Index-linked swaps can pose risks to U.K. water companies' liquidity profiles and may ultimately impair creditors' recovery prospects, says Moody's Investors Service in a new Special Comment.
These derivative instruments may introduce market risk to a regulated utility that has little market exposure in its fundamental business, a risk that the company may not be able to adequately manage and/or mitigate.
"The financial crisis has shown that companies and their advisors can be innovative in designing new elements of funding, such as index-linked swaps," says Stefanie Voelz, an assistant vice president -- analyst in Moody's Infrastructure Finance Group and co-author of the report. "In contrast to the very limited room for manoeuvre that well-designed project financings with amortizing debt structures leave to single-asset projects, the highly-leveraged structures in the water sector need to allow a degree of financial flexibility to these corporate utilities that continuously need to refinance their debt.
"This flexibility and the continuing evolution of the companies and the market in which they operate can lead to new risks being faced and structural features not providing the degree of protection that was originally intended."
The report focuses on the U.K. water companies but the issues discussed in relation to potential additional credit risk posed by index-linked swaps also apply to other regulated utilities that use these instruments.