November 1, 2002
Focus on the Fixed Rate: Buyers Doing Last-Minute Analysis of DWR Deal
SAN FRANCISCO – Investors awaiting the fixed-rate portion of California’s mammoth $11.9 billion power bond deal slated to begin selling today were still analyzing the credit as of yesterday and speculating about what interest rate the bonds will need to offer, given lingering concerns about the state’s energy market and the deal’s complicated legal framework.The state’s Department of Water Resources plans to issue $6.75 billion of tax-exempt, fixed-rate revenue bonds over the next week. Lead manager J.P. Morgan Securities Inc. said earlier this week it plans to begin taking retail orders today with an institutional pricing on Wednesday or Thursday.
Of that amount, $3.75 billion will carry insurance, leaving some $3 billion of bonds to be sold based on a lower investment-grade underlying rating. Another $800 million of taxable debt will also price next week. The deal follows last week’s offering by the DWR of $4.25 billion of variable-rate power bonds, which observers say was well-received by investors.
The debt, which is being issued to pay for costs stemming from the state’s energy crisis, will be secured by a special charge on 10 million customers of California’s three largest investor-owned utilities. That charge must be set by the state Public Utilities Commission at least annually, in accordance with a contract called the rate agreement.
While the still-uncertain energy market, litigation involving the bonds, and an untested rate-setting structure continued to weigh into analysts’ opinions about the deal, the lead underwriter expressed confidence that the worst is over for California and the bond issue is on solid legal footing.
“Last spring and summer, the energy market still exhibited substantial volatility,” said Nathan Brostrom, a vice president at J.P. Morgan. “Now the power market has stabilized. The rate agreement and the indenture have built in many safeguards to protect bondholders.”
By now, members of the financing team estimate they have spoken to about 500 potential buyers in seven institutional investor meetings, two retail broker presentations, and more than a dozen other meetings with individual companies.
“What everybody wants to get comfortable with is what’s the reasonable, credible, worst- case scenario?” said John Hallacy, managing director and head of municipal bond research at Merrill Lynch & Co., one of the co-managers. “People want to gauge where they think there are holes, if those are reasonable risks to take, and are we being adequately compensated?”
Standard & Poor’s assigned the deal a BBB-plus, Moody’s Investors Service rated it A3, and Fitch Ratings rated it A-minus.
Some investors said they expect the uninsured power bonds to yield around 5.50%. They said the bonds could yield 75 to 100 basis points above the scale for triple-A insured bonds, a moderate premium above where triple-B rated bonds tend to price. As of Wednesday, Municipal Market Data reported a yield of 4.82% for insured bonds due in 20 years, which is the final maturity for the DWR bonds. That could mean the uninsured DWR bonds may yield between 5.57% and 5.82%.
Some speculated earlier this year that the bonds would yield as much as 6.20%, but interest rates have fallen sharply since lawmakers first approved the bond plan in early 2001, when rates on long-term revenue bonds were about 50 basis point higher than they are now. This has prompted market players to observe that the continued postponement of the deal has turned out to be a benefit to the state.
Sources this week noted that the $4.25 billion of variable-rate bonds sold on Oct. 23 did not price as cheaply as some analysts and fund managers had expected.
“The variable-rate sale is hard to look at as a proxy,” said David Blair, senior analyst at Nuveen Advisory Corp. “Those bonds were backed by letters of credit and insurance and aimed at a different investor target” – namely, money market funds.
The fixed-rate bonds will be marketed nationally, with Ambac Assurance Corp., MBIA Insurance Corp., Financial Security Assurance and XL Capital Assurance Inc. all having committed to insure a portion of the deal, according to J.P. Morgan. Ambac, FSA, and XL also insured portions of the variable-rate bond offering last month.
“Those are benefits to the marketers, but it should be set at a price that’s going to be attractive,” Blair said.
But buyers may not get the yield premium they are hoping for, in the view of Bernie Schroer, senior portfolio manager at Franklin Funds. “I think it’s a well-secured credit and am surprised it didn’t get better than a BBB,” he said. “It will cost something to issue that kind of size, but when that day comes I assume it will still be the best buy around.”
Different analysts see the credit as deserving from a AA-category rating to barely investment grade, said Terry Goode, senior credit analyst at Wells Capital Management.
