High-yield portfolio managers are being forced to bone up on the utility sector as downgrades send more and more issuers into their indices. With last week's downgrade of El Paso Corp. (Ba2/BBB) by Moody's Investors Service, they now must contend with the fact that two of the five largest components in the Merrill Lynch High-Yield Master II index are in the utilities sector (Williams Companies is the other). Utilities now comprise 7.9% of the index and have a market value of $32.2 billion. That compares to 4.8% and $13 billion just two years ago.
Utilities are likely to be one of the main drivers of performance in 2003, according to Patrick Flynn, portfolio manager of distressed credits at Putnam Investments. "It's a big sector and it's getting bigger. People have a bet on it whether they own it or not," he says. Flynn would not be specific about Putnam's exposure to the sector, however.
Ron Bringewatt, responsible for some $1.5 billion in high-yield at TimesSquare Capital Management, has recently been buying first mortgage bonds of Western Resources (Ba2/BB+) and Nevada Power (B1/B+), which are secured by the companies' assets. He says secured notes such as these have historically done very well even in the event of a bankruptcy filing, as demonstrated by recovery levels for Pacific Gas & Electric. Bringewatt says TimesSquare is more likely to add exposure to these credits rather than independent power producers or those that have relied on merchant energy trading, such as El Paso, Calpine Corp (B+/BB), Mirant (B1/BB), AES Corp. (B3/B+) and Dynegy (B3/B).
Other portfolio managers say they will not rule the IPPs out. Eric Misenheimer, portfolio manager at Northern Trust Global Investments, has been tracking the stock prices of companies such as AES and Mirant, noting that a continued rally might indicate they could strengthen their balance sheets through an equity or convertible offering. In such an event, they might merit a closer look, Misenheimer says. While the stock prices have doubled, they still remain under $3.
Some investors are also taking a look at higher-yielding investment-grade utility issues. Arthur Calavritinos, portfolio manager at John Hancock Advisers, recently bought the TECO Energy 10.5% notes of '08. Priced at 92.684, TECO (Baa2/BBB-) had a yield of roughly 12%--greater than many high-yield issues.
Sell-siders such as Shawn Burke, a high-grade utility analyst at HSBC Securities, say they are increasingly hearing from high-yield accounts about the sector. Burke says high-yield money managers sat up and took notice after Credit Suisse First Boston and Berkshire Hathaway lent $1.31 billion to CenterPoint Energy--a sign that the smart money sees value in the sector. "Will high-yield guys focus on this next year? The answer is clearly yes. The accounts that can move swiftly with a more aggressive risk appetite essentially are already doing it. Everyone realizes the 'sell everything' trade is over. Accounts will have to be more selective on the upside to pick the winners from the losers."