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Oncor Bonds Show Energy Future Contagion Risk: Corporate Finance

Bond investors are challenging the notion that the regulated transmission and distribution unit of the former TXU Corp., the electricity provider saddled with $36.7 billion of debt from the 2007 buyout by KKR & Co. and TPG Capital, will avoid being dragged down by its parent.

Relative yields on $800 million of 7 percent first-lien notes due 2022 from the Energy Future Holdings Corp. unit, Oncor Electric Delivery Co., widened to 220 basis points as of April 11, from 185 basis points on Jan. 13. The spread on similarly rated utility bonds tightened 17 basis points over the same time period, according to Bank of America Merrill Lynch index data.

Oncor’s Baa1 rating was put on review for downgrade in February by Moody’s Investors Service, which cited contagion risk from Energy Future Holdings and the parent’s reliance on its units to repay its debt. Dallas-based TXU was taken private in 2007 for $43.2 billion, the biggest leveraged buyout ever, and KKR and TPG agreed to hold a majority stake in Oncor for five years.

“The Armageddon outcome is that Energy Future Holdings goes into bankruptcy and a judge says this ring fencing is nonsense,” Philip C. Adams, a debt analyst at Gimme Credit LLC, said in a telephone interview. “While remote, it’s a risk factor Oncor has mentioned in their 10-K.”

Default Swaps

Three-year credit-default swaps tied to Texas Competitive Electric Holdings, the company’s unregulated merchant power unit, have soared 38 percentage points over the past 12 months to 80.8 percent upfront yesterday, according to data provider CMA. That level indicates a 96 percent chance the company will fail to meet its obligations in the next three years.

“We believe Oncor’s ring-fence arrangement is very strong and protects all of Oncor’s stakeholders, including ratepayers, creditors and Oncor itself,” said Allan Koenig, a spokesman for Energy Future Holdings, in an e-mailed statement.

Energy Future Holdings relies on its units, which hold almost all of the company’s assets, to pay the principal, premium and interest on debt incurred by its leveraged buyout, according to a Feb. 21 regulatory filing.

When TXU was taken private, Energy Future Holdings made commitments to the Public Utility Commission of Texas separating itself from the unit, which included a requirement that Oncor’s board have a majority of independent directors.

The commission placed two restrictions on the size of dividends Oncor could pay its parents. The first constraint, which expires at the end of the year, stipulates that cash distributions don’t exceed adjusted cumulative net income; the second requires the regulated unit to maintain a capitalization ratio of 60 percent debt to 40 percent equity.

‘Signs of Pressure’

“We believe elements of the ring fence are beginning to show signs of pressure as Oncor is placed into a more meaningful role in assisting both Energy Future Holdings and Texas Competitive Electric Holdings with their interest and debt service obligations,” James Hempstead, an analyst at Moody’s, wrote in a Feb. 27 report.

Oncor paid $145 million in cash distributions to its owners last year, down from $211 million in 2010, and as of Dec. 31 its regulatory capitalization ratio was 59.7 percent debt and 40.3 percent equity, the company said in a separate Feb. 21 regulatory filing.

“The ring fence provisions of Oncor have not been violated,” said Terry Hadley, a spokesman for the commission. “We are monitoring the situation.” Hadley said state law “specifies that the utility not subsidize the business activities of an affiliate with revenue from a regulated service.” The commission hasn’t seen any evidence of this law being violated, he said.

Debt Ratio

Energy Future Holdings had $36.7 billion of consolidated debt as of Dec. 31, not including the $6.1 billion of borrowings at Oncor, the company said in the filing. About $120 million of that comes due before 2014, $4.3 billion in 2014 and $3.3 billion in 2015, the company said.

As a result of its high ratio of debt to earnings as well as low forward gas prices, Energy Future Holdings may not be able to repay or refinance its obligations as they come due, or arrange additional financing, according to the filing. An inability to extend or pay down its debt could force the company to conduct a distressed-debt exchange or file for bankruptcy protection.

“If any member of the Texas Holdings Group were to become a debtor in a bankruptcy case, there can be no assurance -- however remote in consideration of the ring-fencing measures -- that a court would not order an Oncor ring-fenced entity’s assets and liabilities to be substantively consolidated with those of such member of the Texas Holdings Group,” according to the filing.

Gas Prices

Natural gas futures have fallen 71 percent to $1.98 per million British thermal units since the day KKR and TPG took Energy Future Holdings private, just as the recession sapped demand and drilling expanded in the gas-rich Marcellus shale in the eastern U.S. creating a supply glut.

As gas prices have dropped, wholesale electricity prices plunged, hurting owners of independent wholesale generators such as Energy Future Holdings. The company had a net loss of $1.91 billion last year, after a deficit of $2.81 billion the previous year, according to data compiled by Bloomberg.

Regulated utilities such as Oncor are allowed by the states to adjust prices to ensure certain levels of profits, protecting them from swings in commodity prices. Oncor reported net income of $367 million last year, compared with $352 million in 2010, according to its annual filing.

‘A Maze’

“Oncor itself is pretty sleepy; it’s a high-grade company that’s regulated and ring fenced,” Chris Chaice, an analyst at New York-based Covenant Review, said in a telephone interview. “This is a maze the owners have been working on for years: how to realize value in equity in Oncor and leave as much parent TXU debt behind.”

Moody’s rates Oncor’s senior secured debt Baa1 and changed the company’s outlook to “negative” from “stable,” according to the Feb. 27 report. The rating company assigned a Caa2 grade to Energy Future Holdings. Standard & Poor’s rates Energy Future an equivalent CCC.

The Moody’s report indicated that Energy Future Intermediate Holdings, a unit of Energy Future Holdings and the direct parent of Oncor Holdings, has issued debt secured by its equity interest in Oncor, which also places pressure on the corporate separation.

“You probably have some skittish holders of debt who would rather sell now than wait for a TXU bankruptcy just in case there are some repercussions for Oncor in the bankruptcy process,” Marc Gross, a money manager at New York-based RS Investments, said in an e-mail. “I don’t believe there will be any repercussions, but there are some very conservative investment-grade accounts who would sell out of the name out of an abundance of caution and perhaps to avoid any questions from risk management.”

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