Loan Guide

Introduction
KBN is of the view that it is important for municipalities to have their own, reasoned views on interest rate choices, risk levels and how the borrowing processes is carried out. We have therefore brought together some useful information into a loan guide.

The composition of loan portfolios
The municipality's finances must be managed so that the economic capacity is maintained over time. The municipal debt affects the economy and therefore it is important to have knowledge of how the debt is composed, the properties of the products and the risk the debt portfolio is exposed to.
When managing a loan portfolio, it is crucial to consider its composition, including how large a proportion should be on fixed rate terms and how large a proportion on floating rate terms, as well as what proportion should be shortterm loans and what proportion should be longterm loans. Loans with short and mediumterm maturities are normally not instalment loans, but rather fall due for repayment in their entirety at maturity and then need to be refinanced.
Municipalities’ finances are the most important basis for making decisions in terms of the level of risk associated with and the composition of loan portfolios. With a floating rate loan, the amount of interest paid is in line with developments in the market, while fixedrate loans offer more stable interest payments and greater predictability. Loans with no repayment instalments prior to maturity create a need for refinancing, while longterm instalment loans offer stable financing. Examples of questions that it may be relevant for municipalities to consider include: What size of interest rate fluctuations can our municipality’s finances tolerate? Does our municipality have sufficient liquidity to cope with frequent refinancing? Does our municipality have the expertise and resources needed to take a complex approach to managing its debt?
Municipalities are required to have internal financial regulations that regulate their debt management framework and the type of loan products they can use. Municipalities that use loans that give rise to refinancing risk are required to set limits for the proportion of their loan portfolio that can mature in any given year.
The interest rate risk associated with a loan portfolio can be defined as the effect that a given increase in interest rates would have on the municipality’s capacity to act in financial terms.
The majority of municipalities will have a range of loans linked to areas of their activities that generate revenue that varies in line with changes in interest rates. Examples of this include loans for full cost recovery areas (water, wastewater and refuse collection) and loans that are subject to interest rate compensation. This makes it important to consider the size of a municipality’s net interest bearing debt in the context of the composition of its loan portfolio.
Many municipalities have segregated liquidity pools and/or hold interestbearing securities that provide interest income and that will counteract any increase in interest expense caused by an increase in interest rates. It will be natural to take this into account when calculating the actual extent of the interest rate risk associated with a portfolio. Doing so generates what could be referred to as net interest rateexposed debt.
The first step is to analyse where and in what way interest rate risk could arise at your municipality. As net borrowers, municipalities have interest rate risk in their loan portfolios and are therefore exposed to increases in interest rates. The extent to which a municipality’s borrowing costs will change will be affected by the extent to which the municipality’s borrowings are on fixed rate terms, and it is important to follow up on this in relation to all loans in order to see whether an increase in interest rates would lead to increased costs.
The next step is to measure how an increase in interest rates would be reflected in your municipality’s interest costs. One method is to look at the effect on your interest rate costs over one year of a 1 percentage point increase in interest rates, for example. Such a simulation can be done in KBN Finans. The results of this analysis should then be included in a stress test that incorporates the consequences of such an increase in interest rates on the municipality’s assets in order to produce an overall picture of the risk.
Interest rate risk in a loan portfolio can be reduced by using fixedrate loans and by using separate interest rate hedging instruments (derivatives). Municipalities’ internal financial regulations must stipulate limits on the use of fixedrate loans and interest rate derivatives.
Municipalities’ internal financial regulations must address two important issues:
 The proportion of loans that will be fixed rate and the proportion that will be floating rate. A municipality could, for example, decide that a maximum of 50% and a minimum of 20% of its combined longterm debt will be on fixed rate terms. Each municipality will have to assess what constitutes the appropriate proportion of fixed rate debt on the basis of its financial situation and its policy on interest rate risk. A municipality's decision on the proportion of its loans that will be on fixedrate terms should be based on its net interest rateexposed debt. Unless the municipality takes into account debt associated with full cost recovery areas and debt that is subject to interest rate compensation and also its liquidity holdings and investments on floating rate terms, it is possible for it to end up having a level of borrowing on fixed interest rate terms that exceeds its interest rateexposed debt.
 Choice of the average fixed rate period. By spreading a municipality's loan portfolio over multiple loans with different remaining fixed rate periods, the risk of fluctuations in longterm interest rates having a major impact on the municipality’s interest expense can be further reduced, even if a large proportion of its borrowing is on fixed rate terms. It may be appropriate to impose a limit on the proportion of fixedinterest rate loans that can mature in any single year, and also to set a target range for the average interest fixing period.
