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Thames Water bondholders are bracing for more than £10bn of the company’s debt potentially being downgraded to junk status, a move that could result in greater regulatory scrutiny and send shockwaves through Europe’s high-yield bond market.
Rating agency S&P said last week that it could downgrade the utility’s safest class of bonds, which have the lowest investment-grade rating of BBB-, because the UK’s biggest water supplier “might not be able to maintain adequate liquidity”.
The rating action would mean that £10.8bn-equivalent of the safest tier of Thames Water debt — made up of euro- and sterling-denominated bonds — would sink to a level that could trigger intervention by regulator Ofwat.
The water utility needs to maintain two investment-grade ratings in order to comply with its licence, unless Ofwat makes an exception to allow just one. Moody’s also assigns the lowest possible investment-grade rating to Thames’s most senior bonds, with a negative outlook.
A downgrade could also raise the cost of borrowing for the company, which provides water and sewage services to about 16mn households.
That would pile pressure on Britain’s biggest water utility, which is already struggling under its £18bn debt pile and seeking to avoid being taken over by the government’s special administration regime — a form of temporary renationalisation.
The SAR is most likely to be triggered if the company is unable to repay its debts or is found to be in breach of its principal duties to provide efficient water supply and sewerage systems.
A downgrade is also likely to put pressure on the €500bn European high- yield debt market, with bonds issued by Thames — whose riskier class of debt is already rated junk — potentially accounting for about 11 per cent of the sterling high-yield index, instantly making it the largest issuer in this market.
“This would be the largest ever sterling corporate issuer to be junked and could cause quite a headache for high yield considering the quantum and complexity of debt instruments that are in play,” said Simon Matthews, a portfolio manager at Neuberger Berman.
“There’s not really anything Thames can do in the next few weeks that can change S&P’s mind, in my opinion,” said Johnathan Owen, a portfolio manager at TwentyFour Asset Management.
“The market expects the downgrade, the downgrade can trigger the licence breach, and that may be the trigger that initiates special administration.”
The company says it has enough cash to last until May next year but needs to raise £750mn in equity from investors by then and a further £2.5bn by 2030.
It is hoping to raise debt and equity this autumn but it is unclear whether this will succeed after its existing shareholders — which include the pension funds Omers and USS as well as the Chinese and Abu Dhabi sovereign wealth funds — declared the company “uninvestable” and reneged on a pledge to invest equity into the business.
Thames Water declined to comment. Ofwat did not immediately respond to a request for comment.
In a sign of investor nerves since S&P’s announcement on July 10, which was followed by Ofwat placing Thames into a “special turnaround oversight regime” the next day, a sell-off has pushed the price of some of the safest class of bonds down to a record low of just over 75 cents on the euro, compared with 83 cents on the euro at the beginning of last week.
Traders are marking Thames’s riskier £250mn tier of bonds at a record low of 38 pence on the pound.
Owen said that while there would be a “huge” amount of Thames Water bonds for the high-yield bond market to “digest”, lots of the debt is likely to have changed hands from investment-grade funds to investors in lower-rated debt, given that the debt has been seen as risky for some time.
“It’s got short-term liquidity, it’s highly over-levered, it’s absolutely not a triple B on any kind of metrics,” said one credit fund manager.
“The bigger issue for them with being junked is: do they lose their licence?”
The financing model used by Thames Water, in which cash flows service different tiers of debt, tends to result in higher investment-grade ratings for top-ranked bonds than standard corporate bonds at companies with similar levels of debt. Backed by a consistent revenue stream linked to inflation, investors in Thames did not expect it to become a junk issuer.
S&P also placed Thames’s bottom tier of debt, which are already junk rated, on its “CreditWatch negative”, meaning it could lower the rating in the coming weeks if it believes the company does not have adequate liquidity.
