Bonds

‘Win-win’ prepaid natural gas deals abound in Southeast

The recent slew of prepaid energy bond issues in the Southeast continues to revive interest in the sector as demand remains strong for the tax-exempt paper.

In a prepaid natural gas deal, public utilities secure a long-term supply of natural gas at a discounted rate. A conduit issuer, typically a special-purpose entity, sells these bonds.

The majority of the tax-exempt deals are issued as 30-year notes with mandated 10-year redemption periods, giving municipalities the ability to readjust contracts at the halfway point and adjust for changes in the market.

“Prepaid gas bonds can provide supply with good credit quality and structure,” said Matt Fabian, a partner at Municipal Market Analytics.

“Each party in this deal benefits in some way,” said Seema Mohanty, founder of Mohanty Gargiulo.

It’s a win for the issuer and market participant standpoint because they’re getting a discount to the market, and also the funding recipient, who is getting diversified funding, she noted.

There have been several prepaid gas bonds to start the year, most of which are in the Southeast.

Recently, Morgan Stanley upsized a pricing for Energy Southeast, Alabama on April 16 of $941.635 million of energy supply revenue bonds, rated A1 by Moody’s Ratings, with 5s of 12/2026 at 4.45%, 5s of 6/2029 at 4.31%, 5s of 12/2029 at 4.31%, 5s of 6/2032 at 4.42% and 5.25s of 7/2054 at 4.50%, callable 3/1/2032.

Prior to that, Goldman Sachs priced for the Black Belt Energy Gas District, Alabama, on March 12 $467.595 million of A1 Moody’s rated gas project revenue bonds with 5s of 9/2025 at 4.33%, 5s of 2029 at 4.28%, 5s of 2032 at 4.38% and 5.25s of 2055 at 4.40%.

In both cases, as is typical for a prepaid gas deal, Moody’s said the rating rested primarily on the credit of the funding agreement provider — Athene Annuity & Life Company for the Black Belt deal, and Morgan Stanley for Energy Southeast, both rated A1. The credit quality of the providers of the guaranteed investment contracts provided for the debt service account, debt service reserve account and the commodity swap reserve account also factor; Moody’s requires them to be rated at a level that supports its bond rating.

Spreads on prepaid gas deals are wider than several years ago, which specifically widened during the banking crisis in March 2023, said Mikhail Foux, managing director and head of Municipal Research and Strategy at Barclays Investment Bank.

Afterward, spreads “came back mostly,” but they are still wider than the pre-banking crisis.

The widening of spreads happened due to the increase in supply, issuer-specific caps and lack of demand from certain investors, Foux noted.

The recent deals continue the sector’s upward trajectory over the past several years.

The early round of prepaid gas bonds — long-term, 30-year fixed-rate deals — was in the mid-2000s before “going away” due to market conditions as the relative value market didn’t “lend itself well to doing these deals,” Mohanty said.

However, a put bond structure for prepaid gas bonds was introduced in the mid- to late-2010s, with the range working from a relative value standpoint, she noted.

“These deals started to work economically, and then everyone jumped at the opportunity,” she said.

The issuance of prepaid gas bonds slowed in 2020, mostly due to the pandemic, before rebounding during the second half of 2021 and continuing to gain momentum, with the sector seeing a “very high level” of activity in 2023, according to a Moody’s report.

In 2023, Moody’s rated 25 prepaid transactions totaling $19.3 billion, 114% more than the 15 rated in 2022 for $9 billion, the report noted.

Issuance was helped by “refunding activity for older gas bonds which reached their mandatory tender dates,” the report said.

For some of the transactions that came to market over the past several years, the five- to 10-year range generated the largest discount, said Dennis Pidherny, a managing director at Fitch Ratings.

“So you could sell 10-year debt and make the discount work for that initial period to incentivize people to participate,” he said.

“That was built into the financing structure whereby at the end of that initial period the bonds would come up for remarketing and there would be enough money for the suppliers to recalculate and reoffer the gas at dated spreads based on market conditions,” Pidherny said.

A good portion of the deals from the past two to three years were already outstanding but are in the process of being remarketed, he said.

Market participants in the muni market are looking for “yield, yield and more yield,” and prepaid gas bonds provide the “yield base” and the additional spread most are looking for, said Jeff Timlin, a managing partner at Sage Advisory.

Market participants are comforted by banking of these “too big to fail banks” and the “quasi-backing” of the U.S. government, he said.

“That dynamic that gives people comfort in a credit that maybe wouldn’t work as well,” he said.

Interest in prepaid gas bonds stems in part from banks’ focus due to the drain of their deposits when market participants move money out and reallocate it to other high-yielding alternatives, Foux said.

Additionally, “a higher interest-rate environment allows for a wider spread between the taxable and tax-exempt rates, making this financial structure more attractive to financial sector guarantors by offering a tax-exempt, cost-effective funding mechanism,” the Moody’s report said.

That interest creates demand, which remained strong during the year for both new issuance and secondary market trading, the report noted.

“There’s a lot of demand for tax-exempt supply, and these prepaid gas bonds can provide supply with good credit quality and structure,” said Matt Fabian, a partner at Municipal Market Analytics.

Additionally, he noted current prepaid gas bonds lack the current risk the earlier ones had.

And with “no shortage” of demand for prepaid gas deals, especially since municipal utilities are willing to buy at lower than index prices, Pidherny said it comes down to “big enough [discounts] to incentive someone to participate in the program.”

The economics of such deals “hinge on the ability to borrow at very attractive tax-exempt rates, and earn a higher taxable return on those funds,” he said.

However, “if the attractiveness of the discounts can increase or stay high, there’s always going to be a steady enough demand that these deals could become more predictable,” Pidherny said.

Until recently, demand for prepaid gas transactions came from the same group of investors, such as mutual funds, Foux said.

However, over the past few years, the buyer base has expanded. Separately managed accounts “increasingly” include prepaid gas bonds, a sign of strength for the sector, Fabian noted.

For example, Sage Advisory, an investment management firm focused solely on SMAs, started “picking up” some prepaid gas bond exposure after the 2023 banking crisis-induced spread widening led to attractive valuations, Timlin said.

“Since then, the attractive valuations and the outperformance those particular bonds have … caught the attention of many SMA players in the market,” he said.

As part of a diversified portfolio, Timlin said prepaid gas transactions have their place.

Sage’s secondary supply of prepaid gas bonds is limited due to their criteria of coupon structure, maturity structure and call features, among others, he said.

The prepaid gas bonds are not offered every often, but “every time we put them out into the market to sell, we’ve had no problem selling those,” Timlin said.

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