Persistent low real interest rates would negatively affect UK regulated utilities' fair value leverage, liquidity and interest cover, which could lead to companies needing to deleverage to maintain key financial metrics in line with their assigned rating, says Moody's Investors Service in two Special Comment reports on UK regulated utilities published today.
The reports cover Thames Water, Anglian Water, Yorkshire Water, Southern Water and Electricit
In the first special comment, "Low Real Interest Rates Reveal Risks of Funding Choices of UK Regulated Utilities", explores the company-specific implications of low real interest rates in terms of their impact on regulated utilities' market or fair-value capital structure.
The decline in market interest rates prior to May 2013 exposed the risks of funding decisions that some UK regulated utilities have made. These decisions will come under increased scrutiny if low real interest rates persist.
"In such a scenario, creditworthiness within the sector will diverge, because allowed regulatory returns will converge with market rates at a faster rate than some companies' embedded cost of debt," says Scott Phillips, a Moody's Vice President - Senior Analyst in Moody's Infrastructure Finance Group and co-author of both reports. "Leverage, when measured on a fair value basis, highlights that the market value of debt has almost eroded the equity buffer within some companies' capital structure."
The recent increase in bond yields since May 2013 has reduced high fair value leverage and is in line with Moody's Macro Board's forecasts for rates to rise to trend levels over time. However, the outlook for market interest rates remains uncertain. "Should yields fall once again, the resulting increase in the fair value of debt and derivatives would increase the financial risk for some highly leveraged companies," explains Mr. Phillips.
In the second report, entitled "UK Regulated Utilities: Cash Flow Vulnerable to Low Real Interest Rates", Moody's focuses on the negative sector-wide implications that arise from the combination of the UK regulatory framework and persistently low real interest rates.
The combination of low real interest rates and the UK regulatory framework has a potentially negative effect on companies' liquidity. This risk arises because regulated firms earn an allowed rate of return calculated in real prices but fund themselves predominantly through vanilla fixed-rate bonds that include an inflation component, leading to a mismatch.
"The significant decline in real interest rates in 2013 and will, over time, be reflected in a lower allowed return for regulated utilities," continues Mr. Phillips. "If low real interest rates return and persist, companies may need to deleverage to maintain key financial metrics in line with their assigned rating. A lower allowed rate of return will lead to a decline in operating cash flow generation and the adjusted interest cover ratio."