The worsening situation of these companies is down to their reckless use of index-linked bonds to finance their borrowing. Index-linked bonds guarantee that people lending to a company will get their money back having allowed for the impact of inflation when it is repaid.
The interest rate these bonds pay is usually quite low but people who buy them don’t do so for the interest. They buy them because these bonds guarantee repayment of the original sum lent as adjusted for inflation, meaning that the value of the bond does not fall in real terms.
Let me offer a quick example. Suppose a bond is issued for £1 million with a 1% interest rate, and it is index linked. Assume inflation was nothing for 5 years. In those years the interest was £10,000 a year.
Then, though, inflation hits 10% all of a sudden. Now the cost of repaying the loan goes up by £100,000 in the year that happens. And interest is now paid on £1.1 million, the new repayment sum owing. So that year’s interest costs £111,000. That’s a massive increase.
If the inflation continues for a second year you can see how this might ruin the profitability of a company. If it moves into a third – as now seems possible in the UK – it could mean the end for a vulnerable company with a lot of these bonds.
When the Treasury accounts for interest on inflation linked gilts in exactly this manner then they’re wrong according to Spud. But the truth is always subject to the narrative, isn’t it?
And even better:
So, the only cash cost to be paid is the cost of the interest on the new bonds issued to replace the bonds and share capital now in issue. Let’s assume the total compensation package is £60 billion in a couple of years, by which time base interest rates will have fallen a lot.
Let’s say the borrowing cost will be 4%. That’s a cost of £2.4 billion per annum when the average interest and dividends paid by the companies over the last amount to £3.4bn a year. Even if £90bn compensation was paid (and that would be crazy, in my view) the cost would be £3.6bn.
In other words, this industry can pay for its own nationalisation out of its own cash flow.
If the cash flow covers the capital costs then it’s not insolvent and requiring nationalisation, is it?
Isn’t that leveraged buyout? Using the money of the company you’re buying to buy the company. Buying a box of gold using the gold inside the box. Surely those of the Spud school loath this sort of thing.
Among Murphy’s followers, the ability of the free cash flow of the seized asset to cover the interest and redemption costs of the gilts issued to “compensate” for the “nationalisation” (theft) of the asset is an argument *in favour* of nationalisation. The taxes raised to “pay for” the nationalisation can be diverted to their pet projects (such as paying them large salaries for doing nothing).
IIRC the reason the water companies were privatised was because there had been no investment by the government for decades and no desire to catch up.
The reason being that any requirements have to compete with other demands (new reservoir or new hospital? New treatment plant or new school?) and water always ended up at the back of the queue.
If we could somehow fast forward through 10 years of the UK being run along the lines that Spud demands, it would be worth it just to see his decaying corpse hanging from a lamp post.
@ jgh
No – “leveraged buyout” is borrowing large amounts of money to buy a business from controlling shareholders (usually by the business’ management) instead of providing all of the purchase price from their own pockets. The claim is usually that the company’s management can run it better without the dead hand of controlling shareholder and the burden of central overheads – sometimes that is even true!
Using the money of the company that you are buying to pay for that company is technically illegal so the practice doesn’t have a standard name.
“Asset stripping” involves buying a company with assets that are worth more than the share price and selling them to more than recoup the purchase price, pocketing the difference and not worrying too much what happens to the company thereafter – is that what you were thinking about?
@ AndrewC
The water companies were mostly owned by local governments (there were a handful of shareholder-owned companies which had legally-imposed upper limits on the dividends that they might pay – Cambridge Water is an interesting example as most of its shares are owned by some of its larger customers who can take multi-century views on investment so it hasn’t been taken over), not by central government. There had been one major investment in the previous decade, the Kielder reservoir built by Nortumbrian Water to meet demand from industry in the north-east which was growing in the Thatcher years.
Apart from those two details you are right.
The water companies were mostly owned by local governments (there were a handful of shareholder-owned companies which had legally-imposed upper limits on the dividends that they might pay –
I’d say you were correct on that. I can remember there were a lot of debenture issues & I believe some preference shares knocking about for all sorts of obscure companies. It was a section of the Official List where nothing ever happened. Odd holdings turned up in the inherited portfolios of little old ladies. Some pretty certificates, though.
IIRC correctly, water bills are linked to RPI.
What a load of bunk on the calculation. Index linked bonds reprice the principal to be paid. So £1m @10% inflation = £1.1m so the coupons go up by 10%. That’s expensive so these are generally only issued by firms with index linked revenue. If they’ve not sold that to banks as sellers of floating RPI.
Nationalising the utilities would have huge knock on effects for banks who’ve repacked the counterparty risk to investors like us.
Crazy times.
Could Mr potato clarify whether
A) the principal goes up by inflation and is paid out at the end (first para).
Or
B) the effect of inflation is paid out as it occurs (worked example).
Aside from that the UK water companies have invested close on £200bn since privatisation, and probably need to invest another £100bn. I’m not convinced much of that would have happened as nationalised industries, certainly Wales and Scotland don’t provide shining examples.
For a reminder Wales has 7 of the top 10 polluting regions, Scotlands data is not published. And Surfers Against Sewage was set up because of turds toilet paper and tampons, not bacterial trace.
Using the money of the company that you are buying to pay for that company is technically illegal so the practice doesn’t have a standard name.
“Asset stripping” involves buying a company with assets that are worth more than the share price and selling them to more than recoup the purchase price…is that what you were thinking about?
Googling the gold box analogy, I think I was thinking of the TSB quasi-demutualisation where the TSB bought itself using its own cash raised by floating itself.
@Swamnypol. Linked bonds increase the principle. The coupon rate remains the same and the coupons go up proportionally with the discount increased principal. It’s multi year inflation where the debt burden really starts to bite.
Needless to say there are huge variations in the market and one needs to read the small print terms to model out the inflation impacts. Mistakes are often made on both debtor and creditor sides. Let me leave it at that….
@ jgh
The TSB was demutualised by order of the government and the civil srvants involved only realised after they had set the whole thing in motion that the government did not own TSB but that it was a mutual, so the government didn’t get any money out of it. All TSB account-holders were allotted shares in echange for the rights as co-owners and some additional money was raised from selling new shares to the public. [I have reason to remember this as my mother-in-law was a TSB account-holder and she asked my advice.]
I haven’t read Google’s story so I shan’t comment on it.
“All TSB account-holders were allotted shares in echange for the rights as co-owners”
We were not.
@ Sam Duncan
All those who qualified as long-term holders of TSB accounts – yeah, I ashould have written two or paragraphs but (I thought that) I only needed to make the point that TSB was a demutualisation and that it was not bought with its own money.
Yeah, I’d only had an account for the best part of twenty years, opened back when it was still the Glasgow Savings Bank, so I suppose I didn’t count. The whole thing was a farce. Maybe not quite so much of a farce as “buying itself with its own money”, but still a farce.
Spud has obviously forgotten just how shit (literally) our beaches and waterways were in the 1980s.
We had less than 20 beaches that met safety standards. Today we have around 625.
Have the current water companies cocked up their finances? Seems so. Could they do better? Of course. But any idea that things would be better if they were run by the government is ludicrous.
@ Sam Duncan
No idea. Scottish TSB was different but I cannot remember what was different about it because I didn’t need to know. Scottish Law differs from English Law, so the rights of account-holders were different.
I was talking about TSB, not Scottish TSB
Yes, one of my earliest memories of finance news was TV reports about the government trying to insist that they should get the money from floating TSB, and TSB and the courts saying Don’t have a larf. It triggered my interest as I had a kiddie’s account, with the nice blue plasticy paying-in book.