In common with other water companies and UK infrastructure such as Heathrow, there’s a whole business securitisation in place, ring-fencing the main operating assets and those that sit within the regulatory perimeter. 

“Whole business securitisation” is actually a bit of a misnomer; from a regulatory perspective these are not securitised bonds at all, but secured corporate bonds issued from an opco. The stream of cashflows is not from a series of income producing financial assets, but from the whole regulated business of Thames Water, monopoly water utility for north of 10m customers in London and the south east of England.

WBS of this kind is pretty much unique to the UK, because it relies on creditor-friendly UK law. Per Fitch: 

“The key protective feature in UK WBS is the ability for the security trustee, on behalf of the secured creditors, to appoint an administrative receiver upon borrower event of default, or an insolvency of the borrowing company. This allows bondholders to take control of the operating assets and allows the operating company to trade through insolvency, as a going concern. This mechanism is made possible in part by the issuer/borrower structure of UK WBS, which allows for enforcement of security at the borrower level without note acceleration. Therefore, breaches of these covenants do not necessarily constitute payment default of the rated notes.”

We will come back to the WBS — there’s a lot of rather hyperbolic commentary around about Thames Water’s £14bn debt stack, and the HUGE bailouts required — but the key point, for the high yield bonds, is that they’re very much on the outside.

9fin’s Org Chart, drawn from the bond offering documents, is slightly simplified, but gets the point across well enough. Thames Water Utilities Holdings is the top of the WBS, above that is Thames Water Limited, and above thatare the Kemble entities.

So the ability to pay the Kemble bonds relies on continued dividend payments out of the WBS. There’s some cash locked away outside the WBS structure to cover 18 months of interest payments, but actual repayment and longer term debt service needs dividends.

This hasn’t been seen as a huge problem — hence the bonds bopping along at a spread-to-worst of 5-6% for most of last year and this year — but there were distinct signs of trouble around the corner. 

Earlier this year, Ofwat, the water regulator, introduced regulatory changes which looked set to tighten dividend capacity out of the regulated entity. The minimum corporate rating for dividends was to be increased from BBB- to BBB and without any negative outlook (it’s currently Baa2/BBB) from 2025, but the more immediate issue was a promise “that dividends declared or paid take account of service delivery for customers and the environment over time”, introduced in May.

This might seem a little late in the day, given the spate of sewage leaks in UK waters over the last years, but nonetheless it represents a financial threat to Kemble, with the regulator cautioning:

“It is not sufficient for companies to justify or scale their dividend payments on the basis that a holding company in the group needs to meet specified interest costs or other holding company obligations. Dividend decisions are the responsibility of the board of the regulated business. These decisions should be made independently of the group, and justified on the performance or financing needs of the regulated company. We do not consider it appropriate for dividends to be justified on the basis of group obligations. Companies whose holding companies have intercompany loan or group loan obligations to fulfil should reasonably expect that the group structure builds in sufficient resilience and flexibility to manage holding company liabilities in periods when the regulated company is unable to justify dividend payments or if dividend payments are insufficient to meet those obligations”.

In other words, HY investors, you’re on your own.

WBS structures have several covenants which can trap cash, including interest cover, and an modified LTV concept looking at the “Regulatory Capital Value” vs debt. Thames Water had limited headroom on this measure anyway, with gearing above 80%, and a class A covenant at 70% restricting additional debt incurrence. However, it remains compliant with its overall WBS covenants, with an event of default covenant set a 95%.

Which inflation?

Thames Water and other UK utilities have been further squeezed by another regulatory decision, back in 2020, which transitioned between inflation measures. When the water companies set up their WBS structures, they billed customers according to an RPI-linked formula, their asset values were calculated according to an RPI-linked formula, and they issued mainly RPI-linked debt, or nominal bonds swapped to RPI-linked.

From 2020, customer bills were linked to CPI, asset values were partly linked to CPI — but debt issuance remained mostly RPI-indexed. As RPI has surged ahead of CPI this year and last year, the water companies are squeezed.

Effectively, they’re earning CPI and paying out RPI, just as these diverged sharply, and they’re doing so at a very high leverage point. This is…not great for cashflows!

But all of this was pretty much known ahead of this week. Thames Water had a widely disclosed plan to inject a further billion of shareholder equity to get its ratios down to more attractive levels, and it had always found a way to service holdco debt in the past.

What changed this week was that the equity injection seems to have fallen into doubt — prompting the “contingency plan” from the government for nationalisation, and the plummeting HY bonds.

What could the government do?

If nationalisation does happen, what does it look like? 

In the WBS bond documents, there are two changes of control. If there is a change of control in Thames Water Utilities Limited (the WBS), this constitutes an event of default, and gives bondholders the right to take over and run the company (subject to votes, cure periods etc).

If, however, there is a change of control in Thames Water Holdings, an entity outside the WBS, the requirement is only to notify WBS bondholders. Crucially, this entity is below the Kemble entities where the HY bonds sit; if the government came in at this level, it could leave the WBS and operating company untouched, while burning equity and HY bonds alike.

There’s a further twist to consider as well — as I wrote in 2019, Thames Water issued some private placement notes with a nationalisation clause in place (Bloomberg also recently highlighted the clause).

These quite chunky, at £560m, and were issued from Kemble Water Finance plc, an entity outside the WBS, above Thames Water Holdings and Thames Water Limited, but a guarantor of the HY bond entity.

The nationalisation clause grants a put option in the event of nationalisation of any part of the group (so including at the Thames Water level). So if the government were to step in and take over Thames Water at the Thames Water Limited level, this would trigger the put.

That makes this even bleaker for the Kemble bondholders — not only would they be cut off from any dividends coming out in the future, but £560m of private placement notes would have temporal seniority and a claim on any cash and assets that were outside the group (there’s a bit of property too). 

Reports from Sky News suggest that ministers are looking at using the Special Administration Regime to take over the firm. According to the regulator, this can only be used when a company:

“fails to meet its legal obligations and does not or cannot take remedial action; or is unable to finance its functions due to, for example, poor decisions by its management, significant unexpected changes to its costs (a ‘cost shock’) or an inability to raise or refinance its capital as required.”

Thames Water has around £1.8bn of Class A and B debt within the WBS maturing in 2023 and 2024, and around £1.3bn of undrawn liquidity. The Class B bonds fell by around three-points yesterday and the Class A issues widened by 30-60 bps, according to a note from JPMorgan. 

If you believe the nationalisation narrative, time to flush this one.