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03 Feb 2025
4 min read

Research and Active Engagement: Surveying the UK water sector

2024 was not a banner year for British water providers. Could a new package from the regulator allow the sector to move on?

Water UK

This article is an extract from our Q1 2025 Active Fixed Income outlook.

This quarter, we’re considering the impact of regulatory changes on the UK’s water sector, which experienced several challenges over the course of 2024. Overall, we are constructive on the sector – barring the weakest names.

The past: what just happened?

On 19 December, UK water regulator Ofwat published its long-awaited Final Determinations (FD) for tariffs for the five years from April 2025. The draft version released in July had been considered very tough and prompted a sell-off in UK water bonds.

The FD is a very complex set of documents and will take time for industry and the markets to digest. But looking at the headlines, there have been significant improvements over the draft version and we think the improvements overall have exceeded market expectations. For some of the weaker companies, though, the improvements left big gaps remaining versus the companies’ requests.

The present: tightening spreads

Overall, UK water bonds performed well on the FD announcement, tightening significantly, although they are yet to retrace fully the moves wider we saw early last year. Southern Water unwrapped bonds also performed relatively well, although the issuer remains on a knife-edge, just about clinging onto investment grade composite ratings.

What could go wrong?

In spite of the large improvements from the regulator, it’s not clear how the rating agencies will react. Both S&P and Fitch have indicated they could revise the water sector’s business risk assessments after the FDs. The size of the movement from Ofwat may well be enough to avoid such a revision from the agencies, reducing the scale of rating actions in the sector, but it’s difficult to be confident.

Among the weaker names, Southern Water and Thames Water each could consider referring their FDs to the Competition and Markets Authority (CMA). This could delay resolution towards the end of 2025, disappointing markets, and in the case of Southern Water it could trigger a downgrade to high yield.

Outlook

We’re expecting companies to consider their FDs and decide whether to accept them or refer them to the CMA by mid-February. We may see measures from companies following this decision to offset any rating pressure, and then we expect the agencies to conclude rating reviews. For companies that appeal to the CMA, this process could last for between six and 12 months.

Other than for the weakest companies, we are constructive on the outlook for UK water spreads as we believe the improvement will mostly be sufficient for the companies to move on. While we anticipate plenty of issuance, we think spreads can compress further as rating reviews are completed and the companies move onto delivering investment and improved operating performance.

The outlook for the weakest companies is less clear. It remains a difficult call whether Southern Water will now receive unconditional support from its main shareholder Macquarie Asset Management; in the meantime, we think holders of the unwrapped bonds are in a precarious position. Thames Water is already heading for restructuring, but a better FD might have reduced the chance of a CMA referral, enabling a quicker resolution. Again, it’s difficult to say confidently which way it will go, but, in the case of Thames Water bonds, the good news is that forced selling appears mostly to be behind them and it is now mainly a valuation argument and a question of timeline to resolution.

Read our full Q1 2025 Active Fixed Income outlook.

 

For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, and the investor may get back less than the original amount invested. Assumptions, opinions, and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.

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Jonathan Constable

Senior Credit Analyst

Jonathan joined LGIM as a senior credit analyst in October 2013 with lead responsibility for the utilities sector. Jonathan spent nearly five years as an…

More about Jonathan

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