Capital Ideas^™ 
Investment insights from Capital Group

Amid the ongoing uncertainty of tariffs and geopolitics, one area of the corporate bond market that stands out as providing a stable and reliable source of income is the U.S. electric utility sector. This has been an important focus of our investment-grade portfolios for some time.

More than just another corporate bond

The traditionally defensive utility sector offers a unique opportunity among investment-grade credit. From an investment perspective, utilities benefit from a regulatory backdrop that provides effective cost recovery mechanisms to help ensure the essential services these companies provide continue. For example, maintenance and operational costs can be passed directly on to the consumer, with any interest expense arising from the issuance of new debt directly applied to customers’ bills.

In practice, this means a utility company’s revenues and expenses are typically aligned, enabling them to generate a steady and stable cash flow independent of the macroeconomic cycle. Even in situations where there is a surge in commodity prices, such as in 2022, these costs can eventually be (and were in 2023) passed on to consumers.

There are further important structural distinctions between utility companies and the broader investment-grade corporate universe that I believe make the sector an attractive investment opportunity.

First, issuance in the utility sector is fragmented, with many companies issuing debt across multiple regions. Duke Energy, for example, has around $100 billion of debt outstanding, but this is split across more than 10 different entities, with bonds issued in the Carolinas, Florida, Kentucky and Indiana. This fragmentation leads to a structural wideness and dispersion of spreads.

Second, many U.S. electric utilities issue secured debt. These bonds are secured against substantially all of the regulated monopoly’s business and, importantly, the issuance is subject to protective covenants. One of the most significant of these is a “limitation on liens” (a covenant limiting the amount of incremental secured debt a borrower can issue at a given point in time).

Across the utility sector, the lien on secured debt is typically limited to 70% or less of the asset base. In other words, for $100 of assets, a utility can only issue secured debt up to $70 or less. This is important for a company’s asset coverage because, even at 70%, the asset coverage ratio is a relatively healthy 1.43x. This means the value of the asset base would need to decline by 30% before the bond becomes impaired and unlikely to be repaid in full. The balance sheet strength this covenant provides is one of the reasons why, on the rare occasions utility companies have faced bankruptcy, secured bonds have always been repaid in full.

Despite these strengths, secured bonds in the utility sector, which are split-rated between AA and A, are generally priced wide of lower quality single-A rated corporate bonds. This is largely due to the fragmentation described above. From an investment perspective, this means that rather than having to give up 10-20 basis points (bps) of yield to hold higher quality assets, investors can, in fact, increase the credit quality of their portfolio through a defensive asset while also picking up an additional 5-10 bps of yield.

Utility companies cannot afford to lose their credit ratings

The buildout of artificial intelligence (AI) data centers is leading to a surge in demand for electricity and, therefore, investment in the U.S. electric infrastructure. This has important implications for utility companies' revenue growth and capital spending.

My expectation is that over the next five years, the sector will generate around $700 billion of operating cash flow. However, for utilities to also meet AI demand, modernize the electric grid, integrate more clean energy resources into the system and strengthen the grid against extreme weather events, they are going to need to invest somewhere in the region of $1.2 trillion. In addition, they are expected to pay dividends of around $200 billion.

In other words, the sector faces a cash flow deficit of between $500 billion to $700 billion. Some of this can be funded through equity, but the majority will likely be raised in the debt markets.

Alongside this cash flow deficit, the utilities typically manage their balance sheets with a laddered bond maturity schedule. This means more than $200 billion needs to be refinanced by the sector over the next five years. Given this structure and the cash flow deficit, it is imperative that utility companies maintain their high credit quality. 

Maintaining the rating is also important at the holding company level. This is because these companies are important dividend-paying stocks that are priced as bond proxies in equity markets. A mid-BBB rating is required in order to preserve the multiples that equity investors demand of these businesses.

There is a big difference in the yield offered by these mid-BBB issuers and those rated low-BBB. The dividend-paying stocks with weaker credit ratings trade at lower prices and have lower equity multiples, which means their cost of capital is higher. Many utility management teams do not have the appetite to allow their credit ratings to be downgraded from mid-BBB to low-BBB, so they will need to issue equity to maintain their credit metrics and ensure a stable cost of debt and equity.

Regulated versus non-regulated assets

The U.S. utility sector includes both regulated and non-regulated assets, and the distinction between the two is important. This is because regulated assets are included in the rate base, which is the value of assets on which the utility is allowed to earn a return through customer rates. Non-regulated assets are not included, and so returns on such assets are more variable and dependent on market conditions.

