Debt markets update

Peter Dooley

May 2017

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How successful has it been?

• More than GBP115 billion of investment since privatisation, from private sources

• Far more efficient and better quality service provision

• Long dated money raised at attractive rates for a generally cash negative industry

– Astonishing achievement, based on investor faith in the regulatory framework

– Long may this continue – significant funding required for the sector, it would be unhelpful to 'kill the golden goose'

Water financing – magic?

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Water financing –magic? (cont’d)

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Why does water regulation work?

• Regulation has been an excellent and effective tool

• (Unwritten) in law or licence commitment to RCV, regulatory precedent, investors expected to know ‘the deal’

• Broad customer base, used to paying for an essential service

• Relatively small daily charge vs. energy

• Bills sufficient to support the service and pay financing charges (unlike e.g., the farebox for Network Rail) albeit not on a “current” basis

• Inflation linked, not linked to (domestic) volume

• Limited risk of ‘stranded assets’

• Water 2020 - Incremental change rather than revolution? Boiling a frog or bringing investors along for the journey?

Risks?

• Political

• Regulatory

• Short memories, big ideas

OR:

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• Company performance / natural disasters

• Financial markets, rates, costs

• Regulation, Politics, Wider Economy

– Cost of Capital

– CPI/RPI

– Cost of debt index?

– Water domestic retail competition – on the back burner

– NHHR

– Upstream markets – postponed?

• Ratings / returns / capital treatment

• Wider Insurance / Pensions market and regulation

Sector issues relevant to debt

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Variability of water company outturn – far greater focus on performance rather

than delivery

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Significantly more potential variability of outturn, broadly skewed to the downside

Source: Ofwat

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GBPUSD cross-currency basis movements10 year US Treasury and UK Gilt rates (%)

Source: Bloomberg

Market Conditions

6

Macroeconomic Forecasts (Bloomberg Consensus)

Q2 2017 Q3 2017 Q4 2017 Q1 2018

BoE bank Rate (%) 0.25 0.25 0.25 0.30

10 year UK Gilts (%) 1.44 1.55 1.64 1.73

Fed Funds Target Rate (%) 1.15 1.30 1.50 1.65

10 year US Treasuries (%) 2.65 2.78 2.90 2.98

Spread Indices

Key events 2017

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

UK triggers

Article 50 (29 Mar)

Dutch Parliamentary

Elections (15 Mar)

French Presidential

Election 1st round

(23 Apr)

French Presidential

Election 2nd round

(7 May)

German Federal

Elections (24 Sep)

Trump inaugurated as

US President (20 Jan)

End of ECB

CSPP (Dec)

NWM expects Fed

hike (13 Dec)

NWM expects Fed

hike (14 Jun )

NWM expects Fed

hike (20 Sep)

Fed hike (15 Mar)

0.40

0.65

0.90

1.15

1.40

1.65

1.90

2.15

2.40

2.65

Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17

10yr US Treasury 10yr UK Gilt

120

140

160

180

200

220

240

260

Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17

CSI BBB Index iBoxx.GBP.£Corporates.BBB

-25

-20

-15

-10

-5

0

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17

5yr 7yr 10yr 12yr

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The Brexit Effect?

110

130

150

170

190

210

230

250

270

290

iBoxx.GBP.£Non-Financials iBoxx.GBP.£Financials

23-June Brexit referendum

GBP Iboxx Performance (in bps)

Jan-Jun 16

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Investor Region Allocation%

United Kingdom 91.6%

Rest of Europe 8.1%

Others 0.3%

Investors remain more focused on the BoE than politicians - Brexit effects to date have been eclipsed by BoE actions

Jul-Dec 16

Investor Region Allocation%

United Kingdom 78.3%

Rest of Europe 15.7%

Others 6.0%

2017 YTD

Investor Region Allocation%

United Kingdom 80.7%

Rest of Europe 19.1%

Others 0.2%

Key Points

➢ Triggering Article 50 was a comparative non-event for markets. In the coming

months with negotiations beginning in earnest and BoE actions unknown, credit

investors are much more focussed on what action the BoE takes next

➢ Following the vote to leave (23rd June), the BoE rate cut and introduction of CBPS (4th

August) caused a ~20bp tightening in Sterling corporate credit and pushed 10yr

Gilt yields as much as 30bps lower

➢ This combined effected triggered abnormally high volumes of new issuance; since the

announcement there has been an average £7.3bn of new issuance per quarter vs.

