A normally boring corner of the UK investment market is wobbling, highlighting the potential trouble ahead for corporate debt exposed to inflation.
Thames Water, Britain’s largest water supplier, is in talks with government officials about its options for dealing with its more than 14 billion pound ($17.8 billion) debt pile. Its burden has grown more onerous in large part because of its use of inflation-linked bonds, which account for more than half of its senior debt and has remained high in the UK.
As central banks hike rates to tame inflation, companies have faced immediate hits in at least two ways: they’re paying more interest on their floating-rate debt, and their inflation-linked obligations are growing bigger. There’s more than $1.8 trillion of this kind of debt outstanding worldwide that was sold in capital markets, most of which is leveraged loans, but also corporate floating-rate notes, and inflation-linked securities.
The outlook for much of that debt is getting worse, with Fitch Ratings citing inflation uncertainty as one of the reasons for lifting its default rate forecast for US leveraged loans to as much as 4.5 per cent this year from a January forecast of as little as 2.5 per cent. BNP Paribas analysts this week advised clients to sell leveraged loans in the US rated B- because of some companies’ unsustainably high interest expenses.
Companies that rely on floating-rate debt will be “heavily affected” by the higher-for-longer rates environment, said Michael Koehler, a credit strategist at Landesbank Baden-Wuerttemberg. He expects most other corporations to escape relatively unscathed.
Now Thames Water’s struggles have shifted the spotlight to British utilities. More than half of the 60.6 billion pounds ($80 billion) in debt issued by water companies in England and Wales is indexed to inflation, according to Ofwat, the industry regulator.
UK companies account for nearly a third of the inflation-linked corporate securities globally. Only Brazilian corporations are bigger borrowers in the space.
The blow to the utilities could have been cushioned by using derivatives to protect against spiraling inflation but several firms failed to do so. Many private equity firms have also been hit by their decision to opt against hedging arrangements that, for most of the last decade, could have shielded companies for very little cost.
To be sure, the majority of the global corporate debt market consists of fixed-rate obligations that will only become painful once the time to refinance them comes.
Still, companies with high levels of floating-rate and inflation-indexed debt may end up needing the most relief, and may find themselves with few options for fixing their trouble.
“In a context of higher rates, we see private credit and loans as more vulnerable than public credit as their financing terms are more often floating rate and they have fewer financing alternatives,” said Elisa Belgacem, a senior credit strategist at Generali Investments.
