UK water companies are confronting a financial crisis so dire that the government briefly considered a partial nationalization. One cause of the industry’s woes is its preference for inflation-linked debt. This arcane corner of the global bond market rarely makes headlines because of its relatively small size and the unremarkable returns it offers in normal times. However, by mid-2023, an extended period of high inflation had sent these utilities’ debt obligations soaring, eating into the resources they need to upgrade the nation’s aging infrastructure. The situation is also affecting the UK government, one of the largest issuers of debt tied to inflation.
UK water companies are confronting a financial crisis so dire that the government briefly considered a partial nationalization. One cause of the industry’s woes is its preference for inflation-linked debt. This arcane corner of the global bond market rarely makes headlines because of its relatively small size and the unremarkable returns it offers in normal times. However, by mid-2023, an extended period of high inflation had sent these utilities’ debt obligations soaring, eating into the resources they need to upgrade the nation’s aging infrastructure. The situation is also affecting the UK government, one of the largest issuers of debt tied to inflation.
1. What is inflation-linked debt and how does it work?
Whereas ordinary bonds pay a fixed return, the principal and interest payments on inflation-linked debt rise in step with consumer prices. This protects investors in the notes by ensuring their income stream doesn’t lose value over time. The face value of the debt tracks an inflation index that is clearly defined in the bond’s terms. The interest payments also rise since they are calculated as a percentage of the principal. Inflation-linked loans raised by companies work in a similar way. There are also swaps where fixed payments are exchanged with inflation-adjusted amounts. These can effectively transform a regular bond into one tied to inflation, and some UK water companies have used them too.
2. Why do companies and governments issue them?
Inflation-linked bonds can pay significantly lower coupons than ordinary debt as they don’t have to compensate investors for the risk of future inflation spikes eating into real returns. They can be a savvy way of raising money if inflation turns out to be lower than expected. They are especially appealing to companies in industries whose profitability is closely tied to rising — or falling — consumer prices. UK water utilities are allowed to increase customer bills in line with inflation. Inflation-linked bonds allow them to hedge these fluctuations in earnings. The interest payments increase when the company has more money to pay back debt, and fall when it has earned less money due to a drop in prices. Non-financial companies worldwide have issued almost £150 billion ($193 billion) of inflation-linked bonds, with more than half of the total raised by borrowers in the UK and Brazil. That’s still less than 2 percent of the global investment-grade corporate bond market.
3. Why so much interest in the UK?
The UK government has issued inflation-linked securities since the 1980s. They found eager buyers in local pension funds, which tie their own payouts to inflation, and it was only a matter of time before companies issued similar bonds to tap into that deep pool of capital. The country has become so exposed to “inflation-linkers” that about a quarter of the government’s debt is now tied to rising consumer prices, more than twice as much as the second-largest sovereign issuer, Italy, according to a report by the Office for Budget Responsibility.
4. What about Brazil?
Brazil’s government is the second-biggest issuer of inflation-linked debt after the US, followed by the UK. The country has faced occasional bouts of hyperinflation that caused the value of its bonds to evaporate. The resulting risk premium made issues of conventional debt relatively expensive, and inflation-linked debt became a useful solution. These notes offer a fixed payment adjusted to variations in the nation’s official IPCA inflation benchmark. Bonds that are tax-exempt for individual investors, such as infrastructure bonds, are usually linked to the IPCA.
5. How did things get so bad in the UK?
Of the £60.6 billion owed by Britain’s privatized regional water utilities as of March 2022, more than half was indexed to inflation, according to industry regulator Ofwat. The country has suffered from higher, stickier inflation than other wealthy nations. What’s more, the vast majority of UK corporate inflation-linked debt is tied to an older measure of inflation, the retail price index, which has been even higher than headline price growth. Bills charged to water customers rose in response to inflation, but not fast or high enough to offset the surge in debt interest.
6. What was the result?
Thames Water, the country’s largest water and wastewater company, ran into trouble after its net financing costs jumped by 24 percent in a year. Government ministers were weighing options including a potential temporary nationalization of the business until investors agreed to inject £750 million into the business in July. Inflation linkers are also a problem for the government, which has a relatively high proportion of inflation-linked debt compared to other Group of Seven nations. Its 12-month interest payments reached £117 billion, double the level as of September 2021, with the Treasury’s fiscal watchdog saying the public finances are on a “very risky” footing.
