Retail Bonds: Severn Trent’s Case Study
Severn Trent is one of the UK’s 10 main water and waste water treatment companies. The company supplies customers in regions from Gloucestershire to the Humber and mid-Wales to Leicestershire, and is based in the West Midlands town of Coventry. Severn Trent also runs an international business, operating water plants and providing key equipment to the industry.
Figure 1: Overview of Severn Trent’s Operations
Source: Severn Trent
Severn Trent has a tradition of raising money from the bond market and recently renewed its bank facility. The company has net debt of over £4bn and a £500m annual capital expenditure programme to finance. So why did it decide to access the nascent retail bond market? Essentially the company was seeking to diversify its sources of funding and looking for a new class of investor.
The company has taken a very cautious approach to its finances throughout the credit crisis. Severn Trent has raised money ahead of its requirements and held several hundred million pound cash balances for the past four years. It is fair to say that the treasury team has concerns about the bank sector and its long-term ability to provide cost-effective funds for large businesses. Equally, the company sees the sterling bond markets as dominated by a small number of large institutions. Today financial institutions have sufficient capacity to invest in Severn Trent’s bonds, but who knows whether regulatory changes or their own portfolio constraints will eventually push up the cost and reduce access to this market.
Retail Bonds: An Opportunity
The retail bond market is seeking to access the savings of individuals and discretionary funds managed by private client brokers. These investors, who have funds in individual savings accounts (ISAs), private pensions and bank deposits, have seen returns slashed as interest rates and bond yields have fallen as a consequence of quantitative easing. Today, the real yields on gilts are negative, so inflation is eroding the value of savings. The denomination of bonds in the wholesale market of €100,000 or equivalent effectively closes the bond market to these investors. This also limits some other classes of investor, for example small charities, where their portfolios would not allow such large bonds to be held. It is estimated that these investors collectively have over £1 trillion of funds.
In common with other regulated utilities, Severn Trent’s business benefits from inflation-linked assets and annual price rises. The company seeks to have some of its debt in an index-linked format as this provides a natural hedge against its index-linked income. Already around 30% of the company’s debt is in an index-linked format. In accessing the retail bond market, Severn Trent chose to offer index-linked bonds as the rarity of this product, which provides a good defensive investment and capital protection, allowed it to obtain efficient pricing. There was also a wish to capitalise on being a well- known company with a large following of individual shareholders.
Timing and Strategy
The treasury team had been considering the retail market for some time and the decision to launch the transaction in June 2012 was, in part, determined by the need to incorporate some changes to Severn Trent’s medium-term note (MTN) programme to permit the £100 denominations needed for the retail market. The company already complied with the disclosure and reporting requirements for retail bonds, as Severn Trent is a UK-listed company and prepares accounts under International Accounting Standards (IAS). The team also had to prepare an offering document and press adverts.
Severn Trent appointed two banks, Barclays and Investec, to lead the transaction as both have teams that are experienced in the retail bond market.
Marketing of the issue was different from the company’s previous wholesale bonds. Severn Trent’s investor road show involved a week of meetings with potential investors in London, Edinburgh, Jersey and Birmingham, as well as holding calls with some others. The majority of these meetings were with fund managers or in-house analysts at private client stock broking and wealth management companies. Several of these brokers became named distributors and were responsible for selling the bonds on to investors, in return for a share of the deal commission.
On the launch date, the offering attracted considerable interest from the press and electronic media and the company worked with its corporate PR agency, Tulcan, to plan and manage the communications. Severn Trent’s finance director (FD), Mike McKeon, even appeared on the BBC lunchtime news.
The offer was open to subscribers for two weeks. This is a big difference to the wholesale market, where major companies such as Severn Trent can usually close the book within a morning. Orders came in steadily over the period, and ranged from a few thousand pounds to several million. In the end 50 different brokers and fund managers subscribed, although there will be many more individual investors represented.
Figure 2: Source of Orders and Outcome for Severn Trent’s Retail Bond:
Source: Severn Trent
Figure 3: Demand for Severn Trent’s Retail Bond over the Two-week Subscription Period
Source: Severn Trent
The company deliberately limited the size of the transaction, as its funding requirements were relatively modest. While another UK utility, electricity and gas company National Grid, had raised over £280m in 2011, Severn Trent targeted a range of £50m to £100m and was pleased to achieve £75m. This marks a difference from the wholesale market, where typical sterling issues are £250m to £400m, as this ensures that the bonds can be included in investment indexes. The objective was to open the market and establish Severn Trent’s name and as this market grows the company intends to become a regular issuer.
So where does the retail market go now? Bank deposit rates remain low and investors need to find secure places to improve their returns. As ISAs and defined contributions pensions grow more investors will chose to manage their own savings. The large sizes in the wholesale bond market, coupled with poor returns from the UK’s National Savings scheme and gilts, will encourage investors to look elsewhere.
From the corporate issuer perspective, banks can no longer provide cheap money as their own funding costs exceed those of well-rated companies. The retail market provides direct access to investors.
Severn Trent’s objective was to open the market and establish its name. A new class of investor, who is hungry for investments that give a return at low risk, has developed. As this market grows the company intends to become a regular issuer and sees this as becoming a useful source of future funding.