October 26, 1999

Credit Markets

Now, Bonds for Investors

Who Suffer in Cold or Heat

By GREGORY ZUCKERMAN and DEBORAH LOHSE

Staff Reporters of THE WALL STREET JOURNAL

NEW YORK -- Here is an investment for Weather Channel junkies: weather bonds.

Two big utilities -- Koch Industries Inc. of Wichita, Kan., and Enron Corp. of Houston -- are selling about $200 million of risky "weather" bonds, the first such deals of their kind. While it has been difficult to find investors willing to buy these bonds, despite the promise of juicy returns, investment banks such as Goldman Sachs Group Inc. and Merrill Lynch & Co. are shifting resources to the area in the belief that issuance of these bonds from all kinds of companies will rain on investors in the years ahead.

The bonds are appealing to companies that "have weather risk and are interested in spreading that risk," says Paul VanderMark, vice president of risk applications for risk-modeling firm Risk Management Solutions, of Menlo Park, Calif.

There already exists a market for so-called catastrophe bonds, or bonds issued by insurance companies to protect themselves from their own exposure to losses caused by calamities such as earthquakes or storms. But these bonds would be the first securities to help companies like utilities reduce risks caused by weather that is hotter or colder than expected.

Put simply, utilities' earnings can take a hit when weather is colder or hotter than usual because energy costs could rise or consumer demand could slip. (But it may be hard to raise rates.) These bonds pass on some of the risk to investors because the interest rates on the bonds drop (potentially to zero) the more the weather varies from historical norms, cushioning the effect of the earnings decline.

Say that temperatures in the Northeast prove especially cold one year -- and Koch has to pay more to buy energy to supply its clients. In that case, Koch might recoup some of its extra expense by slashing the interest paid on the weather bonds. The interest depends on the weather in the 19 cities in which Koch operates, according to people familiar with the offering.

Investors in the Koch deal are being offered two types of bonds: high-yield senior bonds rated below-investment grade (or "junk") and a class of unrated, even riskier, bonds, according to people familiar with the deal.

But these investments aren't for fair-weather investors. If temperatures in the 19 cities in which Koch operates remain in line with historical averages, as measured by the National Weather Bureau, during the three-year length of the bonds, investors in the senior bonds will score returns of 10.5%. But if temperatures are colder by one-quarter of a degree a day on average in the Northeastern cities in which Koch has exposure, investors could see their returns sliced to 10%. Returns could go up to 11% if temperatures are warmer by one-quarter of a degree. Investors could even lose principal if weather in those cities proves extremely unusual.

In New York City, for example, winters in which the average temperature falls below the 40-degree Fahrenheit historical average could cause losses for investors, according to terms of the bond.

Investors can expect a staggering 30% return on the unrated bonds if temperatures remain at the historical means. But there is a nearly 50% chance temperatures will shift enough so that investors will lose some of their principal, according to people who have seen the deal's prospectus.

For Koch, a closely held company, the bonds will serve as insurance in case temperatures vary enough in the coming three years to hurt its business, which provides energy to utilities, distributors and others around the country. Koch gets hurt when weather is colder than expected and has to buy energy at higher prices on the open market to serve its clients. Warm summer weather in the South also could drive up energy prices, possibly hurting Koch's bottom line.

The Koch deal is expected to close later this week. A spokeswoman for the company said she couldn't discuss any pending issuance. Goldman Sachs, which is said to be underwriting the deal, also wouldn't comment. Enron declined to comment on its prospective deal as did its underwriter, Merrill Lynch.

Besides a hefty yield potential, investors might be attracted to the diversification that weather bonds can provide a portfolio. Weather is a function of Mother Nature, not economic events, so the bonds' performance might not have a correlation to other investments in a portfolio.

So far, insurance companies, mutual funds, hedge funds and other energy companies are proving most interested in weather bonds. Although they aren't yet being sold to individuals, some version of the bonds could be sold to individuals if the market takes off.

But most investors are proving slow to warm to weather bonds. Enron's bonds were supposed to have been sold in September but haven't found enough investors, according to industry executives. Koch was forced to scale down its deal to $100 million from $200 million, in part due to difficulties in finding investors. Others have tried, and failed, to sell these bonds in the past, according to bankers.

"Weather bonds are just an extension of the catastrophe-bond market, if they're structured correctly," says Greg Hagood, who manages Willis Corroon Catastrophe Fund in Bermuda and is looking at the deals. "But it's a new market and there's a learning curve for investors and there's an element of caution" among investors.

Indeed, these bonds are quite complicated and turn off some investors. It is also a time of rising rates on all kinds so "investors are saying 'Why not just buy something I'm familiar with that has a high return?' " says an investor who has looked at the weather deals. Either way, investment banks are betting that the weather-bond market will heat up. In an age of deregulation, utilities are seen as being less able to pass along rate increases to consumers. The utilities will have to take steps to reduce their risks to such things as fluctuations of the weather. Agriculture companies, electric and gas companies and even retailers might turn to weather bonds, say Wall Street investment bankers, always eager for a hot new security to sell.

"It's a young market, but so were mortgage and asset-backed securities not that long ago," notes Mr. Hagood, the investor at Willis Corroon.

Treasurys

Treasurys ended little changed after rebounding from sharp losses earlier in a lackluster session.

The benchmark 30-year Treasury bond ended down 2/32 point, or 62.5 cents for a bond with $1,000 face value, to 96 29/32. Its yield rose to 6.347% from 6.342% late Friday, as bond yields move inversely to prices. Prices spent almost the entire session in negative territory, and the 30-year bond yield rose as high as 6.40%, its highest in about two years.

Investors worried that a widely watched Labor Department gauge of wage costs due to be reported Thursday -- the employment cost index -- will show building inflationary pressures. The Federal Reserve, in announcing its rate-tightening bias in October, cited a risk that wage gains could outstrip productivity gains. Third-quarter gross domestic product data are also scheduled for release Thursday.

The Treasury sold $18 billion of 13- and 26-week bills at its regular weekly auction. Here are details:

All bids are awarded at a single price at the market-clearing yield. Rates are determined by the difference between that price and the face value.

13-Week 26-Week

Applications $27,314,385,000 $24,990,910,000

Accepted bids $10,004,385,000 $8,004,969,000

Accepted noncompet'ly $1,338,116,000 $1,068,690,000

Auction price (rate) 98.737 (4.995%) 97.414 (5.115%)

Coupon equivalent 5.145% 5.338%

Bids at market yield 65% 61%

Cusip number 912795DE8 912795DT5

In other credit markets Monday:

Municipal bonds were unchanged, as a sluggish secondary market took a back seat to attractively priced new issues.

Mortgage-backed securities underperformed Treasurys, as well as swaps and agency debentures.

Carolina Power & Light sold $500 million in corporate bonds Monday, while Diageo PLC postponed its $500 million offering.

European government bonds fell on weakness in U.S. Treasurys and hawkish comments by the European Central Bank's chief economist.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Deborah Lohse at deborah.lohse@wsj.com

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