Has Bristol Water opened the tap on corporate inflation linked bond issuance? The water utility company came to market last Friday with a small £40m 30 year deal which pays a coupon of 2.701% plus inflation.
The interest payments on corporate inflation linked bonds – as the name suggests – move in line with inflation. Each issue has its own quirks but, as an example, the Bristol Water new issue pays a coupon of half of 2.701% every six months, uplifted by the change in the UK Retail Prices Index from issue (there’s a 3 months lag in the inflation number used because of the delay in collecting and releasing the inflation statistics). The final redemption proceeds in March 2041 are also uplifted to reflect inflation over the lifetime of the bond (giving a “real” return). The bond mechanics are pretty similar to those in the index-linked gilt market, although in this case there is a credit spread as well as the underlying real yield. In this case the bond priced at 200 bps over the 2040 index linked gilt, reflecting both credit risk (Bristol Water is an investment grade company, Baa1 rated by Moody’s) and something for illiquidity (£40 mn is one of the smallest corporate bond deals).
We haven’t had any corporate linker issuance for a year or so but it appears that some firms are now looking at it as an option – we’ve been approached by 3 other issuers in recent months who are considering issuance. Maybe it’s the sustained elevated level of inflation – RPI is currently at 5.5% year on year – that is giving these companies pause for thought. If, like Bristol Water and other utility companies, your revenues are explicitly linked to RPI (due in this case to Ofwat, the UK water regulator) it is eminently sensible to have your liabilities linked to it also. When inflation starts to recede you don’t want to be left with fixed debt payments while your revenues are falling away.
Is there likely to be issuance outside of the utility sector though? Why would corporates issue inflation linked debt in a world where inflation is high and rising? At least when governments issue inflation linked bonds they have some control over keeping inflation low (through tighter fiscal and monetary policy). Well, outside of the utility sector another big type of issuer is infrastructure related companies. Operators of toll bridges (Severn Bridge in the UK, Oresundsbro Konsortiert which runs the bridge between Sweden and Denmark), railways (RFF in France), and PFI projects (Kings College Hospital) all have inflation linked revenues. We also have Tesco – a supermarket which sells most of the things in the inflation basket nowadays – some banks, and a handful of other issuers. But are corporate treasurers going to want to have borrowings linked to consumer prices at a time when inflation expectations are on the rise? On the whole probably not, although the inflation swaps market (a form of derivative where fixed rate payments are switched for payments linked to inflation) allows borrowers to issue debt to match investors’ demand. In the end though you still need to find somebody who is happy to “pay” inflation. So the inflation market is unlikely to ever grow to anything like the size of the traditional corporate bond market, but with investor demand for inflation protection growing, some issuers will see this as an attractive form of issuance much in the same way that the high yield market grew from nothing in Europe at the end of the1990s to the big and liquid asset class it is now on the back of investor demand.
We’re pretty keen on corporate linkers here, not just because we think 2011 is a year of persistently high RPI, but also because they look good value relative to ordinary corporate bonds. For example I could buy a Tesco 2016 index linked bond at 1.2% more yield than the equivalent index linked government bond, or I could buy the Tesco 2016 conventional bond at 0.9% more yield than the equivalent conventional government bond. This is the illiquidity premium. Long may it persist, but whilst it does it probably acts as another reason why we shouldn’t expect bumper issuance in the asset class. Corporate treasurers and CFOs should however get in touch if they feel we could be of help!