Utilities: Investing in an "Essential" Muni Bond Sector

We think municipal utilities are likely to remain resilient, though the sector does face some pandemic-related headwinds.

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This article is from the Q2 2020 edition of The Muni Quarterly.

Municipal utilities in the public power, water, and sewer sectors historically have been viewed as defensive, low volatility, names. We believe they have lived up to that reputation at this point of the COVID-19 pandemic (through early July 2020). The inherent fundamental strengths and sound financial profiles of municipal utilities have, to date, offset COVID-19 driven headwinds.

Municipal utilities benefit from the fact that they provide services that are essential in any economic environment, their monopoly status, and unregulated independent rate setting authority. Ratepayers typically pay their utility bills without thinking twice because water and power are essential services, and these services can get disconnected in the event of customer nonpayment. Given no competition in their service areas and the ability to raise rates as much as necessary, municipal utilities entered the COVID-19 environment with generally sound financial cushions. Per Moody’s, public power and water utilities have historically had medians of 200+ and 300+ days liquidity on hand, respectively. In addition, debt service coverage ratios have been healthy, with historical medians of over two times for both public power and water utilities.

Pandemic Headwinds

These fundamental credit strengths and sound financial profiles have helped municipal utilities offset the credit headwinds driven by COVID-19. One potential challenge presented by COVID-19 has been higher delinquency risk. Utilities nationwide have provided relief to ratepayers struggling with personal finances and unemployment by suspending service shutdowns in the event of nonpayment. In other words, the ratepayers will continue to get utility services even if they are not currently paying their utility bills. Therefore, we expect delinquency risk, which has been historically low for utilities, to increase, especially for utilities operating in economically disadvantaged service areas.

Another difficulty arising from COVID-19 has been weaker commercial and industrial revenues, as these customers may not be operating at normal capacities. However, losses in commercial and industrial revenues may be offset by decreased operating costs or increases in residential revenues.

Credit Considerations

In the COVID-19 environment, we have been making certain credit distinctions among similarly rated municipal utilities. We have been preferring utilities with higher liquidity levels and wealthier service areas, in order to offset delinquency risk. In addition, we have been focusing on utilities deriving a lower percentage of revenues from commercial and industrial customers.

Although we are making distinctions between municipal utilities, we must note that we continue to generally expect all high-grade municipal utilities to retain that credit standing even with COVID-19 related pressures. In addition, we expect municipal utilities to continue to maintain lower credit and headline risk relative to other high-grade municipal sectors. People and businesses are always going to need water and power. Time and again, municipal utilities have demonstrated how essential—and resilient—they are, and we believe this likely will not change in the time of a pandemic.

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

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The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.