3.4.1 Appendix
Treatment of data reported in companies' accounts
Standard debt instruments that are not linked to inflation rates see their nominal face value evolve over time as a function of principal repayments only. Standard UK RPI-linked debt instruments typically require to index their principal to the retail price index or RPI. Interest payments can be fixed or floating and benchmarked to RPI (change in RPI + spread). The table below illustrates the difference.
Table: Cash flows of a traditional and inflation-linked bond | ||||||||
Traditional bond | Inflation-linked bond | |||||||
Nominal Principal | Real Principal | Nominal Interest | Real Interest | Nominal Principal | Real Principal | Nominal Interest | Real Interest | |
1 | 1,000.00 | 980.39 | 50.60 | 49.61 | 1,020.00 | 1,000.00 | 30.60 | 30.00 |
2 | 1,000.00 | 961.17 | 50.60 | 48.64 | 1,040.40 | 1,000.00 | 31.21 | 30.00 |
3 | 1,000.00 | 942.32 | 50.60 | 47.68 | 1,061.21 | 1,000.00 | 31.84 | 30.00 |
4 | 1,000.00 | 923.85 | 50.60 | 46.75 | 1,082.43 | 1,000.00 | 32.47 | 30.00 |
5 | 1,000.00 | 905.73 | 50.60 | 45.83 | 1,104.08 | 1,000.00 | 33.12 | 30.00 |
Adjustment of debt face value data
However, all face value data reported in audited accounts has also been adjusted to reflect its nominal face value as per the instrument indexation terms and reflecting a base date for indexation (which determines from when to start the adjustment), and the inflation rate window should be used (typically six months to eight months before the assessment date). Examination of the audited accounts of firms that also issue public RPI-linked debt confirms that infrastructure companies report the face value of index-linked debt to reflect this adjustment to a nominal value. This is also illustrated in the figure below.
Most of the data available for benchmarking infrastructure debt is not available in public markets, and thus, the data collected and aggregated in the EDHECinfra database of private debt instruments require some adjustments.
To allow direct comparisons with the cash flows of non-indexed debt, the future CFs of index-linked debt can be adjusted thus:
Use the adjusted face value as reported in the Accounts
Estimate principal repayments: based on the latest report on the valuation date, determine the future debt service of each instrument until maturity. Hence, the forecast debt service repayment is based on the adjusted face value.
Estimate interest payments using the implied inflation term structure for the UK (as published by the Bank of England) on every quarter date on each valuation date. Fixed interest instrument interest payments are adjusted for expected RPI until they mature, as is the case for floating instruments paying RPI+spread interest rate. The spreads are a known quantity in the EDHECinfra database.
Compute the adjusted debt service forecast adding both parts of the future cash flows, i.e., principal prepayments and interest payments, are estimated in “nominal” terms.
This treatment also allows for a direct comparison with non-inflation-linked debt, which later allows for mixing both types of debts on the balance sheet of a single borrower (for the purpose of modelling credit risk, for example).
Comparison of the outstanding principal factor in real and nominal terms
Comparison of real vs nominal outstanding principal factor of an amortising listed bond issued by a social infrastructure UK company, South Lanarkshire Schools. This is a senior bond issue of GBP352.5m that matures in 2038. “Real” principal is downloaded from Bloomberg, whereas “Nominal” is filed in the accounts.
Real vs Nominal outstanding principal factor