Capital formation is critical for any lasting economic recovery. Nothing makes that possible like cheap money. And when it comes to strong companies, the green stuff has rarely flowed as freely as it has the past year.
The latest demonstration is this week’s announcement of a $250 million issue of 30-year bonds by Nevada Power, a subsidiary of NV Energy (NYSE: NVE). Eighteen months ago, the company couldn’t issue 10-year bonds for less than 7.125 percent interest. On Thursday, however, it sold 30-year debt with a yield of just 5.396 percent, or only 160 basis points more than 30-year Treasuries.
Treasury yields, of course, are also at their lowest rates in decades. That’s the consequence of an unprecedented loose monetary policy by the US Federal Reserve, coupled with the reality that the US dollar and Treasury paper are still considered the investments of last resort in dangerous markets.
It’s the same policy that’s been in place since the 2008 crash. And with the US economy’s momentum apparently slowing over the summer, it’s not going to change significantly for the tighter any time soon.
What’s changed is investors have extended their appetite to bonds of all stripes, now matter what their credit quality. Nevada Power, for example, only recently regained an investment-grade rating, the result of a long recovery over the past 10 years that began with the regulated electric company on the brink of Chapter 11. The company now rates just BBB- from S&P. And maintaining that depends heavily on the continued cooperation of Nevada regulators, hardly a given at a time when the state’s unemployment rate is the highest in the nation.
As Utility Forecaster readers are aware, my own analysis is that despite the weak economy the solid regulator/utility cooperation in the state will endure past November elections. That should ensure support for the company’s ambitious capital spending plans.
Nevada’s US senate race has captured national media attention for the challenge to Democratic Majority Leader Harry Reid. For investors in Nevada Power and its parent company NV Energy, however, the key race is for governor, as that’s who appoints members of the Public Utilities Commission of Nevada (PUCN).
The good news on that score is that polls strongly favor a continuation of Republican rule. Nevada Power’s long climb back over the past 10 years has only been possible because a succession of Republican governors have appointed PUCN members who have worked with the utility rather than continually bash it, as was the rule before them.
The latest Rasmussen Reports survey shows Republican Brian Sandoval holding a 55 percent to 33 percent lead over Democrat Rory Reid. Past polls show a similar divide between Sandoval and Reid, the son of Senator Harry Reid. Even more encouragingly thus far, the subject of utility rates has remained largely out of the limelight.
Political winds can change swiftly, however. Democrat Reid wouldn’t be the first fading candidate to try to grab the populist mantle in tough economic times by slamming the local utility. And should such a message gain traction, Republican Sandoval would have to respond in kind.
That risk is well reflected in NV Energy’s share price, which is still only 95 percent of book value. It’s in no way, shape or form, however, reflected in the price of Nevada Power’s 30 year bonds at a yield premium of just 160 basis points to Treasuries. And while inflation is nowhere in sight in late 2010, neither is the slightest bit of interest-rate risk priced in whatsoever.
The bottom line is Nevada Power’s bonds aren’t being priced by any rational formula with reasonable assumptions of credit and interest rate risk. Rather, like the entire bond market today, it reflects an overheated and overwrought market mood.
Individual investors and institutions alike are terrified of getting caught up in another 2008. And despite being almost universally negative on the economy and market, they’re equally fearful of missing an unlooked for market rally.
At the root of the mood is that many investors unloaded stocks at the bottom in late 2008 and early 2009 and have been afraid to get back in since. More than a few have succumbed to the relentless barrage of political commentary to conclude there’s no hope and/or that day of reckoning is coming for those foolish enough to stay with stocks. And they’ve grown progressively more frustrated as stocks of high-quality companies have wended their way higher.
To many of these investors, bonds have been the ideal answer to their angst, offering an opportunity to earn a decent yield without the worry of what will happen to the stock market. Ironically, those who buy high-quality bonds now are locking in paltry returns that price in neither credit nor interest-rate risk. Meanwhile, those who buy bonds with lower credit quality or longer-dated maturities are setting themselves up to absorb sizeable losses if either interest rate or credit risk increases, even if the underlying companies stay solvent.
Any perception that a potential recession has become a greater risk to corporate credit, for example, will widen out yield premiums to Treasuries. Bonds like the Nevada Power 30-year issue traded at premiums of 600 points and more in early 2009. Normal premiums are in the 300 basis points range, nearly twice today’s once-in-a-lifetime 160 points.
