The U.S. power sector is facing pressures unlike ever before creating new risks for investors. That makes knowing what you own more important to ever. Our muni team explains.
Laurie King: I’m Laurie King, and you are listening to On the Trading Desk®.
The U.S. power sector is facing pressures unlike ever before, creating new risks for investors. Which makes knowing what you own more important than ever. Three members of our Municipal Fixed Income team, within the Global Fixed Income team at Wells Fargo Asset Management, are with us here to explain aspects of their credit research that they believe are most essential to help protect against uncompensated risks in the power sector.
Lyle Fitterer, Head of Municipal Fixed Income joins us—welcome Lyle.
Lyle Fitterer: Thanks for having me, Laurie.
Laurie: We also have Gabe Diederich, portfolio manager on the team—welcome Gabe.
Gabe Diederich: Hi Laurie.
Laurie: And with us as well is one of the analysts covering municipal credit research, Kerry Laurin.
Kerry Laurin: Hi Laurie, thanks for having me.
Laurie: A quick note to our audience: This conversation highlights key aspects of an Investment Perspective, a paper, that these three authored called, Know what you own: Avoiding shocks in electric power bonds. In it is far greater detail than we’ll be able to cover here—with charts, tables, data and such. So, contact your relationship manager, your partner at Wells Fargo Asset Management, and ask them for the full Investment Perspective and they’ll be happy to send it to you.
Now, Gabe, this Investment Perspective, the topic for it, was born out of an idea of yours. What was the kernel of the idea?
Gabe: Well, Lori, you know, our team gets together at least weekly to go through regular strategy meetings. And in our open trading desk environment, we have the opportunity to talk about things as they happen in the market. And a core part of our investment philosophy is looking at relative value of what we’re purchasing and potentially what we’re selling within client portfolios. In this particular case, we were seeing a lot of activity in a sector that was historically viewed as something quite docile. I think, to us, that was an interesting area to look further and see where risks or opportunities might reside.
Clearly in an environment we’re in, where essential services have been much more in favor late in the economic cycle, I think that only added to the story that we’re looking at here today.
Laurie: So in your paper, you point to three examples of pressures that the power sector is facing. Out west, there were the devastating wildfires in California that created enormous liabilities. Out east, construction delays and cost overruns while building nuclear reactors have hurt utilities in South Carolina and Georgia. Then, across the U.S., renewable energy is changing the competitive landscape. What in your credit research and analysis points you to these three as being significant?
Kerry: Yeah, I’ll take that one. They’re clearly significant because of the implications they’ve had on the credit rating in some cases. And especially with the wildfires, implications for the California utility market as a whole. So for example, PG&E, as you know, has declared bankruptcy. But now the concerns over inverse condemnation and the threat of further wildfires have threatened the ratings of SoCal Ed and San Diego Gas and Electric as well. S&P has even threatened to take them to non-investment grade.
Laurie: So Kerry, can you just quickly tell our audience what inverse condemnation is?
Kerry: Yeah, so essentially, you’ll be held liable regardless of negligence. So you really don’t have a cap on a lot of those claims. Even if you’re not negligent, you can still be sued for all of it. You still have to foot the bill, and you can’t pass your costs on through to your customers in those cases. So you have to eat it yourselves.
Gabe: Well, I know to me, Kerry, that that seems like a pretty risky proposition, given the drought that California’s been operating in.
Lyle: But I also want to say that I think there is a positive aspect to this as well, in that California ultimately, from a long-term perspective, needs access to energy, needs access to the infrastructure that goes along with that energy. And so this is front and center for the government within California. The legislature is looking at this. The governor has been involved. So again, while there are negatives specific to this issue, there could be a positive resolution from a long-term perspective.
Laurie: And what strikes me about these risks is that they are all three very separate and distinct risks.
Kerry: Exactly. If we want to move on and think about the Vogel project—
Laurie: That was the nuclear reactor out east?
Kerry: Correct. What that really highlighted for us, there’s a lot of risk clearly inherent in a lot of these project finance and power deals. And we think that often goes underappreciated by the market and sometimes by the agencies as well. I think from my standpoint, as an analyst, I just stress that we have to understand where our security comes from. So is it associated directly with the project, or is it from the utility as a whole. Because that really changes the risk profile.
