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Finance & Investment Market view Will markets lend a hand? The energy market needs access to vast funds for new infrastructure, but how favourable are the credit markets likely to be next year? Alan Capper investigates. T he investment challenges facing the UK's energy sector are well documented, with the government estimating that £110 billion is needed to upgrade the UK's ageing energy infrastructure. While the UK energy sector has traditionally been regarded as an attractive market for potential investors, continued questions about various parts of the Energy Bill and an unfavourable political landscape has caused uncertainty in the investment community. Two more factors that could direct investor appetite and shape the performance of credit bonds in the energy sector and other markets in 2014 are longevity and forward guidance. These are "known unknown" factors in that they are difficult to predict and plan for. However, the likelihood is that they will shape investment strategy. The Financial Stability Board (FSB) may widen the scope of its "too big to fail" definition to include investment and pension funds. This is an interesting development and we should know more by the end of the year. Although such a move would be designed to stabilise the financial system, it could inadvertently lead to a change in credit conditions due to the impact of longevity on pension schemes. Although investors are familiar with the trend of rising longevity, they may not have fully anticipated the magnitude of its impact on pension obligations and it may not have been fully factored into their valuations. Recent figures from the International Monetary Fund show that each year of increased life expectancy could add around 3-4 per cent to the liabilities of a defined benefit pension plan. With the size of the UK's pension plans currently standing at around £1 trillion, a 4 per cent increase would put significant pressure on fund managers to find appropriate assets. Historically, the credit market has been affected by systemic risks in other financial sectors such as insurance and banking, and as a result longevity has not been a key consideration. By broadening its "too big to fail" criteria, the FSB could highlight that other elements of the financial market could also 20 | 22nd - 28th November 2013 | UTILITY WEEK pose a systemic risk, which could have a a factor, central bank strategies to curb inflation growth might prove relatively sucknock-on effect across the whole market. The second "known unknown" that could cessful in what remains a weak economic influence credit strategy and investment con- environment. After a long period of volatility, 2014 is ditions next year is forward guidance. This is a tool used by central bankers to tweak mon- likely to mark the beginning of a more staetary policy to reduce long-term volatility ble period in the markets, characterised by and drive greater stability and transparency tighter spreads. Credit spreads measure the in the market. They could keep interest rates typical risk in the credit market and reflect very low for a specified period, possibly con- the return that an investor can earn from a security with more credit risk relative to one tingent on inflation remaining low. Although this initiative may not have with less credit risk. In a recession, spreads tend been especially successful in 2014 in to widen for high-yield and those countries where it was tried, investment-grade bonds to comthis could change as central bankpensate for default and other ers adjust their rhetoric and prorisks that could negatively affect vide more accurate guidance, which a company's ability to service its would bring greater stability to the debt. In contrast, spreads tend to financial markets next year. tighten in a favourable economic However, if we look at the period environment as corporate debt is from 2004 to 2007, it could be argued perceived as less risky, especially that stability in financial markets is when company profits are on an not necessarily a good thing. This After a long upward curve. three-year period was characterised period of Recent data suggest the UK's by low volatility, stable inflation and volatility, economy is heading in the right moderate growth, which created the delusion that these conditions 2014 is likely direction, aided by rising business confidence. Lloyds Bank's would last forever. During this time it to mark the Business Barometer, a monthly became difficult for investors to gen- beginning survey that measures sentiment erate returns. The stability of credit of a more and confidence across 300 busispreads and long-term rates led to a re-leveraging of the system, which stable period nesses, showed that firms started the fourth quarter on a strong led to the demise of the very stability footing and were buoyed by the economy that central bankers had strived to create. History is unlikely to repeat itself in 2014. and their own trading prospects. Early indications suggest this confidence The chastening economic conditions experienced in the past few years have made inves- will continue into next year as the economic tors wiser and we are unlikely to see growth recovery gathers momentum. This is likely to in the synthetic collateralised debt obliga- lead to tighter spreads in the UK credit market as investors become more comfortable tion market in the next few years. Investors will have to secure yield by with higher risk assets. Increased risk appetite and a broader some other mechanism. They are likely to go down the credit curve by extending maturity investment pool can lead to a reduction in the or buying higher beta products, resulting in cost of credit and make borrowing cheaper. spreads for riskier bonds becoming very low. Energy companies and utility providers lookIn this scenario demand for long-dated ing to raise capital in the forthcoming years corporate bonds rather than index-linked to fund new infrastructure projects are likely debt is likely to rise, leading to tighter to welcome this development. spreads and more pressure at the long end of Alan Capper, head of credit strategy, the credit curve. Although inflation remains Lloyds Bank