That adds up to a pretty steep correction in prices and loss of capital for those who buy now. And a premium of just 160 basis points also robs these bonds of any resistance to rising interest rates, ensuring that when Treasury yields do rise, their value will fall commensurately.
Most dangerous of all remain closed-end mutual funds specializing in bonds. Managers of open-end bond funds must continually adjust their portfolios to invest incoming funds as well as cover redemptions. In contrast, the only way to buy and sell closed-end funds is to trade their shares on major stock exchanges.
The positive is they’re never forced by their investors to buy or sell anything. However, with low interest rates spurring companies’ redemptions of higher-cost debt, closed-end bond fund managers are seeing a growing chunk of their portfolios being converted from higher-yielding bonds to cash paying virtually nothing. As a result, they’re being forced to either reinvest in newly minted bonds with lower yields or else going further out the risk spectrum in search of yields comparable to those paid by the maturing debt.
As a result, their investors are being exposed to greater and greater risk that will explode into sizeable losses if either credit or interest-rate concerns surface again. Another danger: These funds’ posted yields are now at or near all-time highs relative to posted percentage yields on individual bonds and open-end bond funds, which always reflect current market conditions.
As a result, investors have run up these funds’ prices to levels–or premiums–that are well above the value of their assets. Market history shows it doesn’t take much to cause sharp contractions in these premiums, should the market mood for bonds darken even a little. That, too, means big losses for owners of closed-end funds, even if asset value remains steady.
Now for the good news: Today’s rock-bottom bond yields are very good news for stockholders. Nevada Power’s bond issue, among other things, will boost the company’s balance sheet by eliminating $206 million in “local furnishing bonds” as well as a revolving credit facility, further limiting any near-term refinancing risk and cutting interest expense as well.
The great refinancing of the past year is the single biggest reason why a reprise of the 2008 credit crunch can’t occur in 2010 and 2011. There just isn’t enough debt coming due to trigger a shortage of available refinancing resources.
Even assuming the increasingly remote possibility that conditions did contract to that extent, companies could simply wait it out. That, in fact, is exactly what most did in the immediate aftermath of the May Flash Crash and European sovereign debt scare. Bond issue volume dried up for a period in May and into early summer but quickly resumed with a vengeance as conditions improved.
Low corporate bond yields/borrowing costs are also extremely bullish for companies playing offense in this economy–in other words, those taking advantage of low asset prices to make quality acquisitions from distressed owners and capitalizing on low raw material and labor costs to build other assets.
Electric utilities like Nevada Power, for example, are extremely capital intensive. Low borrowing rates coupled with low raw material and labor costs mean they can build needed power plants and transmission infrastructure more cheaply. That makes regulators a lot more likely to approve a generous return on the investment, which, in turn, strengthens the balance sheet and boosts the company’s ability to complete more capital projects in a timely and cost-effective way.
The other side of the equation is the cost of equity capital, i.e. issuing stock. With the S&P 500 still nearly 30 percent off its late 2007 high, it’s no wonder most US companies have been buying back shares rather than funding growth by issuing more. In fact, the market has routinely punished companies that issue more shares, no matter what management has pledged to spend the cash on.
One sector that’s been able to issue equity at good rates, however, is master limited partnerships (MLP), particularly those specializing in owning and operating energy infrastructure. With US oil and gas producers drilling the country’s prolific oil and gas shale reserves as never before, demand for building new pipelines, gathering systems, processing facilities and storage centers has rarely been more robust.
That’s created an asset-building boom–with the builders able to fully contract new facilities before turning the first spade full of earth. Further, Cheniere Energy (NYSE: LNG) has now won Dept of Energy permission to begin the task of enabling its import-focused liquefied natural gas facilities to export.
That project will require substantial investment and time. If completed, however, it would allow US shale gas to come to global markets for the first time, where natural gas is priced considerably higher. That, in turn, would almost surely spur more development of shale gas, and even more demand for infrastructure.
Even energy infrastructure MLPs have usually taken hits when they issue equity. Particularly hard hit have been those selling units with the market mired in one of its periodic fear-spurred selloffs. Energy Transfer Partners LP’s (NYSE: ETP) mid-August equity offering, for example, was actually upsized from 8 million to 10.9 million units due to robust demand. That’s a lot of low-cost capital to fund its two major pipeline projects, expected to begin producing revenue next year.
