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Fragile Foundation

The capital markets have recovered … or have they?

Fortnightly Magazine - October 2009

would have issued at 350-basis points over Treasuries in March—and considered themselves fortunate to get it—now can issue at half that spread or even tighter.

The Treasury sees some probability of a double-dip recession. That means there’s a perfect window now, with low rates, tighter spreads and easy access to capital markets.

Bilicic: Everything in the capital markets is reverting to a historical median, and everything is starting to look and feel more normal. But all this feeling of normalcy is sitting on top of a very fragile foundation, and it should make everyone more nervous than they were a few years ago.

Nastro: The outlook for access to capital remains bullish. However, people now are focusing on Treasury rates, which remain close to their all-time lows. There’s a growing consensus that the unwinding of loose fiscal and monetary policy will drive rates up on inflation concerns.

Everyone is asking the same question: We put all this stimulus into place, now how do we get out of these loose fiscal and monetary policies? That’s a question we’ll have to face in the second half of 2010 and early 2011.

In its July 2009 Utility Industry Outlook Report , Moody’s Investors Service raised serious questions about the long-term creditworthiness of U.S. utility companies. Notably, the report focused on rising electricity costs as a function of average earnings, and a “theoretical ‘inflection point’ beyond which consumers will no longer tolerate annual rate increases without protest.” The report suggests the industry will reach this inflection point when the average annual electric bill reaches between 5 and 10 percent of a household’s disposable income—which under some scenarios could happen as early as 2013.

Jim Hempstead, Moody’s senior vice president and co-author of the July report, told Fortnightly how reaching this inflection point might affect utilities’ credit and financing strategies:

“The utility sector is well insulated but not immune from economic turmoil. However, companies with big industrial exposure have been really affected by lower industrial demand. They’re taking a hard look at capital expenditures and their operating cost structure, and cutting costs to mitigate the impact of lower volumes. This is translating into lower earnings and cash flow.

“The sector has done well, with companies reducing their cost structure to mitigate lower earnings. But if we’re in a prolonged economic situation, and if your cap-ex spending can come down only a little because you have to maintain the system, and you don’t want to touch your dividend, how are you going to finance your system? If you have a big cap-ex program, shouldn’t you be retaining more of your cash flow internally? On the one hand you want to invest it in your system, and on the other hand you want competitive cost of capital to attract investors. That dynamic is getting evaluated.”

“In general, we continue to view the utility sector as stable from a credit perspective. That’s a function of companies continuing their solid regulatory relationships. Companies continue to get relatively timely recovery on a reasonably good cost basis. Continued regulatory support is the basic