As the Palisades Fire in Los Angeles County edges closer to complete containment, ramifications for the Los Angeles Department of Water and Power (the “Department”) remain uncertain. To date, there has been no implication that the Department’s Power System infrastructure was responsible for igniting the fire. The investigation into ignition remains ongoing, led by the Bureau of Alcohol, Tobacco and Firearms. Separately, the Department’s Water System has been sued by homeowners claiming the System was unprepared for the wildfire and is therefore responsible for damages, as faulty fire-hydrants and an empty reservoir derailed containment efforts. The lawsuit specifically cites California’s strict “inverse condemnation” liability, the application of which would be somewhat unique for a water utility. The State of California has also opened an investigation into the Water System relative to its preparedness and system functionality as crews battled the blaze.
Since the fires began, Appleton has acknowledged the existence of a “tail risk” associated with potential Department liability, whether through its Power System or Water System. Despite such a risk, our opinion emphasized that the Department had financial resources, insurance coverage, unregulated rate increasing authority and unregulated bonding authority. External support, such as a State loan or a separate mechanism like a securitization program to support funding potential liabilities, was also considered a possibility. We continue to believe that in the event the Department is found liable, these factors would allow the Department to remain a “going concern” that provides the essential services its customers have long relied on.
What Has Changed?
Our view of such “tail risk” liability has evolved over the last weeks following internal discussions and productive conversations with our partners and clients. Handicapping the likelihood of being found legally liable is extremely challenging. Attempting to quantify the size of a potential future liability and its financial impact on the Department, or how the market would price that development is equally difficult. Potential additional rating agency downgrades could also exacerbate selling pressure, forcing some investors to exit if certain rating thresholds were crossed.
Given our commitment to high quality municipal bond portfolio management, we recently concluded that the risk (large financial liability) to reward (limited bond price recovery) balance was becoming skewed to the downside. We have also come to appreciate that this situation will not be settled anytime soon. Even if the Department is fully cleared of culpability, that resolution is likely at least a year away. And if the Department were to be found liable, despite possessing tools to manage the financial implications, court proceedings would take an extended amount of time. Holding LAWDP bond issues would realistically also introduce an opportunity cost associated with not being able to reinvest sale proceeds in other municipal entities that lack such event risk.
A Summary of Our Sell Program
Since the wildfires broke out on January 7th, we have been evaluating market activity in the Department’s bonds as well as other LA-area names. As our investment perspective relative to the Department changed, we implemented a “first phase” of selling on January 23rd that reduced account level exposure. Based on our experience, there were active buyers for relatively large amounts of Department bonds. Drawing upon our dealer relationships, we were able to sell many positions at prices that we believed were prudent and in-line with recent trades.
The first group of sales gave us confidence that the market for the Department’s bonds was functioning reasonably well and that an opportunity existed to further reduce client exposure. Given sustained “tail risks”, we decided to exit all of our exposure to the Department.
As of January 31st, Appleton clients no longer own Los Angeles Department of Water and Power bonds. We also sold bonds issued by Intermountain Power Agency (UT) and the Southern California Public Power Authority Transmission Project, both of which are joint ventures where the Department is a majority participant and obligated to pay a significant share of operating expenses and debt service.
A relatively orderly market existed throughout the process of selling the Department’s bonds. Credit spreads varied based on maturity, callability, and position size, although spread ranges remained consistently stable. Our Portfolio Management and Trading team was able to execute a sizeable selling program within one week, a testament to our longstanding emphasis on holding liquid positions in client accounts and our strong relationships with the broker-dealer community.
Tax Loss Harvesting
While certainly not our primary consideration in deciding to sell, the sale of Department and related entity bonds has been a source of tax loss harvesting for clients previously holding those positions. As an active manager, we are cognizant of opportunities to realize losses for clients, whether derived from duration management or a credit related sale such as this one.
Other Los Angeles County Issuers:
Appleton owns other municipal issuers located within Los Angeles County that have revenue or service area exposure to the wildfires. We fully expect short-term challenges associated with cleanup and debris removal, delayed tax revenues, and additional costs to help kickstart rebuilding. However, we are not making any “sell” recommendations for other Appleton-approved names at this time. Strong balance sheets going into the wildfires, expansive tax bases and service areas, revenue diversity, and experienced management teams are characteristics that we believe will support credit quality for other L.A.-area municipal issuers held in Appleton accounts. We appreciate the confidence our clients and business partners have in our team and its investment process and will communicate further updates as warranted.
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
"Our thoughts are with our clients, business partners, and all individuals whom the Los Angeles area wildfires have impacted. Please note that this commentary is written strictly from a credit perspective and is not intended to minimize the devastating impact of this natural disaster on people and property..."
"Bank of America provides monthly updates on state tax revenue trends. In the Bank’s latest publication it noted that median sales tax collections in July are pointing to a 0.4% decline, which would be the second consecutive drop .."
"It is often said that predicting market direction correctly is much easier than timing. We concur with that sentiment, and one only needs to point to the fact that a year ago Appleton highlighted the risk of holding short-term bonds despite attractive front-end yields. Those yields are still appealing, although with Fed Funds rate cuts likely on the near-term horizon it’s time to revisit the case for adding duration..."
