(Bloomberg) -- The artificial intelligence revolution is driving such an insatiable quest for cash that it’s rewiring one section of US capital markets.
Utilities, which are racing to keep up with surging electricity demand to power AI data centers, have dethroned US banks as the biggest sellers of subordinated securities to big investors. Dominion Energy Inc., CenterPoint Energy Inc. and others have raised nearly $18 billion through sales in 2024, a ninefold jump from last year, according to data compiled by Bloomberg.
More specifically, utilities are turning to hybrid bonds, an emerging category within the asset class. Part of the shift is being driven by a Moody’s Ratings methodology change whereby hybrids can be treated as half-debt and half-equity, so companies carry less debt on their balance sheet than if they had sold a regular bond.
“There’s going to be more energy needed whether you’re talking about cars, whether you’re talking about data centers,” said Mark Lieb, a near five-decade veteran of preferred securities and chief executive officer at Spectrum Asset Management Inc. “You have all these different segments that seem to be converging together.”
Power generators and infrastructure firms are bracing for electricity demand to outstrip supply during the next few years after a period of flat or shrinking consumption, with data centers accounting for the bulk of the increase, according to Bain & Co. Meeting these needs would require utilities to boost annual generation by as much as 26% by 2028, the consulting firm said.
Capital expenditure is set to exceed $200 billion next year, almost double the amount of a decade ago, according to trade group Edison Electric Institute.
For utilities faced with big financing needs, the change in Moody’s ratings methodology in February made hybrids more cost-effective to raise debt without risking rating downgrades. Companies could now classify 50% of capital raised through hybrids as equity, an increase from 25%, in addition to benefitting from deducting interest payments for tax purposes.
Prior to the change, utilities would’ve generally issued preferred stocks, another category within subordinated securities that are usually sold by banks. Hybrid bonds that fit Moody’s criteria typically mature in 30 years and can be repaid five or 10 years after issuance.
“It’s fascinating because utility capital expenditure is going through the roof, so they need to finance it,” said Andy DeVries, head of utilities at CreditSights Inc. “Right as capex is going up with the data centers, Moody’s comes with a gift from above.”
For investors, hybrids can offer yields that rival the returns of junk-rated bonds, even though the instruments are usually issued by high-grade firms. These yields would help support further strong demand as investors look for investment opportunities in a lower Federal Reserve interest-rate environment, said Doug Baker, head of preferred securities at Nuveen.
“We see potential for demand to actually increase, as that dynamic shifts away from investors parking in cash as the Fed cuts and looking to invest it in a better opportunity,” Baker said. “This is one of those areas where we would expect to see that cash to rotate into.”
Hybrid bonds are still fairly new in the US, where the market is underdeveloped compared to Europe. They would typically also take losses ahead of other bonds if a company goes under. In Europe, for example, where perpetual hybrids are the widespread format, a funding crunch faced by Swedish real estate firm SBB prompted a selldown in the firm’s hybrid bonds to mere cents in the euro.
Utilities are well-suited to raise funding through hybrids because the industry is mostly regulated, making firms’ performance fairly easy to predict, said Linus Claesson, a portfolio manager specializing in corporate hybrids at Neuberger Berman. Telecommunications companies and pipeline operators have the same profile, making these sectors suitable for participation too, he said.
You “actually prefer to have fairly capital intensive businesses that are reliant on the public bond market to fund themselves,” Claesson said. “That means the reputational considerations, when it comes to using the optionality embedded in the instrument, becomes very relevant.”
This year’s growth in hybrid supply is set to be only the beginning as power providers set the groundwork for the splurge that would be required for the AI era. The sector is also unlikely to encounter headwinds from a Donald Trump-led US administration, said Brittney D. Sandler, a senior associate at law firm Pillsbury Winthrop Shaw Pittman LLP.
“Demand for data center capacity, resilient infrastructure, and advanced, scalable solutions will continue to grow,” said Sandler, who advises on corporate finance transactions. “Our clients are full speed ahead.”
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