Cloud Covers Energy Bond Sale by State

Questions about the safety of revenues pledged to repay California’s upcoming electricity bond issue are worrying some big investors, which could translate into demands for higher interest rates on the mammoth offering.

The central issue for managers of large mutual funds--prime customers for the deal--is whether the revenues pledged to repay the bonds will be safe from challenges in U.S. Bankruptcy Court. Plans call for the bonds to be repaid with a specified portion of future rates collected from the state’s utility customers.

Specifically, investors are concerned that creditors in the Pacific Gas & Electric Co. bankruptcy, or creditors in a potential bankruptcy by Southern California Edison, might try to claim that some portion of those special fees that consumers will pay are part of a bankruptcy estate.

That would raise questions about whether buyers of the electricity bonds would receive all of the principal and interest the state says they’re entitled to. Because bond investors expect to be compensated for taking on added risk, uncertainty about full repayment could persuade them to demand higher yields on the bonds upfront.

The stakes are high. Proceeds from the $12.5-billion bond issue--the largest in U.S. history--will reimburse the state for the more than $7 billion it spent to purchase electricity for the utilities when power costs skyrocketed last year.

The bond issue, slated for sale in mid-August, also will give the state funds to buy more power if needed.

Because of its size and the potential for attractive yields on the bonds, the deal is still being eagerly anticipated on Wall Street. Though the yields on the securities have yet to be determined, the tax-free bonds in the offering could pay 4% to 6.5%, depending on maturity, analysts say.

For investors in the highest tax brackets, that could mean yields equivalent to 9% or more on fully taxable bank certificates of deposit.

But institutional investors see the revenue-security issue as a major hurdle. Those concerns may have increased recently with renewed Wall Street worries that Southern California Edison could follow PG&E; into bankruptcy.

“The big question is whether in a bankruptcy those rate revenues are the property of the utility, its creditors or the state,” said Steve Permut, vice president and director of municipal research with American Century Investments, a Mountain View, Calif.-based fund that manages $2.5 billion in California municipal bonds.

“That’s the key issue for us as buyers: Are those revenues protected? Without the revenue stream, those bonds have a limited value,” he said.

Another concern is whether there will be a formal agreement between the Public Utilities Commission and the state pledging that additional costs the state incurs buying more power, perhaps beyond a certain date, would be fully covered by utility customers.

That would give bond investors more assurance that they’ll get the interest and principal they’re owed over the life of the bonds, which could be as long as 15 years.

Municipal bond attorneys closely watching the deal said lawyers for the state, including such veteran California firms as Orrick Herrington & Sutcliffe; Sidley, Austin, Brown & Wood; and Hawkins, Delafield & Wood, have their work cut out for them.

“I don’t know how this all will pan out, but Hawkins and Orrick will have to give clean opinions that this revenue stream is insulated from an appeal by the utilities and by Bankruptcy Court,” said one municipal bond lawyer.

“It’s unclear how they can carve out a dedicated revenue stream when there is the potential for Bankruptcy Court to come in and try to take it.”

State officials are planning a conference call with major municipal bond investors nationwide on June 19 to provide more information on the bonds, according to the state treasurer’s office. The prospectus for the bond offering, which will disclose any legal risks associated with the bonds to potential buyers, is expected to be available for investors in July, officials have said.

“When they see the [bonds’] structure, [the buyers] will see that they are protected,” Treasurer Phil Angelides said last week. “Until then, it’s only natural they would have questions,” he said.

Angelides and other state officials contend that several pieces of legislation passed this year protect the revenue stream intended to repay the bonds.

One is a bill lawmakers passed in January that calculates how much money is needed from consumers over time to reimburse the state for energy purchases, and uses that calculation to determine the total the state can raise by selling bonds.

Another bill, passed in May after lawmakers began to fear legal action by utilities over the future-revenue issue, gave the state added powers to protect bondholders, Angelides said.

He contends that, despite potential legal challenges, the portion of electric rates collected to pay bondholders will be the property of the state.

“The law is very explicit--those revenues are not the property of the utilities,” he said.