If we think about the renewable generation and how we have started to see more of that and that’s kind of exploded over the last several years, it clearly has the potential to and it has disrupted some markets. And we think that we might even start to see more renewable deals in our own market. It kind of depends on how those are structured. But we start to think about things like what problems are we going to see with the technology. What changes could we see in the regulatory environment? Especially as it relates to things like storage. What kind of disclosure do we have at the project level? Just those sorts of concerns.
Lyle: And as we move forward, another aspect of this I think is the whole ESG component of this. How does that play into the situation? What is good energy from a long-term perspective? Is coal going to go away? Are renewables going to take over? And how do we get from point A to point B and what are the implications for a lot of, historically, very stable, heavily regulated entities that have built up a lot of infrastructure and have a lot of debt outstanding. How is that going to look going forward and how are they actually going to support paying off that debt?
Laurie: So what do you do differently in assessing credit or buying power bonds?
Lyle: Now, I think each and every decision, you almost have to go back to Kerry or one of the other analysts on our team and say, hey, what is my security package? What plant is this specific to? Is this cross-collateralized? Do I have a security interest? Am I unsecured at the corporate level? And how quickly could this rating ultimately change and therefore impact the valuation on this particular bond?
Kerry: You know, from my perspective, I think understanding the macro environment is crucial in our analysis. I think sometimes, analysts get very focused on bottom-up analysis, in which the company might look okay initially. And maybe there is some failure to appreciate the big picture and the impact that that might have on the credit. So we need to understand the issues that are facing different areas of the country. And I think we need to understand the legal and political climate in all of the states, quite frankly.
Laurie: Well—talking about valuation—how is all this affecting the price of the bonds? How has the market been responding?
Gabe: Well, I think the market has been responding, but, it’s the timing of that response that I think is where we can really use this to the benefit of client portfolios. We’ve seen instances where maybe some of this information is being telegraphed. We’re seeing hints of issues where investors should be demanding more income on a security and the market doesn’t recognize it, doesn’t recognize it, and then boom. Recognizes it in a big way.
And some of these either news items or recognition of information can lead to extreme price volatility in some of these securities. And I think that’s where you want to make sure you’re entering those securities at an appropriate time and understanding the risks of where those securities could go from a valuation perspective.
What makes it more difficult right now, broadly speaking, is that there is a scarcity of munis out there, and as a result, you’re seeing very tight spreads—so you’re getting a low level of compensation to go down in quality, and you’re seeing very little differentiation among securities within the muni market. That’s a difficult environment to operate [in], and I think it’s just time to really be aware of risks so that you don’t step into a security where you’re not being compensated to take on future volatility if it arrives.
Laurie: And those are the shocks you’re trying to avoid?
Gabe: That’s correct. Those are the shocks we’re trying to avoid, hopefully, to dampen volatility in client accounts.
Laurie: You paper’s title begins with, “Know what you own.” Can you talk to that a little bit?
Lyle: Yes. I think it goes back to what we’ve always said, which is when we’re doing work on our portfolios, you can’t just rely upon a rating or a rating agency. You need to understand what you own. You need to assign your own internal rating. And you need to have a good idea of what that sector is and what’s impacting that sector on a day to day basis.
Gabe: And certainly when we’re buying these securities and lending money to them is to make sure that the valuation is appropriate. We have the good fortune of having a 15 person credit research staff here. And I think that that type of approach is warranted, not only in the higher risk segments of the market, but even a sector like this which has historically been viewed as a much more stable corner of the market.
Kerry: You know, it’s very important, obviously, to kind of look under the hood, because investors can’t do that themselves.
Laurie: Well, thank you for that. I want to remind our audience, ask your partner here at Wells Fargo Asset Management for the full investment perspective from Lyle, Gabe, and Kerry, especially if your clients are concerned about the power sector. But, for now, we’ll wrap up our time together and thank all three of you for joining us.
Gabe: Thank you.
Kerry: Thanks Laurie.
Laurie: Of course there’s more investment insight on our blog AdvantageVoice® and right here on this podcast. Until next time, I’m Laurie King; take care.