“We’ve approved the bonds for purchase, but we do feel like the credit is more in the BBB-category range,” he said. “On the face of it, the legal framework seems to be very strong and provides a meaningful mechanism where rates have to be raised to meet debt service or additional costs related to power purchases. But it’s still largely untested.”
Fundamentally, the rate agreement that backs the bonds provides a pretty solid security structure, according to Nuveen’s Blair. “The large reserves imbedded in the deal [which total about seven months of operating costs] allow the PUC the flexibility to implement appropriate utility rate changes if needed,” he said.
Even more basic than that, power is an essential commodity for the state’s residents.
“People are unlikely to allow their electric bills to go unpaid and have their lights turned off,” said Peter Bianchini, a vice president at Charles Schwab Investment Management. “Our major concerns are the legal issues surrounding the power bonds.”
Pacific Gas & Electric Co., the state’s largest utility, is currently operating under bankruptcy protection. Last month it filed a lawsuit again questioning whether the prices the DWR has negotiated for long-term power contracts are just and reasonable and can be passed onto consumers. The agency signed the contracts at the height of California’s energy crisis in 2001.
The suit was anticipated by state officials and rating analysts and is disclosed in the preliminary official statement and a supplement to it.
Even “if you believe the most likely outcome will not impact the bonds, it’s one of the factors that goes into your pricing expectation,” Bianchini said.
The PUC’s questioning of the DWR power contracts served to stall the bond issue for months and the commission still has complete discretion in how it sets rates across customer classes and regions, which could cause problems for bondholders, said Joseph Fichera, chief executive at Saber Partners, an advisory firm.
While the DWR has the legal authority to set its own revenue requirements to meet the costs of the power contracts and debt service on the bonds, “bondholders could also be caught in the crossfire in a dispute between DWR and the PUC over what costs are legitimate” and can be included in rates, he said.
The “uninsured bonds are not for the faint of heart,” Fichera said. “Timely payment of interest and principal doesn’t mean there will not be a lot of headline risk and price volatility in the secondary market.”
Large reserves, critical to the deal achieving an investment-grade rating, will be set aside for both power costs and bond costs. They will be funded by bond proceeds and a complicated flow of revenue from utility customers. Such reserves are probably unprecedented, according to Merrill’s Hallacy.
“But we’re not talking about a big coverage on these bonds, we’re talking about a sum sufficient,” he said. “There are layers upon layers, but they hope to never have to touch any of those. The second they tap the reserves, the ratings would be back on the table.”
Hallacy’s biggest concerns revolve around when the state will be able to extricate itself from the power-buying business. The DWR originally was expected to cede back to the utilities the responsibility to purchase power, both in the open market and under long-term contracts, by the end of the year.
In January 2001, the DWR – already the state’s largest purchaser of power for the State Water Project – stepped in to buy power for customers of the investor-owned utilities after they could no longer do so on their own due to sharply rising power prices in the wholesale energy market. Observers attribute the ensuing power crisis to a faulty deregulation plan, alleged market manipulation, transmission constraints, and dry weather that decreased the amount of hydroelectric power available.
Many potential investors continue to question California’s ability to increase the amount of power generated in-state and its ability to improve transmission lines that carry power into and across the state.
“There’s always issues there, but over the long haul there’s a fair amount of hope that there’s going to be much more attention paid to taking care of [the state’s power needs] than has been paid in the past,” Hallacy said.
About $6.7 billion of bond proceeds will reimburse California’s general fund for power purchases and retire $3.5 billion in outstanding loans from five banks. Another $1.2 billion will go towards debt service reserves. Another $2.2 billion from the remaining proceeds and existing collections from ratepayers will fund operating reserves, which will fluctuate with the department’s power-buying needs.
Along with J.P. Morgan, co-senior managers are Lehman Brothers, Bear, Stearns & Co., EJ De La Rosa & Co., and Salomon Smith Barney Inc.
UBS PaineWebber and Morgan Stanley & Co. head up a group of nine other retail managers, and 16 co-managing firms round out the investment banks in the syndicate.
Montague DeRose & Associates and Public Resources Advisory Group are co-financial advisers. Hawkins, Delafield & Wood is bond counsel. Sidley Austin Brown & Wood is special counsel and Orrick, Herrington & Sutcliffe is disclosure counsel.
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