‘Derivatives’ is an umbrella term for financial contracts that are derived from one or more other financial instruments such that the value of the contract is determined or derived from the performance of the underlying instrument(s). Examples of derivatives include options, futures, interest rate swaps and forward rate agreements (FRAs). The derivatives that are most relevant to municipalities’ debt management are FRAs and interest rate swaps.
KBN does not offer derivatives, but it does offer its customers loans with interest rates that are fixed for up to ten years, which are a simple way of reducing interest rate risk. Taking out loans of this type saves municipalities from having to enter into separate interest rate hedging agreements.
If a municipality wishes to use derivatives, it needs to have significant expertise in using financial instruments and good systems for monitoring them. The use of derivatives must be authorised by the municipality’s financial strategy and information must be provided on all derivatives in the notes to its accounts and documented in accordance with Local Government Accounting Standard (KRS) 11.
Numerous elements have to be in place in order to comprehensively hedge a loan using an interest rate swap. The hedge must, for example, match the underlying loan in terms of size, interest payment dates, the reference interest rate, repayments and duration. If the hedge does not match the loan in all respects, the municipality may be left with both market risk and margin risk, in addition to the interest rate risk that the instrument was intended to reduce or remove.
A forward rate agreement (FRA) is an agreement between two parties to lock in an interest rate for a future period on a loan or investment. They can ensure a set interest rate for one or two years in the future. The agreements are related to three or six month NIBOR.
An interest rate swap is a contract to exchange interest rate terms – from floating rate to fixed rate or vice versa. Such swaps usually involve exchanging a fixed rate (the swap rate) for a short term money market rate (three or six month NIBOR). When the agreement is entered into, the period for which the swap will apply, the amount (notional principal) and the terms and conditions for the fixed and floating rates will be agreed. Swap agreements do not involve the principal amount being exchanged – only the interest rate terms are swapped. The principal amount is only used to calculate the stream of interest payments that is swapped. Interest rate swaps are considered to be longterm hedging instruments, with maturities offered today of up to ten years. Longer maturities are less common.

Comparing loan offers
When comparing loan offers, it is important to look at the overall price, including all the fees and costs. This is expressed as the effective interest rate, which reveals the overall cost of the loan.
The effective interest rate includes all costs and fees, and is calculated as the total annual cost/interest rate, which makes it possible to compare different loan offers. Only loans that have one repayment instalment due per year and have no other costs associated with them have an effective interest rate that is the same as the nominal interest rate.
A key difference between loans from KBN and borrowing in the capital markets is that there are no fees associated with loans from KBN, while borrowing in the capital markets involves various types of fee. Even if a municipality can borrow at the same nominal interest rate, there may be a big difference in the effective interest rate, depending on the amount borrowed and the duration of the loan.
A whole range of factors influence a loan’s effective interest rate. The following are the most significant:
 The loan’s nominal interest rate
 The interest calculation method
 When the interest is payable, i.e. in advance or in arrears
 The number of repayment instalments
 Costs in the form of fees (instalment, set up, redemption etc.) and commission
 The length of the loan
 The size of the loan (e.g. fees and commission as a percentage of the balance of the loan)
 Borrowing in the securities market involves paying fees to Nordic Trustee and the costs associated with account operators/issuers, as well as listing fees if the loan is listed
 Any commission payable to any loan intermediary/corporate finance manager
The effective interest rate quoted by the provider will not necessarily include all of the above costs.
In the loan market, different calculation methods are used for different types of loan to calculate the number of days on which interest accrues. The choice of calculation method will influence the effective interest rate, meaning it is important to use the correct basis for calculating the number of days on which interest accrues when comparing different loans offers.
Product
Calculation method
Standard variable rate loans, certificate loans
Actual/365
NIBOR, FRA, floating interest rate swaps
Actual/360
Fixed rates
30/360
Converting from
To
Formula
30/360
Actual days/360
Interest rate * 360/365
Actual days/365
Actual days /360
Interest rate * 360/365
Actual days/360
30/360
Interest rate * 365/360
Actual days/360
Actual days /365
Interest rate * 365/360
Actual days/365
30/360 or vice versa
No conversion required
Semiannual interest rate
Annual interest rate
R = (1 + r/2)^2 – 1
Annual interest rate
Semiannual interest rate
R = 2*((1+ r)^1/2 – 1)

Financial terms
Relevant financial terms are explained belowed.
A loan where the sum of the amount paid in interest and capital at each instalment is constant.
