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Fixed Income Quarterly—Gas & Electric Utilities
Viewpoint
During Q1/14, Utilities outperformed from a broad perspective despite slightly underperforming in the short, mid and long buckets, reflecting the above-average duration of the sector. Within the FTSE TMX Canada Universe Corporate Bond Index, Broad Energy – Distribution generated a total return of 4.92%, which is above the 2.95% Broad All Corporates total return. More specifically, the short bucket return was 1.31% compared to the Short All Corporates return of 1.39%, mid- dated Energy - Distribution paper generated a return of 3.56% vs. 3.85% for Mid All Corporates, while longs came in at 5.97% vs. 6.06% for Long All Corporates.
Infrastructure – Utility generated a broad total return of 4.83%, which was above the Broad All Corporates total return of 2.95%. In the short bucket, Infrastructure – Utility generated a total re- turn of 1.53%, above the Short All Corporates return of 1.39%. In the middle of the curve, Infrastructure – Utility generated a total return of 3.83% vs. 3.85% for the Mid All Corporates, while longs came in at 6.15% vs. 6.06% for the Long All Corporates.
Energy – Generation outperformed from a broad perspective (4.40% vs. 2.95%). We note the outperformance from a total return perspective in the short (1.95% vs. 1.39% for the Short All Corporates) and middle (4.42% vs. 3.85% for the Mid All Corporates) and the underperformance in longs (5.32% vs. 6.06% for the Long All Corporates).
Broadly speaking, we are expecting continued strong results from the Canadian Utilities, largely driven by rate base additions due to the large capital expenditure programs currently in place (i.e., Hydro One, AltaLink and CU Inc.).
Recommendations: 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 Underperform rating is twofold: (1) in a rising interest rate environment (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 dura- tion; 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. We stress that our Underperform recommendation is interest-rate-driven, as we remain optimistic on industry fundamentals. Underpinning this optimism is our expectation for improving ROEs over the medium term, supportive regulatory mechanisms during periods of above-average capex and a continued need for gas and electric- ity infrastructure development across the country.
Hydro One is our top pick fundamentally among the large Utility issuers. Looking ahead, we believe the company is well positioned to benefit from rate base growth as the Province of Ontario works to rebuild its aging infrastructure and to integrate renewable en- ergy projects into the grid. While it is logical to expect Hydro One
Chart 1: 10-Year Indicative Utility Spreads 400
350 300 250 200 150 100
50
CU Inc.
Hydro One FortisBC Union Gas Ltd. Ontario
0
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14
Source: BMO Capital Markets
bonds to face relative weakness on the back of significant financ- ing needs over the next few years, we believe the bonds should trade at a premium to its peer group given Hydro One’s strong cash flow outlook, forecasted rate base growth, stable regulatory environment and above-average trading liquidity.
In the Gas Utility space, our preferred issuer is Enbridge Gas Distribution given the company’s enviable franchise area, growth rate, liquidity and strong financial metrics. While Union Gas bonds appear to have an attractive valuation relative to Enbridge Gas Distribution, we believe technicals will continue to trump fundamentals in 2014. Our thesis is that Enbridge Gas Distribu- tion bonds will continue to trade at a premium valuation given manageable supply expectations coupled with the myriad “BBB” options available at wider spread levels (relative to BBB+ rated Union Gas) that investors with credit rating constraints have to choose from.
We recommend an Overweight position in AltaLink, L.P. bonds and take notice of the current slate of electric transmission oppor- tunities in Alberta, a regulatory environment that we continue to admire. Our thesis remains that the emergence of cash flows once projects are completed will begin to complement a regulated asset base over the next few years. In addition, for investors comfortable with the inherent risks of owning utility holdco paper, we highlight the likely scarcity value of owning AltaLink Investments, L.P. (AILP) given the reduced need for AILP issuance going forward (other than maturities), as AltaLink’s capex needs are expected to decline significantly in 2015 and beyond.
We recommend holding a Market Weight position in EPCOR Utilities Inc. While we suspect S&P’s Positive outlook will ulti- mately result in a rating upgrade to A-, we believe this is already priced in given the significant spread compression. EPCOR bonds are currently trading 9-10 bps wider across the curve relative to Hydro One, versus 34-37 bps wider at the beginning of 2013.