20040916Stegeberg.pdf

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September 13, 2004
Ms. Tern Carlock
Idaho Public Utilities Commission
472 W. Washington
Boise, ID 83702
RE: Case No. IPC-E-D3-
Dear Terri:
Upon reviewing Order No. 29505 relating to the Idaho Power Company general
rate case, I noted that there was an issue related to the basis for establishing a
methodology for estimating interest rates for variable rate debt. As you know,
historic rates are not an accurate predictor for future interest rate behavior.
suggestion for you to consider would be to use conventional market-based
techniques ror estimating future interest rates on variable rate tax-exempt or
taxable debt.
Institutional investors, the derivatives market and portfolio managers use
forward interest rates to implement investment and interest rate hedging
strategies. These same forward interest rates can be applied to future expected
borrowing costs. This methodology applies arbitrage-free theory in developing
forward interest rates based upon the company's current new issue yield curve.
See Attachment A as an example of a forward rate curve for AAA-rated pollution
control revenue bonds. If this approach appeals to you, I would be pleased to
assist you to develop a method applicable for use in future rate cases.
I hope that you recall me from my employment at PacifiCorp. Since
resignation in 1998, I have continued to follow the utility industry with great
interest and have been providing utilities with corporate finance and capital
markets advisory services. Please find enclosed a brochure describing the
services that we are providing.
Office: 503.697.1061 ~\TW1-V. capmktsolutiOllS.com Fax: [phone]
As my business has developed, I have found that debt portfolio management is
an area that has been traditionally underutilized by utilities. A product that we
have under development involves benchmarking utility's debt portfolio
performance to determine its efficiency under various market conditions. This
tool indicates the debt portfolio s risk to changing market conditions over time
and can be used to evaluate how effective past and future financing decisions can
be managed to obtain the lowest cost possible. The Idaho Public Utility
Commission might find this of interest to use as an additional parameter to
reward management effectiveness when establishing an authorized return on
equity, to compare utilities cost of debt on a relative basis or to monitor a utility's
debt financing program.
If I can be of any assistance with the development of your variable rate bond
methodQlogy or if you are interested in the benchmarking performance tool,
please let me know. I will plan to give you a call over the next week or so.
any event, it would be good to catch up with you.
Sincerely,
John R. Stageberg
Principal
Enclosures
Office: 503.697.1061 www.capmktsolutions.com Fax: [phone]
APITAl MARKETS
SOLUTIONS
Attachment A
Estimating Future Interest Rates
Using Forward Rates
The Yield Curve is the tenn structure of interest rates indicating at a given point in time the
various maturities and yields available for a company to issue or price its debt securities.
According to the Expectations Hypothesis, ... the shape of the yield curve results tram the interest rate
expectations of market participants...and .. .the equilibrium long-term rate is the rate the long-term
bond investor wauld exped to earn through successive investments in short-term bonds over the term to.
maturity of the long-term bond.
Forward Rates are derived from the Yield Curve and quantify_the market's expectations for
future short-term rates.
Calculating Forward Rates for a short horizon is fairly simple. However, extending the Forward
Rate calculation over several intervals can be significantly more complex requiring sophisticated
software applications to accomplish the results quickly and accurately. Capital Markets
Solutions has the benefit of one of the most highly regarded fixed income analytics and advisory
services firms on Wall Street, Andrew Kalotay Associates (AKA)2. AKA has provided Capital
Markets Solutions with its proprietary debt management software, DebtPaysTM, to calculate
forward rates for any yield curve and time horizon.
The following page is an example of the Forward Rates calculated based upon the AAA-rated
tax-exempt revenue bond yield curve3 at August 8, 2004. The Forward Rates in each column
represent the future expected rate for each maturity at six-month intervals in the future. For
example, the current 6-month spot rate is 1.29%. The expected 6-month rate six-months in the
future is 1.752%, one-year in the future is 2.116% and so on.
A key provision to the theory applied to Forward Rates is that the rates are arbitrage-free. This
means that investors would be indifferent to investing in a sequence of inveshnents with short
maturities or an inveshnent with a long maturity as long as the inveshnent horizon remains the
same for each invesbnent alternative strategy.
In the case of Idaho Power Company, although its bonds re-price as frequently as every seven
days, the arbitrage-free criteria indicates that over a long horizon (e.g.. six-months or greater)
investor expectations require the expected future short-term rates to provide equilibrium with
longer dated invesbnent alternatives. This condition is consistent with the Expectations
Hypothesis described above.
The key to applying this methodology to Idaho Power Company, or any other company, is to be
able to obtain accurate yield curve data for the debt security that is to be measured.
1 Investment Analysis Portfolio Management, Frank K. Reilly and Keith Brown, Chapter 19 The Analysis and Valuation
Bonds pp. 756-759.
2 Andrew Kalotay Associates website is www.kalotay.com
3 Goldman, Sachs Municipal Market Update and Municipal Money Markets Morning Report (dated 8/04/2004).
Forward Par Curves
Treasury
Years Forward Month Year Year 3- Year 5- Year Year 10-Year 20- Year 30-Year
000 290 520 900 247 910 300 730 600 870
500 752 933 277 611 217 548 937 753 981
000 116 288 623 954 3.478 773 123 894 083
500 2.462 630 963 294 717 980 294 025 177
000 801 968 302 635 928 170 4.451 147 263
500 138 307 643 898 124 342 592 259 342
000 3.4 78 648 988 101 298 4.497 717 361 5.412
500 821 993 212 270 4.448 630 825 5.451 5.474
000 168 342 343 390 571 740 916 530 526
500 521 4.441 4.418 4.480 668 826 988 597 569
000 359 343 4.416 529 735 886 041 650 600
500 327 393 501 623 826 964 128 710 639
000 4.461 4.492 628 742 926 049 225 773 679
500 524 612 746 855 018 127 321 830 717
000 703 771 876 975 109 202 5.422 886 753
500 841 887 985 070 184 266 520 935 785
8. 000 934 985 084 151 249 321 617 978 812
500 038 088 169 223 308 5.405 718 017 838
000 139 188 240 285 359 5.491 821 051 860
500 239 255 296 336 5.401 580 927 080 879
1 0.000 271 294 337 375 435 671 037 104 896
Term
Treasury Yield (%)
Interest Rates6 me 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 15 yr
290 1.520 1.900 2.247 2.910 3.300 3.730 4.170
Date: 08/04/2004 Short-rate volatility: 0.0% Mean reversion speed: 0.
20 yr
600
30 yr
870
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