The Long and Short
Vistra P-Caps top senior secured debt
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Vistra Corp (VST: Baa3/BBB-/BBB-) tapped the market recently with a novel 5-year pre-capitalized security (P-Cap), a structure more common in the insurance sector. Under the terms of the P-Cap, VST has set up the Palomino Funding Trust, which will use the proceeds to purchase a portfolio of Treasury debt. VST can use the Treasury debt as collateral in commodities transactions and, in return, pays a fee that gets passed along to investors as a spread over the Treasury debt. Pricing on the deal suggests a hefty concession of nearly 67 bp to equally rated senior secured bonds and looks like a good way to pick up incremental yield.
The deal provides an attractive way for buy-and-hold investors to pick up incremental yield to the senior secured bonds (Exhibit 1). We see value in the P-Caps down to a concession of roughly 35 bp, which is roughly the average P-Cap concession in the insurance sector (Exhibits 2 & 3). Even at that concession range, the P-Caps will yield more than VST’s unsecured debt that is rated Ba2/BB/BB. The structure will likely be less liquid than the senior secured bonds, but the incremental yield helps to compensate for the lack of liquidity.
Exhibit 1. VST Curves (Senior Secured and Unsecured Bonds)
Source: Bloomberg Trace, Santander US Capital Markets
P-Cap Structure Utilized in the Insurance Sector
Exhibit 2. Insurance P-Caps vs Senior Unsecured Curves
Source: Bloomberg Trace, Santander US Capital Markets
Exhibit 3. Insurance P-Caps Spread Concession
Source: Bloomberg Trace, Santander US Capital Markets
Agencies all Agree on VST’s P-Cap Ratings
All three ratings agencies assigned ratings to the P-Caps equal to those of the senior secured bonds. The agencies believe that the credit quality of the P-Caps are on par and rank pari passu with the senior secured notes (that contain fall-away provisions). The strong ratings linkage is derived from how the trust is structured to handle insufficient funds. Should the trust not have adequate funds to pay interest and principal on the P-Caps, VST is contractually required to fund the obligation through a delivery of senior secured notes, or via a substitute payment itself. It is understood that VST’s obligation to make the payment is absolute, irrevocable and unconditional. Additionally, the payment obligation is secured by a first-priority security interest of the same collateral used to secure the senior secured notes, hence the equalized ratings.
The agencies also noted that the P-Cap structure helps to support liquidity for the credit. The issuance is expected to release some of the cash collateral postings, which stood at $1.9 million at the end of fiscal first quarter 2023. VST’s collateral needs are largely tied to commodity related requirements based on natural gas prices as well as power purchases/sales. VST will be able to use the US Treasuries purchased by the trust as a pledge to meet collateral requirements of its counterparties.
Energy Harbor Acquisition a Positive for Power Generation Transformation
All agencies maintain a stable outlook on the company’s ratings post its acquisition announcement of Energy Harbor Corp., which is expected to close by the end of 2023. Under the terms of the deal, VST will pay $3 billion to acquire the energy provider and combine it with VST’s newly formed subsidiary, Vistra Vision. The new unit will also assume $430 million of debt from Energy Harbor, with Energy Harbor shareholders owning a 15% stake in Vistra Vision. The acquisition is another important step in VST’s power generation transformation as it will expand VST’s nuclear power generation by adding roughly 4,000 megawatts of nuclear capacity to its zero-carbon operations. Additionally, it will expand the company’s retail customer base by approximately one million.
VST will fund the $3 billion cash consideration largely with debt financing, which is expected to increase leverage to the 4.2x-4.4x range at closing. The integration of the assets is expected to run smoothly and enhance its already strong operational performance. That said, leverage is anticipated to decline to the 3.6x-3.8x area in 2024. VST management is still targeting net leverage of below 3.0x and has explicitly stated that it will utilize its net cash for opportunistic debt reduction. VST repaid $500 million of short-term debt in fiscal first quarter 2023, despite that being seasonally the lowest quarter for free cash flow generation. Management believes it can achieve its net leverage target in 2024-2025.
Primer: Pre-capitalized securities (P-CAPs) offer attractive spreads over comparable senior notes
Pre-capitalized securities or P-CAPs are a unique trust structure that until now had mostly been utilized by insurance companies seeking to issue debt, but also wanting to keep leverage off the balance sheet until or if the funds are eventually needed. The bonds trade in the secondary market at a sizable discount to comparable senior unsecured debt issued by the same companies. We believe investors are well compensated for the moderate give-up in liquidity and structural implications associated with these securities.
The motivational concept behind a P-CAP is fairly simple. The issuer creates a trust that accesses the public debt market, but that debt is held off balance sheet of the insurance company and does not contribute to financial leverage. The proceeds of the securities issued by the trust are used to purchase Treasuries (principal or interest strips), from which the trust will pay a coupon plus a locked in spread rate that is paid/provided by the underlying company. In effect, it is a means for an insurance issuer to essentially lock in or create an option on interest rates at a time when they view rates as attractive but might not necessarily need to issue debt. The company has a put option to issue senior unsecured debt into the trust at any time and take ownership of the treasury securities that are held (typically at increments of $50 or $100 million depending on the terms of the deal). Only at that point does the debt count toward financial leverage and the issuer have access to the funds.
All outstanding P-CAPs are rated in-line with the senior debt of the issuer, as the rating agencies view the credit quality as being closely linked to that of underlying insurance company. The notes issued into the trust upon exercise would be pari passu with all senior debt obligations of the underlying company. An issuer would choose to execute voluntarily in the event that it could no longer access the public debt markets or simply views current rates as unattractive to issue new debt. Debt issuance to the trust can also occur as a result of a mandatory exercise event, which we describe below. So far, no company that has issued P-CAPs has ever exercised either voluntarily or through automatic/mandatory action.
An automatic exercise event occurs if either a bankruptcy event occurs at the underlying insurance company, or if the company fails to make scheduled payments to the trust. A mandatory exercise event would occur if consolidated net worth of the company falls below a certain threshold, or if the company defaults on other payments or violates debt covenants. In either case, the senior debt then issued to the trust puts holders of the P-CAPs in a pari passu position with other senior debtholders of the issuer.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
