Two Ohio utility rate reduction bonds that priced this summer rekindle a debate as to the appropriate benchmark for these securities, which are backed by fees charged to consumers to recover the cost associated with deregulation, fund major investments or repair extensive damage.
Historically, fixed income research departments and ratings agencies have compared rate reduction bonds to triple-AAA rated securities backed by credit card receivables or to traditional, investment grade corporate debt, but the two Ohio deals were priced relative to comparatively riskier bonds.
In July, Ohio Power Company, a wholly-owned subsidiary of American Electric Power Company (AEP), priced a $267.4 million deal called Ohio Phase-In-Recovery Funding LLC. The transaction was led by Citigroup and RBC Capital Markets and rated by Moody’s Investors Service.
The ‘Aaa’-rated, 2.25-year notes priced at a spread of 40 basis points over the interpolated swaps curve and the ‘Aaa’-rated, 5.08-year notes priced at 52 basis points over swaps.
Ohio Power Company said the pricing resulted in $18.6 million in nominal savings and $23.82 million in present value savings, which compares favorably to the $21.9 million and $28.8 million savings estimate, respectively that was included in the securitization financing order.
The bonds were issued to refinance the Deferred Asset Recovery Rider balance of Ohio Power Company at a lower cost than the authorized rate of return.
In June, FirstEnergy priced a $445 million deal that was also rated by Moody’s and was underwritten by Goldman Sachs, Citigroup, Credit Agricole and Barclays. The ‘Aaa’-rated, 1.6-year notes priced at 25 basis points over swaps; the ‘Aaa’-rated, 2.5-year notes priced at 40 basis points; and the ‘Aaa’-rated 13.69-year notes priced at 70 basis points.
FirstEnergy said the deal allowed it to cut rate payer costs by $106 million through 2035; that exceeded the $104 million nominal cost saving that was included in the securitization financing order.
Despite these savings, the two utility deals priced wide of deals backed by consumer loans during the same time period.
Money Left on the Table
Saber Partners, a financial advisory firm for corporate and public-sector entities, published an analysis in August that was critical of the AEP deal. It said that, as a result of using the wrong structure and an “unusual and inappropriate bond comparable in its analysis and decision making process,” pricing on the AEP deal resulted in the utility paying at least $1.3 million more in interest and up to $1.6 million in excess servicing costs.
Unlike securities backed by consumer debt, rate reduction bonds have relatively little credit risk. The bonds are backed by the future collections of special charges applied to electric utility bills; these charges are based on power usage and can vary from year to year, based on the weather or economic conditions.
To protect bondholders from fluctuations in collection, the deals are structured with a “true-up” mechanism that adjusts tariff charges to existing and future retail electric customers to ensure timely payment of the bonds.
Typically the securitization benchmark has priced rate reduction bonds in line with ‘AAA’ rated credit-card ABS. That is because credit card securitizations have, at least in the past, been viewed as a “flight to quality” kind of trade. John McElravey, director of consumer ABS research at Wells Fargo, said this is partly because card deals are issued by bank sponsors with deep pockets.
Before the financial crisis, the rate reduction bonds were typically three to five basis points behind credit cards; during the financial crisis, credit cards were priced wider than the rate reduction bonds.
For example, the January 2008 CenterPoint Energy Houston Electric bond led by Citigroup priced its five-year notes at 64 basis points over swaps; the 10.52-year notes priced at 94 basis points. Citigroup said in a report at the time, that “each tranche in the CEHE III offering priced approximately 15 to 25 basis points inside of like-maturity credit card securities.”
By contrast, the two Ohio deals priced wide of three July credit cards deals. AEP, for example, cleared its five-year note at 52 basis points. American Express issued a five-year, floater that priced at 42 basis points over the one-month LIBOR, Chase did a five-year, fixed-rate card at 42 basis points over swaps and Discover priced a five-year floater at 45 basis points over one-month LIBOR.
McElravey at Wells said that because the AEP deal was a fixed-rate coupon, it probably gave a few basis points of concession when compared to floating-rate paper; nevertheless, the deal still priced 10 basis points wide of the fixed rate credit card paper.
PRAG-Oxford, the financial advisor on the AEP deal, chose the unusual benchmark.
