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Announcement:

Moody's: Index-linked swaps may create risks for UK regulated utilities

02 Feb 2012

London, 02 February 2012 -- A number of the UK regulated utilities -- whose revenues and cash flows are typically linked to the rate of inflation -- are increasingly taking advantage of index-linked swaps to align their borrowing costs with their inflation-linked revenue stream. However, while using such derivative products can provide benefits, they also come with their own risks attached and can potentially mask underlying issues in a company's financial structure, says Moody's Investors Service in a new Special Comment published today.

UK regulated utilities have in the past issued significant amounts of index-linked debt. However, Moody's notes that prevailing market conditions over recent years have made it harder for them to do so. As a result many have reverted to borrowing at a fixed rate and enter into a derivative transaction to swap their fixed-rate exposure into one linked to inflation.

Moody's cautions that increasingly prevalent characteristics of these swaps, such as break clauses or the requirements to pay down indexation accretion ahead of maturity, mean that these instruments may only provide a short-term cash-flow benefit.

Moreover, the use of index-linked swaps may create additional risks in relation to market or counterparty exposure, which can materially affect a company's liquidity position.

Index-linked swaps may also affect the recovery prospects of other creditors, particularly in highly leveraged transactions, as payments under the index-linked swaps often rank ahead of other senior creditors' claims in a default scenario.

Limited public disclosure of companies' swap exposures and the terms thereof may lead Moody's to assume that any swaps entered into by the company do not provide similar cash flow benefits as index-linked bonds, for ratings purposes.

Moody's will continue to request information from issuers as necessary to monitor derivative transactions. The rating agency will review ratings as appropriate in light of (i) historical and projected interest coverage ratios, relative to Moody's guidance and calculated excluding the benefit of instruments that are not viewed as providing long-term cash flow benefit; (ii) the perceived impact of hedging instruments on any structural features incorporated within the overall financing arrangements; (iii) potential counterparty exposure and liquidity risk; and (iv) any rating triggers, or similar terms, that are considered to pose a risk to the issuer's credit standing.

Any potential rating impact resulting from the use of index-linked swaps (or any other swaps that pose similar risks) will depend on the materiality, i.e. the size of the notional amount of swaps relative to a company's total debt and/or regulated asset base. In addition, where a company generally shows comfortable headroom for its financial metrics at the given rating level, the use of derivative instruments may not significantly affect its credit quality.

The rating agency notes that any potential rating impact is likely to be greatest for highly leveraged companies, given their wider use of these swaps, their more limited financial flexibility and the fact that ratings may currently include some level of uplift due to credit-enhancing features, which could be significantly weakened by the use of index-linked swaps.

Moody's report, entitled "UK Regulated Utilities: Why Index-linked Swaps May Not Provide the Same Cash Flow Benefit as Index-linked Bonds", is available on www.moodys.com.

NOTE TO JOURNALISTS ONLY: For more information, please call one of our global press information hotlines: London +44-20-7772-5456, New York +1-212-553-0376, Tokyo +813-5408-4110, Hong Kong +852-3758-1350, Sydney +61-2-9270-8141, Mexico City 001-888-779-5833, São Paulo 0800-891-2518, or Buenos Aires 0800-666-3506. You can also email us at mediarelations@moodys.com or visit our web site at www.moodys.com.

Stefanie Voelz
Asst Vice President - Analyst
Infrastructure Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Neil Griffiths-Lambeth
VP - Senior Credit Officer
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's: Index-linked swaps may create risks for UK regulated utilities
No Related Data.
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