Economic & Market Commentary
02.03.2025
Los Angeles Department of Water & Power
The Latest on Potential Liability
As the Palisades Fire in Los Angeles County edges closer to complete containment, ramifications for the Los Angeles Department of Water and Power (the “Department”) remain uncertain. To date, there has been no implication that the Department’s Power System infrastructure was responsible for igniting the fire. The investigation into ignition remains ongoing, led by the Bureau of Alcohol, Tobacco and Firearms. Separately, the Department’s Water System has been sued by homeowners claiming the System was unprepared for the wildfire and is therefore responsible for damages, as faulty fire-hydrants and an empty reservoir derailed containment efforts. The lawsuit specifically cites California’s strict “inverse condemnation” liability, the application of which would be somewhat unique for a water utility. The State of California has also opened an investigation into the Water System relative to its preparedness and system functionality as crews battled the blaze.
Since the fires began, Appleton has acknowledged the existence of a “tail risk” associated with potential Department liability, whether through its Power System or Water System. Despite such a risk, our opinion emphasized that the Department had financial resources, insurance coverage, unregulated rate increasing authority and unregulated bonding authority. External support, such as a State loan or a separate mechanism like a securitization program to support funding potential liabilities, was also considered a possibility. We continue to believe that in the event the Department is found liable, these factors would allow the Department to remain a “going concern” that provides the essential services its customers have long relied on.
What Has Changed?
Our view of such “tail risk” liability has evolved over the last weeks following internal discussions and productive conversations with our partners and clients. Handicapping the likelihood of being found legally liable is extremely challenging. Attempting to quantify the size of a potential future liability and its financial impact on the Department, or how the market would price that development is equally difficult. Potential additional rating agency downgrades could also exacerbate selling pressure, forcing some investors to exit if certain rating thresholds were crossed.
Given our commitment to high quality municipal bond portfolio management, we recently concluded that the risk (large financial liability) to reward (limited bond price recovery) balance was becoming skewed to the downside. We have also come to appreciate that this situation will not be settled anytime soon. Even if the Department is fully cleared of culpability, that resolution is likely at least a year away. And if the Department were to be found liable, despite possessing tools to manage the financial implications, court proceedings would take an extended amount of time. Holding LAWDP bond issues would realistically also introduce an opportunity cost associated with not being able to reinvest sale proceeds in other municipal entities that lack such event risk.
A Summary of Our Sell Program
Since the wildfires broke out on January 7th, we have been evaluating market activity in the Department’s bonds as well as other LA-area names. As our investment perspective relative to the Department changed, we implemented a “first phase” of selling on January 23rd that reduced account level exposure. Based on our experience, there were active buyers for relatively large amounts of Department bonds. Drawing upon our dealer relationships, we were able to sell many positions at prices that we believed were prudent and in-line with recent trades.
The first group of sales gave us confidence that the market for the Department’s bonds was functioning reasonably well and that an opportunity existed to further reduce client exposure. Given sustained “tail risks”, we decided to exit all of our exposure to the Department.
As of January 31st, Appleton clients no longer own Los Angeles Department of Water and Power bonds. We also sold bonds issued by Intermountain Power Agency (UT) and the Southern California Public Power Authority Transmission Project, both of which are joint ventures where the Department is a majority participant and obligated to pay a significant share of operating expenses and debt service.
A relatively orderly market existed throughout the process of selling the Department’s bonds. Credit spreads varied based on maturity, callability, and position size, although spread ranges remained consistently stable. Our Portfolio Management and Trading team was able to execute a sizeable selling program within one week, a testament to our longstanding emphasis on holding liquid positions in client accounts and our strong relationships with the broker-dealer community.
Tax Loss Harvesting
While certainly not our primary consideration in deciding to sell, the sale of Department and related entity bonds has been a source of tax loss harvesting for clients previously holding those positions. As an active manager, we are cognizant of opportunities to realize losses for clients, whether derived from duration management or a credit related sale such as this one.
Other Los Angeles County Issuers:
Appleton owns other municipal issuers located within Los Angeles County that have revenue or service area exposure to the wildfires. We fully expect short-term challenges associated with cleanup and debris removal, delayed tax revenues, and additional costs to help kickstart rebuilding. However, we are not making any “sell” recommendations for other Appleton-approved names at this time. Strong balance sheets going into the wildfires, expansive tax bases and service areas, revenue diversity, and experienced management teams are characteristics that we believe will support credit quality for other L.A.-area municipal issuers held in Appleton accounts. We appreciate the confidence our clients and business partners have in our team and its investment process and will communicate further updates as warranted.
This commentary reflects the opinions of Appleton Partners based on information that we believe to be reliable. It is intended for informational purposes only, and not to suggest any specific performance or results, nor should it be considered investment, financial, tax or other professional advice. It is not an offer or solicitation. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information. Specific securities identified and described may or may not be held in portfolios managed by the Adviser and do not represent all of the securities purchased, sold, or recommended for advisory clients. The reader should not assume that investments in the securities identified and discussed are, were or will be profitable. Any securities identified were selected for illustrative purposes only, as a vehicle for demonstrating investment analysis and decision making. Investment process, strategies, philosophies, allocations, performance composition, target characteristics and other parameters are current as of the date indicated and are subject to change without prior notice. Registration with the SEC should not be construed as an endorsement or an indicator of investment skill acumen or experience.
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