While an investment case can be made for either type of asset, the higher risk element attached to non-regulated means issuers with significant exposure to them need to offer higher yields to compensate. Such businesses represent a different investment proposition to the defensive, historically stable and dependable income delivered by regulated assets and would typically not be expected to be rated mid-BBB. For credit investors, these risks can be mitigated to some extent through security selection and sector allocation.

This is not to say regulated assets are without risk. Regulatory risk is a key one. For example, if a utility has weak financial metrics and its relationship with the regulator materially deteriorates, its credit rating would likely come under pressure. 

Wildfires

A key headline risk for the sector is wildfires and the associated liability costs they can cause utility companies. This was brought into tragic relief at the start of this year with the wildfires in Southern California.

State legislation aims to help utility companies manage wildfire risks and thereby ensure their viability as investable entities. This enables utilities to deliver essential services to communities and to invest in the country's critical electrical infrastructure.

California currently provides the gold standard in legislation to mitigate wildfire risk through its 2019 legislation AB1054. This bill created a fund to provide financial relief for wildfire-related claims. Importantly, the legislation also introduced a liability cap for the utility companies. This goes a long way toward ensuring utility companies are not the insurer of last resort. In combination with clear rules or very clear standards within utility companies themselves to mitigate against wildfire risk, the legislation provides strong support for the sector.

The asymmetric nature of the risk wildfires pose for utility companies is substantial and, as a consequence, they can have a significant impact on the pricing of bonds in the sector. One of the many investment tools we use to help us understand these risks at Capital Group is a proprietary utility wildfire risk dashboard.

The tool uses models to assess long-term change in wildfire probabilities, and the potential financial exposure in the event of a wildfire faced by 2,900 U.S. utilities, based on geospatial data analytics and large-scale climate data. This helps our investment team to understand the risk from wildfires and to provide a differentiated view of what an appropriate level of yield should be to compensate for it.

We find that in California, spreads potentially overcompensate for the risk, while in Texas, which fortunately has not had to deal with the same level of fires as California, the market appears to be currently underpricing wildfire risks.

The January 2025 Southern California wildfires are highly likely to reduce the California Wildfire Fund. But on September 13, 2025, California lawmakers passed wildfire fund reform legislation, which has been an overwhelming positive for bond and equity holders. The legislation (SB 254) mandates that the California Earthquake Authority (CEA), which administers the wildfire fund, develop recommendations by April 1, 2026, on strategies to better socialize the costs of catastrophic wildfires among a wider range of constituents beyond just the utilities, their investors and their customers. The bill now goes to the governor to be signed by October 13, 2025, and utilities will have 15 days thereafter to opt in.

This new legislation would also distribute the costs among insurance companies, plaintiffs' attorneys and other key stakeholders. The passage of wildfire fund reform legislation has already led to material compression in the credit spreads for the California utilities and significantly positive investment results for bondholders, with the prospect for additional accretive investment results in 2026 with even more legislation passed to codify CEA's recommendation into law.

How these risks are expressed in our investment-grade portfolios

At Capital Group, portfolio positioning within the electric utility sector can broadly be split into two categories.

The first group is what could be termed “sleep-at-night” credits, which are mainly in America’s Southeast and Midwest. These have been solid, dependable issuers that have provided a stable source of income, but due to the fragmentation described earlier, often traded with higher spreads than the broader corporate bond market.

Alongside understanding the financial position of these companies, I also maintain a view on the regulation of each issuer and skew positioning toward those operating in above-average regulatory jurisdictions. These jurisdictions will have significant cost recovery mechanisms for items such as fuel, investments, labor, etc. Additionally, given the fires in California this year, political and legislative risk has increased. I am therefore looking at jurisdictions where there is a low risk of laws being passed or court cases being decided that are detrimental to the sector.

The second group is the West Coast utilities. The market is, in my view, currently overcompensating for the wildfire risk attached to these issuers, providing the opportunity to add additional yield and spread tightening potential to portfolios.

Much of the market takes a seasonal approach to investing in this sector, i.e., they buy in winter before selling ahead of the summer “wildfire season.” The trouble with this approach is that wildfires are not seasonal — this year’s Southern California wildfires occurred in January, well outside of the time period the market considers to be wildfire season. As long-term investors, we think a better approach is to accept that there may be some short-term volatility, but to focus on the long term. Over this time horizon, our expectation is that sizeable positions identified through in-depth proprietary analysis should benefit from the structural tightening of spreads.