Let's bring back utility preferred stock... Sort of
The following is a viewpoint from Todd Shipman, founder of Utility Credit Consultancy, LLC and former senior director of S&P Global Ratings.
Distributed generation, rapid technological advances, ever-evolving environmental mandates that could strand under-depreciated assets and even the U.S. tax code are presenting utilities with greater risk. Capital markets seem poised to raise the cost of capital for utilities just when they need more of it. Ratepayers would eventually foot the bill for any of those higher costs. What's a utility to do?
No, not Priuses and Volvos. Hybrid securities. A mix of debt and equity, but not quite either, hybrid securities used to occupy an important slot in utility capital structures and offer meaningful support for utility credit quality.
If used properly, hybrids can benefit ratepayers as a cost-effective way to strengthen a balance sheet, helping to maintain or improve credit ratings in the face of rising challenges to the historical utility business model and utility risk profiles. It's time to reawaken them, but not in their traditional preferred stock form.
Why Hybrids? Why Now?
A hybrid security has features that place it somewhere between pure debt and pure common equity. As a blend, its cost (the yield it must offer to attract investors) falls in between as well. The payoff is that the rating agencies see it as something that's also in between and assign it "equity credit" that improves their perception of a company's financial risk.
It's a win/win/win: better credit ratings to lower capital costs to relieve the pressure on rates for ratepayers, slightly better returns for investors for accepting a little more risk, and a stronger balance sheet for the utility that strengthens credit quality and eases the cost and access to capital.
What makes a security a hybrid? While the details can be hopelessly complex, the concept is simple.
It pays a stated distribution like debt interest. It doesn't have to pay it though, like a common stock dividend that can be reduced or eliminated. It is subordinated to debt but comes in front of common stock in priority, and it usually is longer-lived than debt though not always perpetual like common stock. In its traditional preferred stock form it is expensive because the dividend was not tax-deductible, so it was for many years not widely used outside of regulated companies like utilities and banks.
For utilities, preferred stock used to make up 10% or more of the capital structure but fell out of favor (see the graph below).
I think a primary contributor to its near-disappearance is that the rating agencies stopped treating preferred stock like 100% equity. As long as hybrids were not overused, they basically ignored them in calculating the credit metrics that guided their assessment of financial risk. Then, new kinds of hybrids upset the status quo.
Some bright people on Wall Street figured out how to make preferred stock dividends tax-deductible by running them through a trust, and the lower cost opened the world of hybrids to a greater assortment of companies. That attracted rating agency attention, and by the mid-1990s, they came up with the concept of equity credit. Along with it, came the notion that the credit should be less than 100%.
At first, the percentage could be anywhere in between, but eventually the settled treatment standardized around the 50% debt/50% equity mark. In some forms, the equity credit can be lower.
The loss of full equity treatment was a terrific blow to utility preferred stock. Rising industry risk in the wake of expensive new nuclear capacity followed by deregulation trends argued for more actual common equity to undergird credit quality.
Something Old, Something New
Why revive utility hybrids now? First, risk is worsening for utilities. Moody's recently went negative on the whole sector.
Second, new types of hybrids and the maturing of rating agency analytical approaches to hybrids means utilities can be more confident that lower-cost hybrids with dependable equity credit from the agencies are now possible.
The idea of rising utility risk profiles hardly needs defending. The very basis for the utility business model, the notion that it's a natural monopoly, is in question even for electric distribution utilities.
Layered on that stress are mega-trends such as the globalization of the natural gas market and the demise of the large central electric generating station as the linchpin of the electric grid. Add to that many other developments such as tax reform and rising interest rates, and it's hard to argue with the moodiness of Moody's outlook.
Advances in hybrids have been less evident but just as profound. The rating agencies, after many years of struggling with how to treat hybrids, seem to have arrived at something of an accommodation with them that should sustain the analytical approach to how much equity credit a hybrid supports.
And hybrids are regularly issued in other markets around the globe with features that help lower its cost while maintaining equity credit, and those structures can be adopted in the U.S.
Parent or Subsidiary
The basic decision facing a utility interested in issuing hybrids is where to do so.
The most straightforward and efficient entity to place hybrids is the parent company when available. It eliminates the need for regulatory approvals and can probably be done in larger increments to keep transaction costs down.
Hybrids issued at the utility level can also be attractive, though more care must be exercised. Adding equity cushioning at the utility is especially useful when direct credit support is needed to support ratings there.
A subordinated debt structure that the agencies can be comfortable with over the long haul will improve credit metrics through equity credit, while keeping the cost of capital down. To work effectively, a utility hybrid should:
Not displace common equity in the capital structure — that would only harm the utility's financial strength. Unlike the old preferred-s, today's hybrids are at best “half-equity” and sometimes less, so using them in lieu of common would actually detract from credit quality.
Be in the form of deeply subordinated debt and not preferred equity. This would reinforce that they are part of the debt component of the capital structure, and it would solve one of preferred stock's major drawbacks, its inflexibility (witness Pacific Gas & Electric's suspension of preferred dividends earlier this year, which they were apparently compelled to do when they suspended common dividends.). I think the debt can be structured to maximize equity credit.
Be used as much as possible to maximize their effectiveness. Rating agencies impose limits on hybrids, but there's nothing wrong with using nearly all that capacity. Hybrids help absorb losses alongside common stock, and they should be as prominent as possible to help an issuer get through a rough patch by alleviating cash flow pressures when necessary.
Be part of a commitment by both the utility and regulator to maintain hybrids as permanent part of the capital structure. That would provide confidence that it is a long-term cushion to improve credit ratings and thus solidify the equity treatment by the agencies.
I encourage utility financial managers to explore greater use of hybrids as one more tool in the kit to deal with the important goal of maintaining or improving credit ratings in the face of increasing risks.
It will take much education to ensure that more activity in this complicated area of the capital markets doesn't unintentionally raise a utility's financial risk and capital costs.
Now is not the time to weaken balance sheets in the face of rising risk. Greater use of the right kind of hybrid securities could “evolutionize” the equity component of utility balance sheets, supporting credit ratings just when it's needed most.