Inflation-linked borrowers feel the pain as ‘natural hedge’ stutters
Thames Water has become the highest profile example of a UK corporation that finds itself hamstrung by inflation-linked bonds issued at a time when persistent high inflation and economic stagnation seemed unlikely bedfellows.
For years, inflation-linked bonds have inhabited the outer reaches of the investment world, seen as safe – albeit boring – investments by virtue of how their principal and coupon payments are adjusted according to the movement of inflation indexes.
Such bonds enable corporations to access funds at favourable rates and have proved much more popular in the UK than other parts of Europe, perhaps in part because of the UK government’s own extensive use of inflation-linked debt.
For issuers, they are also supposed to be a natural hedge on the basis that higher inflation normally equates to higher revenues, so increased debt costs are offset by additional income. Borrowers using inflation-linked bonds would not typically expect to be paying high debt costs while simultaneously grappling with lower revenues from reduced demand.
Estimates place the value of outstanding UK corporate index-linked bonds at between £30 billion and £40 billion, most of which has been issued by utilities whose ability to raise prices is linked to inflation.