State readies record energy bond issue

Kathleen Pender,
San Francisco Chronicle
September 29, 2002

For California investors, the state's $11.9 billion energy bond issue will be like a circus elephant walking through the front door: too big to ignore, kind of scary but maybe worth a ride.

The bonds won't be priced for several weeks, but experts say they should offer attractive yields to make up for their substantial risk and the boffo size of the deal, which will be 3 1/2 times bigger than the previous record municipal bond issue.

Arno Rayner, chairman of Rayner Associates, says the 20-year, fixed-rate, tax-exempt, uninsured energy bonds could yield at least 5 percent. That's equivalent to 9 percent on a fully taxable bond for someone in the top tax bracket, or 7.5 percent for someone in the 27 percent federal and 9.3 percent state tax bracket.

By comparison, 20-year California general obligation bonds, whose income is also exempt from state and federal taxes, are yielding about 4.6 percent.

Twenty-year Treasury bonds, subject to federal but not state tax, are yielding about 4.7 percent.

State Treasurer Phil Angelides on Friday set a timetable for selling the long-delayed bonds, which will come in more flavors than Starbucks has coffee.

There will be about $1 billion in taxable bonds, the rest tax-exempt. About half will be fixed rate and half will be floating rate. There will be a wide range of maturities, out to 20 years. Some bonds will be insured, some won't. More details will become available this week.

The state plans to sell the variable-rate bonds the week of Oct. 21 and the fixed-rate bonds the week of Nov. 4.

In February 2001, when Angelides first proposed selling bonds to repay the state for its power purchases during the energy crisis, he envisioned selling $5 billion in bonds at interest rates of 7 to 8 percent. Since then, the size of the issue has more than doubled, but interest rates have fallen substantially.

About $6.5 billion in bond proceeds will repay the state for energy purchases it made out of its general fund. About $3.5 billion will pay a consortium of banks that provided additional financing. The rest will cover the cost of bond issuance and will go into a reserve fund.

To get an investment-grade credit rating, the state had to add about $800 million to the bond's reserve fund, bringing it to almost $3 billion. To do that, it increased the size of the bond issue.

The bonds will be repaid by customers of the state's investor-owned utilities. A portion of each customer's monthly electricity payment will go toward bond repayment. That amount will be shown separately on the bill.

However, if the state runs into various problems, it could divert some of the money earmarked for bond repayment to cover electricity costs. If that happens, the state can dip into the reserve fund to cover bond payments.

"That's why you need these incredible level of reserves," says S&P analyst David Hitchcock.

Even with the giant reserve fund, the bond still carries substantial risk.

S&P rated it BBB+, two "ticks" above its lowest investment grade rating, BBB-. S&P has rated the state's general obligation bonds A+, which is very low for a state general obligation bond but a full category above the energy bond.

Moody's and Fitch have rated the energy bond A3 and A-, respectively, which are equivalent to each other and a tick higher than S&P's energy-bond rating.

In general, lower-rated bonds pay higher yields.

A BBB+ rating is not unusual for revenue bonds, which are repaid through the revenue from a project, such as a golf course or in this case electricity bills.

General obligation bonds, by contrast, are backed by the full faith and credit of the issuer. They are generally rated higher than revenue bonds because the issuer can raise taxes to pay them off.

The power bonds are revenue bonds issued by the California Department of Water Resources.

Some experts have called them quasi-GO bonds, saying the state would never let DWR default on them. But in a conference call Friday, Angelides said, "The revenue source for these bonds is very clearly the revenues payable by customers of the three investor-owned utilities."

David Hitchcock, an analyst with S&P, says the greatest risk associated with the bonds will come after 2004.

"In later years, the amount of power the state has under contract declines. If DWR is still in the spot market, the amount of spot market purchases they have to make will grow and expose them to more price volatility.

"In later years, the legal covenants will allow the level of reserves to decline. You could have increased volatility, greater revenue needs and less reserves, all assuming that DWR is still making spot purchases," he says.

Kevin Olson, executive director of MunicipalBonds.com, says the greatest risk is that the state won't have enough power to support its growing population. "What I fear most is the structural imbalances we have," he says.

Ken Williams, president of Stone & Youngberg, says the biggest risk is the one posed by all bonds in this era of historic low interest rates.

If interest rates rise, the price of previously issued bonds will fall. Investors who hold their bonds until maturity will get back the face value of the bond, but if they have to sell before maturity, they will get less than they paid.

"The greatest risk is interest rate risk," Williams says. "Despite all the politics, I have the full confidence that this state . . . is not going to issue debt that doesn't get repaid. If DWR would default, the state couldn't afford to let it go bad."

Investors who want to buy bonds should contact a broker. Virtually every major bond dealer in the state is involved in the deal.

Buyers can choose whichever flavor they want. "Insured tax-exempt is the piece I'd be most interested in," says Rayner, who manages the Fremont California Intermediate Tax-free fund.

As I've noted recently, retail investors often pay big, hidden commissions when they buy previously issued municipal bonds on the secondary market. But this is usually not a problem with newly issued bonds.

On an original issue, "you know the price. You'll get the same price, in general, as an institution," says Olson.

Learn more by reading the full rating reports at www.sandp.com (available Monday), www.fitchratings.com or www.moodys.com. br>