In a memo to the Ohio utilities regulator the Public Utilities Commission of Ohio (PUCO), the financial advisor said it didn’t even use the credit card comp as a benchmark in pricing the deal, although it didn’t explain why it took this step. Instead it used as a benchmark auto loans and dealer floorplan ABS, two asset classes that are even more subject to consumer risk than credit card structures. The financial advisor did not return calls requesting comment for this article.
In the memo, PRAG-Oxford compared the utility deal to a prime auto lease transaction done by Volkswagen on July 17, which had a two-year tranche that priced at 50 basis points over swaps. This comparison is flattering to AEP’s shorter-dated bonds, which priced 10 basis points tighter.
Likewise, PRAG-Oxford said the 52-basis point spread on the five-year note of AEP’s deal “conforms to the broader ABS new issuance market of utility securitization and prime auto ABS.”
First Southwest, the financial advisor on the First Energy deal, used a similar line of reasoning in defended the pricing of that deal in a separate memo to PUCO. The financial advisor told the regulator that the spread of 25 basis points on the 1.6-year notes conforms to the broader ABS new issuance market of prime auto and student loan ABS.
At the time the FirstEnergy deal priced, short-dated auto and student loan ABS with weighted average lives of less than one-year priced in the range of 17 basis points to 26 basis points over the interpolated swaps curve, according to the memo. Likewise, the 2.5-year notes priced at 40 basis points, in line with spreads on student loans and prime auto ABS bonds, which ranged from 40 to 55 basis points at that time.
Saber Partners’ chief executive, Joseph Fichera, said fluctuations in pricing relative to comps could set a bad precedent. “Once it starts pricing wide then investors do start expecting that premium, and it is very difficult, though not impossible, to bring it back,” he said.
Fewer Comps for Longer-Dated Bonds
Ultimately, there is no perfect comp for rate reduction bonds, particularly those with a longer tenor. A banker who has advised on utility deals but declined to be quoted said that credit cards, prime auto loans and front-pay student loans are all comps that people can point to when they think of high-quality, liquid, well enhanced, very credit-remote pieces of paper. But for longer duration bonds, north of 10 years, there are fewer comps. As a result, this person said, there are likely to be price points all over the place and certain people will have different views on where a deal should price at any given time.
Rate volatility, both in terms of underlying rates as well as with swaps spreads, can also impact the price at which a deal is done, according to the banker.
PRAG also said pricing on the AEP deal was affected by the market dislocation at the time. In its memo to PUCO, the financial advisor said that investors’ concerns over a possibility that the Federal Reserve might look to taper the pace of open market purchases, “caused the U.S. Treasury prices to fall and yields to rise significantly within a short period.”
However Saber said in its analysis that it was “unusual for an advisor to compare pricing on 2.25-year or 5.08-year bonds with the 10-year Treasury rate, which rose to 2.53% on June 21st from 2.18% on June 18th.”
“The market dislocation happened on bonds with duration of five years and out, there was little or no steepening of the curve for bonds due in three-years or earlier,” said Fichera.
“Further, a market dislocation often boosts investor demand for higher quality bonds and shorter durations, which typically leads to tighter spreads, not widening,” he said. “Given the required schedule of principal payments, a one-tranche 3.3-year structure was more appropriate with these market conditions.”
Andrew Maurey, the bureau chief in the Division of Accounting and Finance at the Florida Public Service Commission, said that the lack of comparables for rate reduction bonds makes it all the more important to get good advice.
“These bonds are of superior credit quality and it takes a committed effort to market them in the manner necessary, not just like everyone else has done, to get the right value for the ratepayer,” Maurey said. “At the end of the day, every dollar is a ratepayer dollar in these deals. That’s why it is so important for the ratepayer to have a strong advocate representing their interests in these very complicated transactions.”
Saber Partners acted as the financial advisor for the Florida regulator on the rate reduction bond issued in 2007 by Florida Power & Light that was underwritten by Credit Suisse.
The $652 million in storm recovery bonds lowered the monthly storm cost recovery surcharge that ratepayers were charged by eight cents from $1.10 to $1.02 per 1000 kilowatt hours, according to the Florida Public Service Commission.
The bond also sold the tightest spreads of any utility securitization bond done to date, according to Fichera and Maurey. The 1.97-year notes sold at 9 basis points under swaps and the 4.98-year notes sold at 7 basis points under swaps.
Maurey said that he is puzzled as to why such an incredibly low risk security that has performed so well, hasn’t priced at the same level or at the very least, near the level of the Florida deal.