National Grid’s Inflation Linked Bond – Good Deal?

14th Sep '11 by Steven Dotsch

10 comments 16331 reads

National Grid (LON:NG.) is offering retail investors the opportunity to lend it money, by means of an inflation linked bond issue with a coupon linked to the UK retail price index (RPI). The 10-year bond will pay interest semi-annually at a 1.25 per cent annual gross rate of interest, adjusted to take account of changes in the level of the RPI. On maturity, the amount due to be paid to bond holders will be the full face value of the bonds adjusted to take account of any overall increase in the RPI. In the event that the RPI has fallen during the lifetime of the bond, investors will get the full face value.

The overall picture

Due to its regulated and indispensible business of transmitting power to regional energy distribution companies and consumers (in the USA), National Grid typically enjoys low borrowing costs and carries large amounts of debt to finance its operations. Obviously National Grid can’t control the interest rate environment, but they can structure their borrowings in such a way that they reduce their sensitivity to changes in rates. National Grid has proactively linked over half of its net debt to an inflation index, which has allowed them to borrow at lower rates. As regulators typically grant utilities higher rates of return in the face of higher inflation, it helps to offset rising interest payments if inflation does pick up. Overall, National Grid carries an investment-grade credit rating and pays out roughly 90% of its free cash flow in dividends. Utilities generally pay out at least 90% of their free cash flow as dividends.

Why is National Grid issuing index-linked bonds?

From National Grid's point of view issuing index-linked bonds make sense. The group operates in a tightly regulated environment with forward revenues linked to inflation. Thus, an index-linked source of funding for the company is a good match on an asset-liability basis. Traditionally, National Grid has issued inflation-linked bonds to major institutional investors. The issue for National Grid is that it not already has a lot of debt rather, due to the nature of its business, that it must have access to capital markets in order to fund its multi-decade long investment programme. National Grid has billions in debt coming due through fiscal year 2014. If interest rates were to rise sharply over the next few years, or if its credit rating is downgraded, National Grid…

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Peter Wall

15th Sep '11

WARNING: Coupon is NOT RPI + 1.25% so this is NOT suitable for those looking for high income. The capital value should keep pace with inflation plus you will get a modest, but rising, level of income.

Fangorn

Hmm I must've misread that. And am sure many will. Thanks for the heads up that it isn't RPI +1.25%

Think I'll pass therefore.

emptyend

Sigh. I remember sitting down with the Treasurer of National Grid some 20 years ago and trying to persuade him that he should be issuing index-linked bonds. At least they got there in the end....

Personally I'm very glad to see retail investors being targeted with corporate issues like this - it is something long overdue (and something I could never understand the clearers failing to organise - I could get no interest at HSBC 15 years ago for emulating the Swiss and offering bonds to retail through their branches)....

...but would I buy 10 year National Grid? Sure - but only if I was fully expecting to hold it to maturity as part of a mixed portfolio. National Grid really ought to be one of the most solid credits that a UK investor has access to.

This point, however, is rubbish:

Likewise, if the rate of inflation rises further, bond prices can be expected to fall. If inflation falls to zero, then you'll still get that 1.2 per cent, and the opportunity to sell at a profit.

If inflation rises the pice of an index-linked bond will rise. If inflation falls to zero then it is perfectly possible that the price of the index-linked bond will be below par - so you would be selling at a loss. Indeed this is quite likely, especially if the fall to zero were to happen soon - before there was much accrued "inflation adjustment".

Michael barton

19th Sep '11

I also misread the terms and conditions and assumed the return would be coupon (1.5%) plus inflation as defined in the terms and conditions. To avoid any mishap except default by N:G: an investor should be prepared to hold to maturity, 10 years. Then again, looking at the huge investment costs shortly to be needed by electric utilities and possibly also by some water utilities is it a good idea to invest in utilities at all?
The recent purchase by the Ontraio Teachers (Pension) Fund of a British water utility company is not the only investment in water utilities being made by O.T.F....thye are also buying in emerging markets eg Chile. and scanning other opportunities in water utilities.

Sorry, not 1.5% coupon but 1.25%, apologies-

billywoof

20th Sep '11

So if the coupon is not 1.25% + RPI, what is it???

NickFF

I'm not sure if the writer has read the prospectus correctly.

The coupon is 1.25% adjusted by RPI inflation, i.e. if RPI inflation is 5% the coupon will be initially 1.25% + 5% = approx. 1.31%.

The example in the National Grid prospectus gives the first bi-annual interest payment as £12.80 on an investment of £2000.

However if inflation stays at 5% coupon will steadily go up as inflation adjustment is always measure from the issue date:

"The interest amount due on each semi-annual payment date will be
adjusted to take into account the change in inflation between
the Base RPI figure relating to February 2011 (which is 8
months prior to the issue date of the bonds in October 2011)
and the RPI figure relating to the month 8 months prior to the
relevant coupon payment date"

kenobi

so why would anyone buy these bonds if they pay less than a deposit account ?

and presumably over the 10 years interest rates will go up, thus the bond value will fall, so the only way to recoup your investment is to hold for 10 years ?

Surely you're better off putting it in the bank or bs ? or buying other bonds, didn't disney offer a bond at 5% recently ?

I had assumed that they were prepared to pay rpi +1.25 because this was lower than other borrowing costs or expected to be over 10 years, I cannot see any attraction of this, can anyone explain who this might be attractive to ?

peterg

The minimum investment at issue amounts to £2,000. At maturity the final repayment will reflect the compound effects of inflation

I think the point is that the coupon is 1.25% index linked, but that the capital repayment after 10 years is initial + any increase in RPI over the 10 year period. So in effect the net return is going to be similar to a coupon of RPI + 1.25% (before discounting the timing of payments)

The return comes not only from the coupon payments but also the final redemption amount, which reflects inflation over the whole 10 year period.

I.e. if inflation rises at 5% every year for the 10 years you would get back approx. one-and-a-half times your deposit.

If there is zero inflation you get back your original deposit amount.

The benefit is that you are protecting the real value of your deposit against inflation, whatever it is.

So if you're retiring in 10 years the value of your savings won't be eroded.
I think I'll get some for my SIPP.

National Grid’s inflation linked bond – Good deal?

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Steven Dotsch

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