The company put the inflation-linked swaps in place in 2008 when its parent Kelda Group was taken over by a consortium of international investors.
But the subsequent fall in interest rates in response to the global financial crisis led to a collapse in the market value of the portfolio.
As of March 2014, it would have cost the company £1.5bn to terminate the swaps. Moody’s estimates that this cost has risen to nearly £2bn by December.
In a new report, the agency said Yorkshire Water’s credit quality continues to be pressured by the sizeable portfolio and the deterioration in its mark-to-market value.
This is significant because water companies need to raise debt from financial markets to invest in services and infrastructure and then recover costs from users through bills.
Moody’s noted that the industry regulator largely approved Yorkshire Water’s plan for charging customers and praised the company’s solid track record in operational performance and prudent approach to financial policy.
“We believe that these positive aspects are not sufficient to fully offset the risk embedded within the company’s derivatives portfolio, particularly considering the very long tenor to a number of the inflation-linked swaps,” said Stefanie Voelz, a senior analyst at Moody’s Infrastructure Finance Group and author of the report.
Moody’s said the high rates locked in by Yorkshire Water over an extended period of time puts the company at a disadvantage in relation to its average funding costs when compared with its peers in the UK water sector.
While an increase in interest rates could reduce the negative value of the portfolio, the structure of the swaps means its value will remain highly sensitive to interest rate fluctuations, added the report.
Some of the swaps have maturities ranging into the 2050s-60s.
A spokesman for Yorkshire Water said the company would not comment on Moody’s downgrading.
A statement said: “Yorkshire Water is currently reporting best ever levels of performance and has robust investment plans in place to deliver further service and environmental improvements over the period 2015 to 2020.
“Following a lengthy, in-depth and challenging price review process, our economic regulator Ofwat has just given us the green light to invest an additional £3.8bn in the Yorkshire region over the next five years.
“This will deliver better quality drinking water, cleaner rivers and higher standards of customer service, ensuring we take a significant step forward towards achieving our existing 25-year business objectives.”
The Kelda Group is owned by a consortium of investors comprising Deutsche Bank, Citigroup, Prudential and the Singaporean government. Its chief executive is Richard Flint.
* A derivative is a financial contract between two or more parties whose price is based on an underlying asset. It is designed to hedge risk.
Billionaire investor Warren Buffett has been a prominent critic of derivatives, calling them a “time bomb” and “financial weapons of mass destruction”.