Fixed Income Viewpoint
Gas & Electric Utilities – April 2014
Sector Rating: Underperform Relative Value
5-Year: Underperform 10-Year: Underperform 30-Year: Underperform
Spread View – During Q1/14, performance in the Utility sector bested the FTSE TMX Canada Universe Corporate Bond Index, driven by the 26 bps tightening in long Canada’s. Despite being on the wrong side of the call this quarter, our Underperform stance remains intact. The basis for our Under- perform rating is twofold: (1) in a rising interest rate environ- ment (even moderately) it will be very difficult for the total return of the utility sector to match the broader market given the sector’s naturally long duration; and (2) we do not believe Utility spreads will tighten more than the broad market index, especially given long Utility spreads are beginning to break through their recent trading floor. Fundamentally, we remain optimistic on the sector given our expectation for improving ROEs over the medium term, supportive regulatory mecha- nisms during periods of above-average capex and a continued need for gas and electricity infrastructure development across the country.
Credit Curve – During the first quarter, the Utility 2s-5s credit curve flattened by 2 bps to 22 bps, the 5s-10s curve flattened by 2 bps to 36 bps, and the 10s-30s curve flattened by 1 bp to 32 bps (Table 5). In light of the relative steepness, we see better value in the middle part of the credit curve.
Sector Value – Using 30-year Hydro One spreads as a proxy, at 129 bps, long utilities are trading through the recent 130- 150 bps trading range. We believe spreads will remain tight in Q2/14 given our expectation for minimal supply in the quarter; however, levels will likely widen slightly in H2/14 in conjunction with increased primary supply. We continue to favour liquid names that possess strong rate base growth, good cash flow visibility and favourable regulatory regimes.
Recommendation
Top Picks – Hydro One and AltaLink, L.P. remain our top picks in the Electric Utility corporate credit universe. In the Gas Util- ity space, our preferred issuer is Enbridge Gas Distribution.
Risks
External – Cost-of-service and performance-based regulation mitigates many external risks such as commodity price volatility and interest rate movements.
M&A – Save SNC’s potential sale of AltaLink, we do not expect any material M&A activity in the near term. How- ever, we believe utility and power companies are likely to complete “tuck-in” acquisi- tions in the U.S. given pre- mium valuations in Canada.
Regulatory – We believe there will continue to be a produc- tive regulatory environment in Canada for Utilities, including attractive ROEs and deemed equity thickness as well as the allowance for construction work-in-progress in rate base in selective jurisdictions.
Mark Laing, CPA, CA, CFA
BMO Nesbitt Burns Inc. mark.laing@bmo.com (416) 359-4601
Trading Liquidity – The Utility sector exhibits average trading liquidity in the Canadian bond market. Enbridge Gas Distribu- tion and Hydro One provide the greatest liquidity.
New Issuance – For 2014, we estimate the Utility sector will issue approximately $6.5 billion. In terms of timing, we expect regulated utility issuance levels will be stronger in H2/14, which should bode well for spread performance in the first half of the year given the expected lack of supply.
Credit Profile
Sector Financials – Elevated capex and financing needs will continue to pressure the sector’s financial position in 2014; however, as we are nearing the peak of the current capital cycle, short-term balance sheet pressure should lead to future earnings and cash flow growth.
Sector Fundamentals – Ongoing rate base growth momentum in the context of a productive regulatory environment will have a positive long-term impact on credit fundamentals.
Credit Ratings – There were a number of rating actions during Q1/14: (1) S&P revised its outlook on A- rated AltaLink L.P. and AltaLink Investments L.P to Stable from Negative; (2) Moody’s revised its outlook on TransAlta Corp. to Negative from Stable; (3) DBRS revised its outlook on FortisAlberta to Positive from Stable; and (4) S&P revised its outlook on Brook- field Renewable to Positive from Stable. We expect a number of outstanding rating actions to be resolved in 2014, including those affecting the Emera and Fortis-related entities.