£4.6bn across the 10 quarters prior, dating back to Q1 2014

➢ An increasingly diverse investor base facilitated larger trades whilst concessions

remain low

➢ Nevertheless in contrast to the ECB CSPP, the BoE acts solely in secondary markets

resulting in a compression of spreads and a potential disconnect between secondary

and primary possibilities

➢ Sectors such as; Electricity, Consumer Non-Cyclicals and Communications that

make up ~50% of the BoE portfolio have felt this effect most

➢ 10bn of purchases over 18 months required a run-rate of ~£130m of purchases per

week and the programme is set to reach capacity in less than half that time

Oversubscription levels since Jan -16

BOE Weekly Purchases (£ m)

0x

2x

4x

6x

8x

Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Dec-16 Jan-17 Mar-17 Mar-17

Oversubscription Best fit

535507 517

430

370 360

380 400

494 487465

300

0 0 0

375

473

336

493466

346304

275242

311

0.0

100.0

200.0

300.0

400.0

500.0

600.0

0.0

100.0

200.0

300.0

400.0

500.0

600.0

Weekly purchases Avg. weekly purchases

04-Aug CBPS announced

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CPI vs RPI – A Changing Landscape

Regulatory outlook and merits of CPI vs RPI indexation

• The merits of CPI vs RPI indexation is an area of discussion and contention for many regulators, issuers and investors alike. Some recent price control reviews

conducted by regulators has highlighted the gradual movement of indexation to CPI

• Ofgem and Ofwat used RPI in their recent price control decisions, however Ofwat recently signalled that it would be switching the underlying index used to calculate the

sector’s regulated asset value to CPI in PR19

• The Civil Aviation Authority (CAA) also elected to stick with RPI indexation in a recent price control review, however the decision was debated and is certainly a space

to watch

• Ofcom recently shifted all of its price controls to CPI indexation. Its assessment was as follows:

In considering whether we should propose RPI or CPI … we have found it useful to consider each under the following factors. We also consider that these factors are likely

to represent a useful framework for identifying whether, in particular circumstances, a departure from the default inflation index might be appropriate:

Official status of the index: is the index compiled by a recognised independent body?

Cost causality: to what extent do the costs of the regulated firm move with the index in question?

Exogeneity: is the index outside the control of the regulated firm?

Availability of independent forecasts: since charge controls are set over a period of a few years, typically three, are independent forecasts available

for that period?

Regulatory predictability: is the choice of index clearly reasoned?

• The Office for National Statistics has found that the “the formula used to produce RPI does not meet international standards”, and the formula has a “propensity to have

an upward bias”

• Another useful feature of CPI is that it forms the basis of the Bank of England’s official inflation target. While actual CPI will inevitably vary from the official target, the

Bank of England seeks to set monetary policy to achieve 2% p.a., so in the medium to longer term, we might expect to see CPI at or around 2% p.a.

• A recent paper by Norton Rose Fulbright : http://www.nortonrosefulbright.com/knowledge/publications/145265/pensions-briefing-rpi-and-cpi-10-things-you-should-know

highlighted how the legality of such switches is still under intense scrutiny “the ability of schemes to use CPI instead of RPI clearly depends upon the precise wording

of the rules and the respective powers of the principal employer and the trustees in making any necessary amendments.”