Energy Transfer’s unit price, however, quickly plunged below the offer price of $46.22 per unit, hitting a low of less than $45 on Aug. 25, when the deal officially closed. Already agitated by economic news that apparently saw the economy slowing in the summer, investors could only see the potential dilution by the MLP having more units outstanding.
Since then, however, Energy Transfer’s unit price has bounced back to more than $1 above the equity offer price. Skepticism faded and the buyers came back. The only losers have been those who sold out on the downturn, more than a few no doubt because they followed the mindless and self-defeating practice of setting trailing stop-losses.
Not every stock rates a buy just because the company it represents is able to issue low-cost capital now. That exalted distinction goes only to companies with strong underlying businesses, be they MLPs, real estate investment trusts, utilities or any other high-yielding investment.
But issuing low-cost capital does vastly improve the prospects of any company, and therefore its common stock. That’s definitely the case for NV Energy in the aftermath of its issue of extremely low-cost, 30-year debt.
Conversely, the ability of so many companies to issue low-cost capital is extremely bullish for the overall economy and stock market. History shows it can take a lot longer than anyone expects for strong balance sheets to translate into job growth, or even robust stock market gains. But there’s no better foundation for sustained long-term growth–and higher stock prices and dividends for high-quality companies.
Question of the Week
- I read in the Wall Street Journal that major telecommunications companies are joining the battle to extend low tax rates for dividends. The companies also seemed to be saying that failure to extend low rates would hurt their stocks and ability to invest in American infrastructure. How worried should I be?
Taxes are always a key issue in political campaigns. And with the extensive tax cuts enacted by former President Bush and the Republican Congress from 2001-03 expiring on Jan. 1 it was inevitable they’d take on more than the usual importance this time around.
Equally, it shouldn’t surprise anyone that the typical partisan rhetoric has been dramatically ratcheted up this season. On the Republican side, extending the tax cuts across the board is one of the very, very few issues that really unite the mish-mash of candidates emerging from an exceptionally bloody primary season.
Democrats are less divided, owing to a lack of real primary challenges. But they also know they face huge losses both in the US Congress and state houses unless they can latch onto an issue that resonates with the public. And they’ve decided that offering to make tax cuts permanent for those earning under $250,000 and jacking up taxes to pre-Bush rates for those above that number is something to rally behind.
The irony here is that both sides are really pretty close together on the subject of dividend and capital gains tax rates. President Obama’s 2011 budget proposes raising the top rate on dividends and capital gains to 20 percent. That’s more than the current 15 percent but a lot less than going back to the top ordinary income rate of 39.5 percent. And again, the rate won’t change for those making less than $250,000.
With less than two months left in the campaign, no one has any political incentive whatsoever to sound a conciliatory note. Washington, DC, however, is a town built on doing the deal. And once the sound and fury dies away, however, the need to compromise on what is a very key issue will become paramount again.
Even if Democrats defy the polls and hold onto control of both houses, the leadership and the Obama administration will still have to give ground on investment taxes to appease moderates in their own party. And if Republicans win seats–let alone control–extending low investment taxes is a done deal, very likely at the current top rate of 15 percent.
Between now and then, you should expect to see more horror stories in the financial media particularly about what will happen if investment taxes go back to pre-Bush era rates. The reality, however, is there’s very little chance of that happening. Any selling investors do on that basis will be an opportunity to buy good companies.
If you are that worried that your dividend tax rates are going up, I suggest buying some high-quality MLPs. I recommend several good ones in Utility Forecaster, and Elliott Gue and I co-write MLP Profits, which covers every US MLP.
MLPs shelter income because most or all of their distributions is considered a return of capital (ROC). ROC isn’t taxed when paid, but rather is deducted from your cost basis. You pay tax only when you sell, and your “income” will be considered long-term capital gains.
As for the possibility of MLP tax rules changing, the Democratic Congress that took power in 2007 actually liberalized them in investors’ favor. There is a push to tax carried interest, which is used by hedge funds and some MLPs to shelter income. The lead bill in Congress, however, specifically excludes energy-related MLPs from any new levies, including general partnership interests. Unless you own something like AllianceBernstein Holding LP (NYSE: AB), there’s nothing to worry about.
MLPs’ unit prices would also benefit from a sharp rise in taxes on other income investments. Again, I don’t think that’s likely. But owning a few high-quality MLPs may help you rest easy–and the good ones grow cash flow, distributions and unit prices like clockwork.
Editor’s Note: For additional information on this topic, check out Roger Conrad’s latest report on High-Yield Dividend Stocks.
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