Rate Reduction Bonds - Finding Value in an Esoteric Market

Born out of deregulation in the 1990s, rate reduction bonds (RRBs) are increasingly used by utilities to fund costs associated with natural disasters and help fund the transition to clean energy. Securitized by fees charged to a utility’s customers, they typically provide predictable cashflows and are of generally high credit quality. RRBs are issued by a separate special purpose entity (SPE) and are thus bankruptcy remote. These types of bonds also benefit from a “true-up” mechanism that allows the servicer to increase fees at any time. Typically AAA-rated, RRBs are not easily bucketed into one segment of the fixed income world and are often less liquid than more plain vanilla high-grade bonds. Therefore, they often trade at more generous spreads than other similarly-rated securities, providing potential value as a diversifier in a fixed income portfolio.

RRBs are issued by electric and gas utilities to repair or upgrade their systems and are secured by the right to impose and collect charges from all utility customers in each service area. Older vintage RRBs were born out of deregulation when the resulting decrease in revenues caused many electric utility assets to become uneconomic to operate. RRBs were first developed to help recover the costs associated with these “stranded assets.” However, more recent issuance has largely related to natural disasters, helping utilities recover costs associated with wildfires, floods, and hurricanes.  We could also see efforts to issue RRBs to help fund the transition to renewables and hardening of assets by the utilities.

Similar to other asset-backed securitizations, a bankruptcy-remote SPE is created by a utility for the sole purpose of issuing RRBs. This isolates bondholders from any risk associated with severe credit deterioration of the utility. The securitization is backed by the right to receive payments from a utility’s customers over the course of several years, with the utility collecting and immediately transferring those payments to the SPE (Figure 1).

Figure 1: The SPE Isolates Bondholders from Event Risk Associated with the Utility

Source: PGIM Fixed Income.

A Highly Predictable Payment Stream

The legal framework for RRBs is based on a securitization law passed by each state legislature and an irrevocable financing order issued by the state’s utility commission. Together, these authorize the issuance of financings and create the collateral, which is the right to collect the securitized charges from ratepayers until the bonds mature. Additionally, a non-impairment pledge is taken by the host states to not take or not permit any action that would impair the value of the collateral in the future.

These bonds also benefit from a statutory and uncapped "true-up" adjustment mechanism that allows the utility to increase the charges, at any time and in an unlimited amount, to pay its debt service. We believe the strength of this mechanism largely mitigates the risk that collections could fall short due to a variety of factors including a significant decline in the ratepayer base, an inability to accurately estimate market demand, or an increase in customers moving to cleaner sources of energy.

The securitized charges may be presented on each customer’s monthly bill as a flat fee, or a fluctuating amount based on kilowatt hour usage and typically make up a small portion (e.g. 6%) of customer bills on average. The relatively small charge, along with a large and diverse customer base, helps ensure a highly predictable payment stream to the bondholders.

Relative Value

The cold snap in Texas that caused millions of customers to lose power in 2021 caused a notable uptick in RRB issuance as a number of electric power cooperatives sought to recover costs incurred in the wake of Winter Storm Uri. Given the success and wider use of these structures, we expect to see more issuance in the coming years.

After totaling $21.2 billion in 2022, issuance thus far in 2023 has totaled $5.8 billion (Figure 2).

Figure 2: RRB Issuance Saw a Spike Following Winter Storm Uri ($ billions)

Source: Finsight. As of June 1, 2023.

By far, the largest deal so far this year was a $3.5 billion, AAA-rated issue for Texas Natural Gas Securitization Corporation aimed at recovering costs incurred by several natural gas utilities in the aftermath of Winter Storm Uri. The costs will now be spread out over many years with the ratepayer charges applied to gas utility bills. The RRBs were issued in two nearly equal tranches, one having a final maturity in 2035 with an average life of 5.96 years and one with a final maturity in 2041 with a 13.42-year average life. Final pricing was 90 bps over five-year Treasuries and 125 bps over 10-year Treasuries, respectively. These spreads were relatively attractive versus other high-quality paper in the asset backed (ABS), corporate, and municipal markets. For context, spreads for AA-rated, 5-7-year and 10-15-year corporates were 19 bps and 13 bps tighter at 71 bps and 112 bps, respectively, at the time (Figure 3).

Figure 3: Texas Natural Gas Securitization RRB Spreads Attractive Versus Corporates (bps)

Source: PGIM Fixed Income, Bloomberg. As of March 10, 2023.

The Liquidity Premium

RRBs are not easily bucketed into one segment of the fixed income world. Depending on the sponsor of the issuance, RRBs can find their way into the ABS, corporate, or municipal markets. Since the utilities and SPEs issuing the bonds can be public or corporate, the classification of security type can also vary. We believe this creates the potential for mispricing and an opportunity to invest in high quality securities at more generous spreads than similar rated securities. In addition, RRBs are less liquid than more plain vanilla bonds due to the esoteric nature and generally small size of the market, which also contributes to their somewhat wider spreads.

Although not without risk, RRBs are high-quality bonds that offer a range of duration profiles and a notable yield advantage over other similarly-rated assets—especially in the new issue market when concessions are often offered in order to place the large-sized deals. For investors willing to sacrifice some amount of liquidity, we believe they offer compelling value as a diversifying fixed income asset class.

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Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of 6/13/2023.

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