How fixed income investors view the utility sector.
Josh Olazabal is a vice president in the credit research group at PIMCO’s Newport Beach office. Previously he was a consultant with McKinsey & Co., and worked in corporate development at Duke Energy before that.
Utility management teams—and CFOs and treasurers, in particular—are making their feelings clearly and abundantly known about the current rate and funding environment. There’s been a recent rush to market in both the unsecured and first-mortgage bond markets—especially by electric utility operating companies (“opco”) looking to lock-in historically low rates and credit spreads. The market has been particularly receptive to higher quality deals at the regulated utilities, with investors looking for high quality yields and spread—i.e., the difference in yield and the risk-free rate of comparable maturity—in a market that continues to be characterized by Eurozone troubles, the fiscal cliff, and other uncertainties.
While the market has been an undeniable boon for utilities looking to reduce their costs of capital and term-out longer maturities at attractive rates, how do fixed income (FI) investors view the situation? Moreover, how do bond investors view the risk-and-reward picture at a time of historically low rates?
Here are some thoughts and observations “from the bond-side.”
First, there’s always a place for high-quality utility bonds in fixed income portfolios.
Utility borrowing spreads have narrowed to close-to-historically tight levels, as investors pursue high-quality yields in a low-rate environment, characterized by continued uncertainty. For example, recent deals have priced at Treasuries plus 65 basis points (bps) for first-mortgage bond issues and 70 bps to 80 bps for 10-year unsecured bond deals.
Are these levels tight? Clearly, they are. Will they eventually come to prohibit widespread investor participation in utility deals? Doubtful. Simply put, utility paper continues to offer a very sage spread pick-up to Treasuries in the context of good overall leverage ratios, “virtual covenants” in the form of regulatory limits on borrowing, and, especially, strong and stable regulated cash flows. While there are some issues that can raise red flags in certain situations—outsized regulatory attention on allowed ROEs, expensive generation capex budgets, etc.—one might expect that traditional utility investors will continue to display strong demand for utility bond issuance.
A second observation is that FI investors will likely take a more nuanced and differentiated approach to investing in utility opco bonds.
In an environment characterized by low absolute rates and extremely tight spreads, utility sector bond investors will likely look for differentiated performance by searching for opportunities they believe are attractive from a risk-reward standpoint. Each investor will find an individual comfort zone in this new environment, but some approaches include emphasizing T&D names over integrated names, and adjusting the mix of first mortgage bonds vs. unsecured bonds.
With a number of pure wires companies trading right on top of integrated utility names—with generation exposure—utility investors might ask themselves whether taking the perceived lower risk T&D name makes more sense than buying a comparably integrated name at the same spread or for a pick-up of a few extra bps.
And first-mortgage bonds—and their derivations, including fall-away first-mortgage bonds, general-mortgage bonds, etc.—have been a staple of the risk-averse utility investor for decades, with many of the bonds tracing their roots to indentures that are 80 or 90 years old in some cases. Today’s low-rate environment—coupled with a default-and-recovery history that suggests unsecured recovery (in the very unlikely event of a utility default) isn’t far off of secured recovery—might spur utility investors to move toward unsecured issues given the pick-up in spread (anywhere from 5 bps to 15 bps on a 65 bps to 70 bps spread) for the perceived low incremental risk being taken.
A third observation is that FI investors will start looking at gencos and genco-owing integrated holdcos again.
The challenges to merchant power in a low gas-price environment are well-known and have been the primary driver for a large part of the FI buyers having stepped away from the sector—and from the integrated utility holdcos that own these assets and portfolios—in the context of the shale boom over the last several years.
With low absolute rates and very tight regulated operating company spreads, fixed income investors will likely be looking for signs that gas prices and the forward-gas curve—and accompanying power prices—are at least stabilizing, and that a potential path to recovery is visible. The recent tightening in merchant names—while it might be premature—speaks to the fact that bond investors are keen for signs of a legitimate recovery, and will be looking to move into holdco bonds for incremental spread and yield once they believe that merchant sector risks are abating somewhat.
In addition to these trends, FI investors will likely start asking, “What else?”
With coal and nuclear generation largely stalled in an era of lower gas prices, much of the new build focus on the power side will likely be around renewables development to meet increasingly stringent state RPS (renewable portfolio standards). While the future of wind might be somewhat uncertain in light of questions around production taxes, prospects for solar look increasingly bright in the context of significant component-cost reductions.
To date, fixed income investors haven’t been a major funding source for these promising projects, as sponsors—large and small—traditionally bypassed the capital markets for funding in the shorter-term loan market. In the wake of the financial crisis, though—and with many of the larger European banks pulling back from the project-finance lending sector—there might be a good opportunity to address renewables project funding in the capital markets and fixed income spaces. The positive reception offered to a large solar bond deal last year, for example, speaks to the appetite that fixed income investors might have for an emerging sector that combines both the opportunity to earn higher relative yields and the chance to participate in the funding of critical emerging environmental solutions.
The preceding thoughts address some of the developments one might expect to see in the fixed income utility space, as utility investors seek differentiated and superior performance in a very challenging rate and spread environment.
Investors will likely choose varying approaches based on their risk-and-return profiles, with some investors sticking to the “tried-and-true” utility opcos, and others moving out the risk-reward continuum to merchant power and even nascent renewables markets. One thing will be true regardless of the path that investors choose, however: The power and utility space will continue to be a large and dynamic part of the overall U.S. fixed income market, and one that prudent bond investors will need to pay active attention to in the coming years.
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