• In 2010 the Government switched from RPI to CPI as its preferred measure of inflation for pension purposes, and scheme trustees now have some discretion over

which index to use. Whilst schemes would prefer CPI as an indexation to reduce future payments, Hymans Robertson estimates that this move would take away

around £20,000 in benefits over an average DB scheme member‘s lifetime, thus causing a conflict between members, and those who administer the scheme

Forthcoming regulatory changes require issuers to move significant portion of debt to the CPI index

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NAO: Comparison of cost of debt returned by the Ofwat and ‘Ofgem counterfactual’ approach

Source: Ofgem Debt Indexation Model (2014), Ofwat final determinations (2004, 2009, 2014), Bank of England)

Notes: (1) The iBoxx index is composed of A and BBB rated non-financial sector bonds with maturity of 10 years or above. The average years to maturity of debt in the index is around 20 years; (2) The nominal

index has been deflated by forward inflation implied in 20 years gilt yields; (3) The varient of the Ofgem cost of debt approch used is similar to that used for distribution network operators for the energy regulator’s

2014 RIIO ED-1 price control. This approch uses a 10 years trailing average of the deflated iBoxx index, which extends by one year for each year of the price control until it reaches 20 years.

Debt index discussion – hindsight is a wonderful thing…

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Source: Despicable Me

Note: Investors question political acceptability of ‘automatic’ or ‘mechanical’ pass through of debt costs in a rising rate environment.

Debt Indexation: rates go up and customers are tied to a rising index…?

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Bond markets

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IBoxx GBP utilities yield history (%)

Source: RBS

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr 13 Apr 14 Apr 15 Apr 16 Apr 17

GBP 10Y Benchmark Utilities All in Yield

330bps

77bps223bps

After Brexit

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Gilt Yield Development

Source: Bloomberg

Gilt Yields – no one predicted this…

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0Y 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 20Y 25Y 30Y

Gilt

Yie

ld (

%)

UK Sovereign Curve 31 Mar 06 UK Sovereign Curve 15 Sept 08 UK Sovereign Curve 31 Mar 11 UK Sovereign Curve 31 Mar 16 UK Sovereign Curve 26 Apr 17

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Selected sterling Utility bond performance

Source: Bloomberg

60

80

100

120

140

160

180

Apr 11 Aug 11 Dec 11 Apr 12 Aug 12 Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14 Dec 14 Apr 15 Aug 15 Dec 15 Apr 16 Aug 16 Dec 16 Apr 17

Southern Water 6.64 Mar26 (Baa1/A-) Southern Water 6.192 Mar29 (Baa1/A-) Anglian Water 6.625 Jan29 (A3/A-)

Seven Trent 6.125 Feb24 (A3/BBB+) Seven Trent 6.25 Jun29 (A3/BBB+) Northumbrian water 5.625 Apr33 (NR/BBB+)

Wessex Water 5.75 Oct33 (A3/BBB+) United Utilities 5.625 Dec27 (A3/BBB+) Yorkshire Water 5.5 May37 (A2/AA)

Historic spread context

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Price: Utility comps have broadly moved together; difficult to see any

continued water advantage vs gas and electricity

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Selected sterling Utility bond performance

60

80

100

120

140

160

180

Apr 11 Aug 11 Dec 11 Apr 12 Aug 12 Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14 Dec 14 Apr 15 Aug 15 Dec 15 Apr 16 Aug 16 Dec 16 Apr 17

Southern Water 6.192 Mar 29 (Baa1/A-) Anglian Water 6.625 Jan 29 (A3/A-) Seven Trent 6.25 Jun 29 (A3/BBB+)

Northumbrian water 5.625 Apr 33 (NR/BBB+) Wessex Water 5.75 Oct 33 (A3/BBB+) United Utilities 5.625 Dec 27 (A3/BBB+)

Yorkshire Water 5.5 May 37 (A2/AA) Northern Gas 4.875 Nov35 (Baa1/BBB+) Scotland Gas 4.875 Dec34 (Baa1/BBB)

National Grid Gas 6 May38 (A3/A-) Wales & West 5.75 Mar30(NR/A-)

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