Debt laden UK companies – particularly utilities – are under pressure to explain exactly how they are going to service inflation-linked bonds while maintaining or increasing investment.
No country has embraced inflation-linked debt with greater enthusiasm than the UK, partly due to the privatisation of public utilities that started in the 1980s.
According to Bloomberg, UK companies – primarily utilities – are the biggest issuers of inflation-linked debt in the developed world with more than £40bn worth of the securities currently outstanding.
When inflation is low, such bonds represent a cheap method of raising funds from risk-averse investors. The biggest threat to the value of a bond in the long term is unexpected inflation, so a bond indexed to inflation is very appealing.
Slow economic growth usually means low inflation, so companies that have issued inflation-linked bonds would not expect to be paying high debt costs while simultaneously grappling with lower revenues from reduced demand.
But with UK inflation* remaining stubbornly high (rising by 7.9% in the 12 months to May, up from 7.8% in April), corporate issuers are spending a high percentage of their revenues simply servicing this debt at a time when the UK economy is only just growing fast enough to avoid recession. The problem is particularly acute for utilities, whose ability to increase prices is limited. (*The Consumer Prices Index including owner occupiers’ housing costs (CPIH))
In Thames Water’s 2022/23 annual report, Chief Financial Officer Alastair Cochran observed in the most recent financial year the company prepaid accretion of £310m on index-linked swaps, bringing the settlements forward to March 2023 from September 2023 and October 2024.
The report authors stated geopolitical and macroeconomic challenges were having an inflationary impact on financing and operational costs. However, they also suggested ‘proactive and robust mitigations undertaken result in a stable overall risk outlook’.
The report even went on to suggest that given the regulatory framework where regulatory capital value and revenues are inflation-linked, if a material portion of its debt was not linked to inflation, the company’s viability would be more at risk in scenarios involving low inflation.
The majority of the company’s debt interest is inflation-linked, but the report states the company is ‘reasonably well placed’ to manage inflation risk despite showing a £1bn increase in net debt to almost £14bn.
However, ITV’s Political Editor, Robert Peston tweeted recently the accounts of its financing company – Thames Water Utilities Finance – lists 13 index-linked or inflation-proof bonds with a total value of £3.35bn as of spring last year.
Many of these bonds don’t fall due for ten or 20 years. This implies that every 1% increase in inflation is costing the company £34m a year and based on what has happened to UK inflation over the past 18 months, the additional annual interest cost on these bonds could plausibly be £200m – a non-trivial sum for a company seeking to raise £1bn in additional equity.
In a recent investment note, Hargreaves Lansdown equity analyst, Aarin Chiekrie said United Utilities’ underlying finance costs are expected to be around £175m higher than last year – and £10m higher than previously forecast – because of elevated inflation.
He also referred to the likelihood that net debt would also increase from half-year levels, reflecting the impact of inflation on the group’s index-linked debt, and stated it could find itself in a sticky situation if inflation remains elevated.
According to monetary economist Warwick Lightfoot, the use of debt by the owners of Thames Water offers an interesting perspective on the properties of indexed-linked debt in the private sector.
“In principle, given the price regulation it operated under is tied to inflation, this should be the sort of private sector index-linked debt that a firm could comfortably manage,” he says. “Yet it appears the water company has a debt index to the RPI while its regulated income is linked to the CPI.”
