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Corporate Unbundling: Are We Ready Yet? A Bondholder's Primer

Fortnightly Magazine - June 1 1996

for financing."

If the utility spins off generation (em usually the lion's share of asset value (em management may want the debt to follow the production plant, or choose to release the generating plant from the mortgage by replacing the assets with other appropriate bonded property. Management may desire to exit a business that employs bonded property.

In a recent report, Moody's Investors Service noted that "virtually all" utility plant and equipment is pledged as collateral under the bond mortgage, but that bonding ratios (maximum outstanding debt as a percentage of collateral) range from 60 to 75 percent. Thus, between one- and two-thirds of utility property represents "excess collateral" theoretically available for bonding in the future, or to be "swapped" to replace other property subject to the lien of indenture. But pitfalls abound. Moody's notes that the trustee will value released property at "fair value," but replacement property at original cost, while also ensuring that the business that carries the debt can continue as a "going concern." The problem comes, says Moody's, when a property release and replacement undermines bondholder security.6

Dan Scotto, senior managing director at Bear Stearns and a long-time utility analyst, puts it this way: "If your bonding ratio is 66 percent, then you would need $150 in unbonded assets to float an additional $100 in debt."

Dunn notes that some bond mortgages allow an exchange of property "for notes, financed assets, or a pledge of securities." Others, he says, "limit the percentage of assets that may be financed. Or they may require an engineer to certify that the property is no longer used and useful. But you can't use a purchased-power contract as replacement for other bonded property."

Steven Kinney, Jr., a partner with Reid & Priest, warns that older First Mortgage Bonds (FMBs) often do not permit an vertically integrated electric utility to break up into a GenCo and a separate transmission and distribution (T&D) company and split the debt evenly between both entities. Instead, the indenture might force all of the bonds to go with the T&D assets, whose value is likely only a small fraction of the generating plant. That requires the GenCo to issue purchase-money mortgages back to the T&D company.

"Inflexible mortgages can chew up added bonding capacity and can inhibit restructuring," Kinney warns.

Should utilities forsake FMBs for debentures? Kinney notes that FMBs typically follow the property and earn interest during bankruptcy (and enjoy a first bite at the apple), while debentures (unsecured debt) are simply "thrown in with all the other creditors and tort claims." Nevertheless, FMBs can carry drawbacks, notes Kinney, since they require "periodic accounting and valuation" and incur a recording tax. Interest rates on FMBs are frequently "not that much different from senior unsecured debt," says Kinney. "Rating agencies don't seem to give as much credit to companies with FMBs. The market seems to be more concerned [today] with call protection than collateral protection."

Kinney believes that some companies are looking for ways to convert FMBs to debentures, which would allow some of the debt to flow to