JP’s Journal: Dirty water

The University Boat race, dating back to 1829, is a strange sporting event. Competed by the same two universities each year, with crews now drawn from all over the world, it attracts large crowds to the banks of the River Thames in southwest London.

The light blue of Cambridge came out on top in both the men’s and women’s event, with the men completing the 6.8km race in just under nineteen minutes. As someone who struggles to complete 2,000 metres on a rowing machine in nine minutes, the physical effort on display in the race is amazing.

The run up to the race was overshadowed by concern about the quality of the water, with E.coli being detected in the Thames. Indeed, water quality, generally, has been in the news with concern raised about bathing water quality and sewage being discharged into rivers at times of heavy rainfall. Water privatisation has become unpopular, with shareholders deemed guilty of asset stripping, under investment and unjustified dividend distributions. Thames Water has become a symbol of what is bad about Water.  

Last week the shareholders of Thames communicated that, following dialogue with OFWAT (the water sector regulator) they were not prepared to commit fresh equity to Kemble, the Thames Water holding company, as they deemed that the permitted return on further investment was uneconomic. With £18bn of capital spending required in the medium term there appear to be three choices: OFWAT to permit a higher economic return and thereby access to new equity, which means higher water bills for Thames customers; a nationalisation of Thames that takes the burden off Thames customers but passes it on to the general taxpayer; or a drastic scaling back of investment plans. None of these outcomes are appealing. Can a nationalisation lead to better expenditure? The history of UK infrastructure spending is not encouraging. The Thames Super Sewer has come in over budget but looks a better outcome than what we’ve seen from government around HS2; it looks like the Super Sewer will cost the same as just the rebuild of Euston station. Under state ownership, hard choices would need to be made: is it fewer leakages and better river quality, or more hospitals and schools? These were exactly the same choices that drove privatisation in 1989.

The bonds of Kemble have fallen sharply in value in recent months, as the financial strains have become more apparent. Some of our portfolios have exposure to the issuer, as well as to bonds of Thames Water, the operating company. The spreads on the latter have widened, to 310bps over government bond yields, as the news flow has deteriorated and is a good indicator of the cost of capital that the business now faces. The dilemma is that debt finance is such a key component of future infrastructure expenditure that a failure to recognise the true cost of finance will make business models unviable. It can be argued that this is the utility sector’s own fault, taking on too much debt, but this does not address the problem. Where do we go from here? Equity injections to delever the company will only occur if economic returns on equity can be achieved. We have always recognised our exposure to Kemble debt as a riskier investment, and it forms part of our diversified approach. Even with the headwind of Thames, our sterling strategies are ahead of benchmarks this year. 

Last week bond markets were becalmed ahead of the Easter holidays. Yields on 10-year US treasuries hovered around 4.2%, although they moved higher after the break, reflecting a stronger-than-expected ISM (Institute for Supply Management) manufacturing reading. The index increased in March and signalled an expansion for the first time since September 2022 with the new order and employment subcomponents consistent with sustained growth in manufacturing output. The ‘prices paid’ index was also strong, rising to a 20-month high; this was mainly due to higher oil prices, rather than core inflationary pressures, but will be a concern to the Federal Reserve. The supply disruption that will arise from the bridge collapse in Baltimore, one of America’s busiest ports, has still to play through and will be another factor for rate setters to consider. In the euro area German yields moved a touch lower whilst the UK 10-year was unchanged, remaining below 4%. Credit markets followed a similar pattern, with little activity and movement in spreads.

A survey last week indicated the near certainty that Labour will be the largest party following the next general election in the UK. The financing of future spending plans will be a major concern for an incoming government. A private sector solution in the water sector, even if unpopular with Thames customers, may be deemed a better outcome than the State taking on more debt and the bad press that may follow when there is no quick fix.  

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.