Despite last week's long-awaited and encouraging settlement between troubled California utility Southern California Edison (SCE) and the California Public Utilities Commission (CPUC), asset-backed investors with a penchant for rate-reduction bonds may still not be adequately convinced that the sector is completely devoid of headline risk, sources say.
Although the two parties hammered out a crucial deal last Tuesday allowing the volatile utility to pay off $3.3 billion of its $3.9 billion debt - setting a favorable tone and giving some confidence to bondholders who were put off by utility-sector headline risk earlier this year - an anticipated improvement in the liquidity of California stranded-cost bonds was not immediately seen by ABS traders.
"Our feeling would be that, yes, this is a positive event for the company [SCE] as well as for the rate-reduction sector in general," said a Street trader closely watching the SCE bonds. "However, it hasn't translated into spread tightening as of yet; there is still the underlying current of headline risk associated with those bonds. With these [investors], the proof is in the pudding - they want to see this thing play out."
Indeed, there has been a great deal of uncertainty lingering in the minds of investors since the beginning of this year as to whether west-coast utilities such as SoCal Edison would continue to remit funds to bondholders in light of their burgeoning financial woes.
The recent settlement, filed in U.S. District Court, was expected to allay those fears. "But it didn't really affect the underlying fundamentals of securitization bonds, even though it was a positive development," said Bruce Fabrikant of Moody's Investors Service. "This entire year, investors have had to analyze the situation, and make a determination whether the risk profiles of the bonds have changed. Ever since Pacific Gas and Electric had its problems, there has been additional headline risk for investors and liquidity problems. Spreads had widened with the uncertainty. Most ABS investors can only invest in triple-A securities and so are very aware of the relative value of securities."
End of bankruptcy risk?
Last week's agreement was assembled in response to the lawsuit Edison filed nearly a year ago based on the fact that state regulators were preventing the company from collecting sufficient retail rates to pay for the actual cost of power it was purchasing on behalf of its customers. While the recent deal cements SCE's ability to regain its creditworthiness, the company said that it does not expect its credit ratings to be restored to investment-grade immediately.
However, in a conference call with investors and analysts last week, Ted Craver, SCE's CFO, asserted that the company "will continue to pay the coupon and interest on a monthly basis for [all] obligations.
"Our goal is to pay all the creditors...the amounts they're due in order to get enough cash assembled," Craver said. "It's going to take some time to work through with creditor groups to find out precisely what we do owe them."
Although there was no immediate increase in liquidity for outstanding asset-backed SoCal Edison paper, analysts agree that last week's news will, at the very least, improve investors' comfort level with the bonds. "The settlement agreement, if implemented as it appears, would eliminate bankruptcy risk for these bonds," said Ellen Lapson, an analyst in the energy group at Fitch. "While it doesn't make a material change in rate reduction bonds, it improves the outlook for the likeliness of payment."
In response to the revised outlook for the insolvent utility, Fitch changed the Rating Watch of SCE from Positive to Negative, saying that the settlement agreement provides "price certainty" for the embattled company. That, together with lower power supply costs, is expected to provide surplus revenue for the repayment of unpaid SCE debt resulting from unrecovered power procurement costs.
Perhaps most importantly, the settlement is an encouraging development for the servicer on the deals. "People were waiting to see if there would be a special [legislative] session in California, so the news was a bit of a surprise, and will certainly contribute to the easing of headline risk," said Fitch's Donna DiDonato.
"Bonds are designed to be somewhat bankruptcy-proof, so they can withstand the bankruptcy of the utility," added Jon Prestley of Hartford Investment Management Co. "There is a potential, however, that it could affect market price or cause a servicing disruption. But rate-reduction bonds are still broken down into two tiers: California, and everywhere else...I don't think this has really affected the liquidity of these bonds."
According to DiDonato, the bailout of SCE was originally going to allow for a $2.9 billion securitization of certain fees on consumers' bills, but the current settlement should eliminate the need for that additional measure.
Governor Gray Davis of California had included the securitization in his proposed legislation, but the state Senate recently reduced the amount to $2.5 billion. Regardless, analysts are not expecting an additional securitization from SCE. "Considering the increased market volatility in California, people are looking there and seeing this as something that was supposed to be good but looks like a disaster," DiDonato said.
Meanwhile, there is still a possibility that the California Department of Water Resources (DWR) may pursue a financing alternative similar to a securitization as the legislature looks to separate out DWR's operating expenses from its debt service, but the end result may be closer to a revenue bond.
Nevertheless, stranded-cost ABS has had a tremendous year, with several large transactions taking place. "It is really one of our most liquid sectors," said an ABS banker. "Clearly California had the most issues, from a legislative framework and they've managed to really work around that situation."
Moreover, considering current events of the last three weeks, the nuances of rate-reduction bond spreads has not exactly been on investors' minds. "The underlying theory is that people need power and people will pay for it," said Himco's Prestley. "No matter who they buy it from or who they sell it to, bondholders still get their money. Given everything else going on, the subtleties of tiering between issuers has been lost for the moment."