The part of a financial statement that shows the financial position of a company at a specific point in time, generally at the end of a year.
One basis point is equivalent to 0.01% or one onehundredth of one percentage point.
A basis for comparison. In the fixed income market, the interest rate on government bonds is often used as a benchmark, while leading share indices are used in equity markets.
A loan whose conditions state that no repayment instalments are payable for the duration of the loan, meaning the entire amount falls due for repayment at a set point in time. Most frequently used in connection with bonds with no repayment instalments prior to maturity.
The process of carrying out transactions in securities by updating the accounts of the trading parties and arranging for the transfer of money and securities. Clearing banks act as intermediaries in transactions with the legal effects imposed by law and regulations issued pursuant to law and ensure that transactions are carried out.
An instrument that is derived from another financial instrument(s) and whose performance is decided by the performance of one or more underlying instruments. Examples include options, futures, swaps and FRAs.
The annual cost associated with a loan, which in its simplest form is calculated on the basis of the nominal interest rate and the number of interest payment dates per year. Other factors that will affect the effective interest rate may also need to be taken into account, such as fees, commission, premiums/discounts etc. The higher the notional interest rate and the more frequent the payment dates per year, the higher the effective interest rate.
A forward rate agreement. A mutually binding agreement in relation to the interest rate for a given period in the future and for a set amount.
Protecting against losses caused by changes in market prices.
The funds lent out at the start of a loan.
The risk that a borrower or issuer of a security will not be able to meet its repayment obligations (i.e. interest and principal).
The interest rate paid by a bond that is set when it is issued, and that holders of the security will receive (semiannually) annually (based on the nominal value of the bond).
The uncertainty associated with whether a security can be traded, in other words the danger that they may not be any interested buyers.
The amount of time until a loan is fully repaid.
An expression for the general interest rate in the market.
The risk that applies to the market in general, i.e. the danger that the market will fluctuate in value as a result of changes to, for example, the economic cycle, interest rates and political conditions. Consequently it is impossible to diversify market risk away. Also known as systematic risk.
The Norwegian InterBank Offered Rate. In some places the term ‘IBOR’ is used, meaning you must select the NOK interest rate. IBOR in Norway is NIBOR. NIBOR is the rate of interest that Norwegian foreign exchange banks charge when they loan money to each other. It is often used as a reference interest rate in relation to transactions involving interestbearing instruments. NIBOR rates are available for 1 to 12 month periods, but threemonth NIBOR is the rate most used as a reference interest rate.
The stated rate of interest on a loan.
A bond can be defined as proof that one has lent money. Bond certificates are a security that can be traded.
The real interest rate is the nominal interest rate corrected for price increases (inflation).
Defines how interest amounts are calculated in terms of the number of days in a year.
Bonds/fixed rate loans: 360/360, i.e. 30 days per month, regardless.
Bonds with maturities of 12 months or less/floating rate loans: 365/365, i.e. usual calendar basis.
NIBOR: 365/360
A change to the interest rate on a loan that is made one or more times during the life of the loan. The new rate is set in accordance with the interest rate fixing clause in the term sheet.
The date on which interest is due to be paid.
The risk of potential losses in the form of a decrease in market value cause by interest rate fluctuations.
The additional return an investor expects to achieve by making a risky investment relative to a riskfree investment.
Investments in government bonds are commonly used as the riskfree benchmark, even though no investment is entirely without risk.
Fixed rate loans with a maturity of twelve months or less. In practice, certificate loans function in many ways like bonds, but are subject to somewhat different rules.
Contracts where two parties agree to swap streams of interest payments and/or principal amounts based on a specified notional amount for a specified period. For example, one party may pay the other party a floating rate, while it itself receives a fixed rate.
A document that outlines the most important information associated with a security that is put up for sale in the primary market. Cf. prospectus.
Contracts with settlement dates in the future (longer than the normal settlement date for spot trades) in relation to the purchase or sale of financial instruments and commodities, which stipulate that both the buyer’s and the seller’s liabilities will be settled at a specific point in the future.
An interest rate that will apply to a period starting on a date in the future.
Forward rates are interest rates that apply between two points in time in the future. Under certain circumstances, forward rates may express the market’s expectations about the level of interest rates in the future.
A joint representative for a bond’s holders whose main function is to protect their interests and rights in relation to the borrower. The underlying loan agreement for each bond will specify the exact functions and tasks that the trustee has in each instance.
A measure of interest rate risk. Defined as the change in the market value of an interestbearing instrument caused by a 1 percentage point change in interest rates.