Thames Water: Government must deploy the life raft

Back in April we looked in detail at the challenges and potential outcomes facing Thames Water, the debt-laden UK utility company battling to avoid government intervention.

On the back of a lacklustre set of financial results and being placed into a “turnaround oversight regime” by the regulator Ofwat, Thames Water’s situation took a further turn for the worse last week as S&P placed its investment grade BBB- rating on negative watch, raising the prospect of some £7bn of the company’s bonds entering the high yield market.  

What are the options for Thames Water now?

Thames Water's results published July 9 offered investors no reassurance. While EBITDA rose by 21% and revenues increased by 10% (driven by inflation-linked earnings), these positives were overshadowed by a 9.2% increase in net debt to £15.3bn and a rise in leverage to 80.5%. The primary concern for the market was the company's liquidity, which at £1.81bn as of June 30 is projected to last only 11 months. This liquidity position highlights Thames’ inability to secure additional funding and underscores a more urgent need to address its balance sheet.

Ofwat’s draft determination – the process by which the regulator sets customer bills, company spending plans and their allowed returns for the next regulatory period which runs from 2025-30 – also offered little respite when it was published last week. Ofwat proposed a 3.72% allowed rate of return, almost exactly in line with analyst expectations of 3.71% but short of Thames Water's requested 4.25%. The regulator also proposed a 23% real increase in customer bills versus the Thames request of 44%, and £16.9bn of total expenditure for 2025-30 versus Thames' requested £22bn.

In addition, Ofwat deemed Thames’ business plan inadequate and stated that if it does not improve its plan enough ahead of its final decisions (in December) it will apply a financial penalty of £141m. Thames has also been placed in Ofwat’s “turnaround oversight regime”, which involves more oversight of expenditure and requires Thames to re-evaluate its plans for transformation and provide a financial resilience plan in response to the draft determination.

In our view, the draft determination was broadly okay for Thames – the allowed returns are not unreasonable and the pushback on customer bill increases was expected. It is possible Ofwat will ease its stance come its final determination, particularly if Thames can address some of its concerns, but given how far apart the proposals were on the key metrics, this is clearly an uphill battle for the company.

However, the threat of a downgrade from S&P is a far bigger blow for Thames Water. The rating agency’s concerns are driven by the company’s precarious liquidity position, which it wants to see addressed in the “coming weeks” or Thames faces a downgrade to a sub-investment grade (or high yield) rating of BB+.

Can Thames stay investment grade?

Thames needs to address S&P’s concerns imminently, but shoring up liquidity to hold on to its investment grade rating appears a near impossible task.

The bond market is certainly closed for Thames, and Ofwat’s somewhat neutral draft determination is unlikely to have changed the current shareholders’ stated view that the business is “uninvestable”.

The recent news will also do little to encourage new investors into the business. With the company facing downgrade and potential restructuring, any new investors will be waiting on the sidelines for now, until the inevitable restructuring has happened and the companies swelling debt balance has been addressed.

Government and regulator need reality check

It’s worth noting that having one or more of its ratings below BBB- would result in a breach of Thames Water's license conditions. In light of the update from S&P this now appears likely, and may be the trigger the government and the regulator are looking for to place Thames into their Special Administration Regime (SAR). However, the “turnaround oversight regime” looks like an attempt to avoid SAR to give both parties more time before more aggressive action.

For the government and the regulator there does need to be a reality check, in our view. Neither are innocent in the situation Thames find themselves in (Labour will blame the Conservatives) and it may finally be time to stop kicking the can down the road. It is clear there is nothing Thames can do to encourage essential new investors into the business, and ultimately the only solution is restructuring under SAR.

In that scenario the government would take temporary control and restructure the company, likely imposing 20-25% haircuts on the Class A bonds (the Class Bs and Kemble bonds would be zeroed) in the process, and then look to find a private buyer. With leverage of 55-60% the company would be a more attractive proposition for new owners, giving them scope to add leverage to address the operational issues of the company. UK utilities have been and are an attractive investment proposition for infrastructure funds in particular. While Thames is plagued with problems, we think in a less levered form it will be able to attract fresh capital.

How has the market reacted?

The news from S&P and Thames’ inability to address its concerns had the most significant impact on market prices last week, notably increasing the likelihood and speeding up the timeline towards special administration. This has been most evident in Thames’ short dated bonds, which trade with a higher cash price. Its June 2025 Class A bonds have dropped to a cash price around 80 having traded around 90 at the start of last week. Given analyst expectations for haircuts range from 20-25%, markets are now pricing in a 100% probability of a 20% haircut or an 80% probability of a 25% haircut. At the longer end, Thames’ 10-year bonds are trading around 80bp wider or 5 points lower in cash terms. These bonds already trade at much lower cash prices, with the changing outlook on haircuts having less impact on the present value of longer dated cashflows.

What does a high yield rating mean for bond investors?

Thames has been a problem for investment grade investors for some time. A lot of Thames bonds will have already changed hands, so some will already sit in high yield accounts and the hedge fund community has also been active in the name. What remains unknown is how much remains in investment grade portfolios, and whether these accounts will be forced sellers in the event of a downgrade.

Thames' large capital structure is a lot for the sterling high yield market to digest. If downgraded, Thames would become the largest single name in the index, representing 12% – a very meaningful amount to be absorbed especially with the anticipated hedge fund community exit once volatility dies down.

In our previous blog we highlighted our concerns around contagion across the sector and more broadly across UK utilities. These concerns remain valid, especially with investment grade investors potentially facing haircuts in a fully regulated UK utility company, which reflects poorly on Thames and the broader UK utility sector.

However, we remain optimistic that the market will view this as an isolated incident – using a downgrade to high yield as the trigger for haircuts makes for a clear separation from fundamentally sound utilities. We hope the UK government handles this situation in the most effective manner possible without hampering the overall investment case for UK plc.