Brian Reynolds
Chris Edmonds has been doing a terrific job detailing the ups and downs of the California power crisis. He hasn't left much to add from a fundamentals point, but a number of readers have asked about the impact of this situation from a fixed-income point of view. I believe bond investors need to look at this from both a macro and a micro view, as how this situation plays out could be one of the most significant stories of the year.
From the macro perspective, the crisis is clearly a negative. The more that individuals and companies are forced to pay for utilities, the less they can afford other goods and services. California now looks to be the weakest part of the country; Standard & Poor's announced last week that it may downgrade the state's AA rating. As the state accounts for 13% of gross domestic product, the possibility of even weaker-than-expected U.S. growth is very strong.
often the first to react. I'm still holding the ones that I bought last fall. I also believe that both investment-grade bonds and high-yield bonds will also do well. A slowing economy usually results in decreased credit quality, and I don't believe this time will be any different. However, the wide yield spreads offered by both high- and low-grade corporate bonds more than compensate for this risk. The corporate markets have acted well despite having to absorb a tremendous amount of new issuance this month. I think that this is an important tell, especially with the Fed determined to get the economy going again. The micro perspective pertains to the California utilities' bonds, and related worries that are caused by their recent downgrade to junk status. If you still hold Edison International (EIX Quote - Cramer on EIX - Stock Picks) and PG&E Corp. (PCG Quote - Cramer on PCG - Stock Picks) bonds, my inclination would be not to panic. These issues have been under heavy selling pressure for more than a month, culminating with their downgrades to junk status last week. Many investment-grade buyers and indexers are not allowed to own junk bonds, and have had no choice but to sell. My experience has been that selling into such a tidal wave has never been a good idea. With prices for secured debt of around 80 cents on the dollar for some issues and 50 cents for unsecured issues, we are at the point where speculators are starting to come into the market. Even if the utilities file for bankruptcy, and principal and interest payments are suspended for several years, we are probably closer to the lows in prices because of the potential for some recovery in bankruptcy court. It's a very difficult political situation to judge, and there is strong sentiment to make the bondholders help "pay" for the crisis. Such an outcome would be shortsighted, however, because bond investors have long memories. Most analysts agree that the ultimate solution to the crisis is additional generating capacity, but that will be extremely difficult to finance if bondholders are not treated fairly. A bankruptcy filing, ironically, may actually strengthen the bondholders' position. Although coupon payments would be missed, the uncertainties would be transferred from the political to the judicial arena, where bond investors tend to fare better. This would complicate the broad situation substantially. It would put additional pressure on insurers and banks that have guaranteed some of the bonds and municipal obligations backed by the utilities. Bankruptcy would also guarantee that it would take much longer for the situation to be resolved, so I view the prospect of insolvency as a powerful force to motivate the different parties to resolve the situation as quickly and fairly as possible. This situation also points out the benefits of the diversity that mutual funds can offer. I've written about how difficult it is to build a
diversified bond portfolio on your own, and how funds can provide diversity with little cost. California utility debt represented only a small portion of most funds' holdings. While most bond funds have not been dented badly, there is concern relating to money market funds and government pools that are designed to operate in a similar fashion. I'm not trying to yell fire in a crowded theater and have people rush out and sell their money funds. Peter Crane, vice president and managing editor of iMoneyNet, points out the most managers were aware of the utilities' problems and were able to sell what holdings they had early enough to avoid problems. I believe the problems will be isolated, and investor losses will be rare. There are some problems, though, and it is probably a good idea to make sure that you are comfortable with your money fund. Already, a pool run by Orange County in California (yes, the county that went bankrupt in 1994) and a pool in Texas have announced that they own significant California utility commercial paper positions. Accounting conventions have allowed the pools to avoid declaring a loss, Orange County by allocating the shortfall to income instead of principal, and Texas by carving out a separate share class consisting only of the utility paper. If these were money market funds, which get marked to market, or priced, on a regular basis, they would be faced with breaking the buck -- failure to maintain a constant $1 share price. No money market fund, called a 2(a)-7 fund for the SEC regulation that enables them to exist, has yet announced that it is faced with this problem (only one has ever not returned all of its investors' principal). When money funds have been confronted with this problem, the fund companies that offer them have taken steps such as buying the distressed paper from the fund to insulate shareholders. This puts the company, instead of the fund's shareholders, on the hook. It's in the company's interest to do this, as failure to do so would most likely cause a run not only on the affected money fund, but also on the company's other funds. Of course, the company must have both the financial ability to do this and a big enough product line in jeopardy. For this reason, I feel most comfortable with money funds offered by advisers with $20 billion or more under management. If you own a money fund from a smaller adviser, I'd recommend calling the company to see if it owns this paper. SEC filings are too out of date to be useful for money-fund analysis. Fund companies are under no obligation to reveal their holdings in anything close to real time, as it can be counterproductive for large investors who are widely followed. Still, a number of companies have come forward to announce what, if any, utility paper they hold and they should be applauded for that. If you are not comfortable with the answers you get from your company, and if it is a small firm, I'd consider switching to a money fund at a larger complex. A way to become even more comfortable with your money funds is to consider one rated AAA by Moody's or Standard & Poor's. This rating is no guarantee against a loss, but rated funds have to adhere to a much stricter set of regulations than the SEC allows. Peter Rizzo, director of the Fund Services Group of S&P, adds that, "You have the comfort of knowing that there is a team of analysts monitoring the fund weekly." Martin Duffy, vice president and senior analyst at Moody's, says that there are "no AAA-rated 2(a)-7 money funds that have exposure" to the troubled California utilities. Let's hope this situation will be resolved without the need to resort to bankruptcy court. Even if it does end up in litigation, a little analysis and patience could help keep you from singing the California Blues.
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