(Bloomberg) -- Money managers scouring the credit markets for yield are being seduced by a relatively rare type of security -- so-called recovery bonds -- for their attractive spreads, duration and safety. 

The bonds are typically issued by state utilities trying to recapture losses from natural disasters, such as wildfires or storms, through special fees levied on customers’ electric bills. The charges are then bundled up and sold as notes which get classed as asset-backed securities. 

Issuances of recovery bonds soared in 2021, with roughly $2.3 billion of notes sold. This year, that figure has already doubled to roughly $4.7 billion so far, according to Bloomberg data. Those numbers are only likely to increase over the next couple of years, said JPMorgan strategists in an April 29 research note. 

While these securitizations are still scarce compared to those backed by other asset classes, investors are eating them up. Utility giant PG&E Corp. recently issued $3.6 billion of recovery bonds -- aimed at recouping costs caused by the wildfires that ravaged California in 2017 -- in a deal that has both structured and corporate investors jostling for orders.

Read more: PG&E Offers $3 Billion Recovery Bond to Recapture Fire Losses

This is because recovery bonds unlock opportunities for ABS money managers that they cannot seem to find anywhere else. These include longer-dated tenors -- ranging from 10 to 30 years -- compared to most ABS deals which barely scrape the five-year mark. For corporate investors, who usually do not play in structured products, the appeal is even greater given the high-quality AAA ratings of the notes which is not often seen in the corporate world.

“Corporate investors throw in big orders, splashing the pot,” said David Goodson, head of securitized credit at Voya Investment Management, in an interview. “That duration and spread at the AAA level makes these bonds look attractive relative value-wise.” 

The assets offer a substantial spread pick up relative to other types of consumer ABS, such as bonds backed by auto loans and credit card debt, according to the JPMorgan strategists. The difference in spreads between credit card and stranded asset ABS stands at almost 40 basis points, up from the low single digits in 2019, they wrote in their note.

The bonds are also backed by state legislation that allows utilities to impose recovery charges, making them a safe haven compared to other types of bonds backed by consumer credit, according to market watchers. Delinquencies are also less frequent than in other types of consumer credit-backed bonds.

“Electricity is a necessity so it’s unlikely that the consumer will stop paying,” said Deborah Newman, an ABS analyst at S&P Global Ratings, in an interview. 

Another comfort for investors is that the bonds have a credit enhancement feature called a true-up mechanism. This adjusts customer charges to ensure that payments are balanced out and stabilized even if there are variations in collections, which can be too low or too high some months due to population changes or other factors. 

There are, however, certain risks. Storms or other natural disasters that make it difficult for the utility to provide power is one of them, as the customer’s obligation to pay the charges is tied to receiving that electricity, said Newman.

But the downsides are relatively few. Even if a utility files for bankruptcy, the harm to ABS investors might still be minimal, as the utility will likely continue to operate even through bankruptcy, said Newman.

Apart from the PG&E offering, there is another recovery bond deal that could hit the market soon, led by a subdivision of the state of Louisiana. 

Relative Value: CLOs

  • CLO manager and investor Napier Park Global Capital is eyeing the CLO equity tranche in primary markets and the mezzanine tranche in secondary markets, as it prepares for periods of volatility and worsening economic conditions
  • Deals issued right before a recession have the ability to do quite well in the upcoming years, said Serhan Secmen, the firm’s head of U.S. CLO Investments, in a phone interview
  • Money managers should also check the BB tranche and decide whether it’s going to be a survivor or not, he said. Still, this tranche is more volatile than CLO equity, so investors should be careful, Secmen added

Quotable

Re: URW exiting the U.S. market: “The easiest way to get out of some of their leveraged mall holdings is to not refinance at maturity and Westfield has already defaulted on a handful of malls,” said Lea Overby, CMBS strategist at Barclays

What’s Next

ABS deals in the queue for next week include Libra Solutions (litigation and medical lien ABS), Louisiana Utilities Restoration (recovery bonds) and 25 Capital Partners (single family rental).

(Updates to reflect that Global Jet Capital deal in What’s Next section priced Thursday)

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