to the current
community and/or be associated with significant asset WATC is able to restructure existing fixed-interest rate
degradation and increasing allocation to maintenance loans prior to their maturity date and/or accept any
costs. unscheduled repayments of capital at the request of
Furthermore, LGAs that only borrow where they the borrower. However, to do so requires
expect an independent source of revenue to service determination of the current market value of the
FINANCIAL SOLUTIONS FOR THE BENEFIT OF ALL WESTERN AUSTRALIANS
EFFECTIVE MANAGEMENT OF DEBT FINANCE
FOR LOCAL GOVERNMENT
existing loan. The market valuation of a loan will WATC at Your Service
depend on the interest rate prevailing at the time of
valuation compared with the original interest rate and Should you wish to discuss the appropriate use of debt
the length of time remaining to the maturity date of the finance or loan repayment options for your local
original fixed-interest rate loan. government, please contact:
A market valuation involves valuing the previously
committed fixed-payment schedule at the current Tamara Marsh
interest rate for the remaining term of the loan. This Relationship Manager
form of valuation is required because, where a Local Government
borrower elects to restructure and/or make (08) 9235 9153
unscheduled payments (in full or in part), WATC must tmarsh@watc..au
make the equivalent adjustments with the market
counterparties through which WATC sourced the
funds for the original loan.
If interest rates have fallen since the original loan and Richard McKenzie
the borrower wishes to repay part or all of the loan, the Head of Client Debt Finance and
market counterparty must be compensated for the Investments
foregone interest being paid on the original loan, as (08) 9235 9127
they will not be able to reinvest the repaid funds at the rmckenzie@watc..au
same rate - hence a capital premium will be payable.
Conversely, if interest rates have increased since the
original loan, a market counterparty will be prepared to
receive a reduced amount of the outstanding capital
(i.e. provide a discount) as they will be able to reinvest
the repaid funds at a higher interest rate.
Therefore, where WATC communicates to a client that
a premium is payable when requesting a loan
restructure or unscheduled repayment on an existing
fixed-interest rate loan, this represents the `fair price'
implied by the market valuation in that it reflects the
prevailing market interest rates that could be received
from investing the early repayment of debt. Clients
may often interpret such a premium as an `early
termination fee', `break fee' or some other such cost
imposed by WATC. This is not the case as WATC
derives no financial benefit from these transactions.
This may differ from private financial institutions that
may levy such fees in conjunction with a market
valuation adjustment.
DISCLAIMER
Any opinions, judgments, conclusions, forecasts, predictions or estimations contained in this advice are made in reliance on
information provided to Western Australian Treasury Corporation which Western Australian Treasury Corporation believes to be
reliable. Western Australian Treasury Corporation, however, cannot guarantee the accuracy of that information. Thus, any
recommendations are made in good faith but are provided only to assist you with any decisions which you make. These
recommendations are not intended to be a substitute for professional advice on a particular matter. Before accepting or rejecting
those recommendations you must discuss your particular needs and circumstances with Western Australian Treasury Corporation.
FINANCIAL SOLUTIONS FOR THE BENEFIT OF ALL WESTERN AUSTRALIANS

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