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BY SourceMedia | MUNICIPAL | 11/30/22 01:46 PM EST

Issuers in the Southeast are reigniting the prepaid energy bond market, leading a wave of demand for the long-term, fixed rate natural gas agreements.

Buoyed by federal stimulus and stronger-than-expected recent tax collections, traditional municipal markets rallied in the months and years after initial lockdown measures. Demand for prepaid transactions, however, often structured as tax-exempt bond sale agreements between a municipal utility provider and private energy supplier, remained stubbornly low despite a strong hike in issuances prior to the pandemic.

In a report, Moody's Investors Service (MCO) blamed unstable economic conditions and a budget crunch at all levels of government for the drop off.

Along with a general decline in gas consumption during the earlymonths of the COVID-19 pandemic that unsteadied markets, municipalities began to focus on short-term budgetary needs and the credit agency recorded a 80% dip in the prepaid issuances rated, from an annual average of $7.8 billion in related issuances prior to the pandemic, to less than $1.4 billion in 2020.

An uptick in activity in the second half of 2021 followed by a strong performance for prepaids in 2022 resulted in four times as many issuances IS THIS NUMBER OF DEALS OR DOLLAR VOLUME? this year then just two years ago, evidence of a changing equation presenting municipal utilities with renewed "economic motivations" to pursue long-term energy arrangements once again, said Dennis Pidherny, a managing director at Fitch.

"Pre-paid transactions are now particularly appealing for municipal entities quite simply because they get to buy gas at a discount to market," Pidherny said. "That's what hooks them into these these transactions. That's the motivation and the incentive, and there really is no shortage of utilities that wouldn't love to buy gas at a discount."

Energy consumers and providers have had to contend with a general increase and ever-present instability in the price of natural gas for most of the year.

Along with inflation, Russia's war on Ukraine has had a profound effect on global energy prices as some of the world's largest consumers of crude oil uphold absolute bans on energy imports from one of its largest suppliers.

Despite the U.S. tapping its strategic reserves earlier in the year in an attempt to bring prices down, low production quotas from other global suppliers kept the market in a squeeze, rippling down the supply chain and sending municipal utility providers, both large and small, in search of stable prices amid the unstable environment.

Prepaid deals often hold certain unique features that create robust guardrails appealing to both buyer and supplier on agreements.

Most transactions are issued as 30-year notes with mandatory 10-year redemptions, offering municipalities flexible to address market functions and readdress contacts over the mid-term.

"It's a reset after 10 years to recalculate the discount, and if the offers not good enough, you don't have to buy gas," Pidherny said."That's the kind of the tenor in the bond market where you could actually generate enough savings and enough discount to make it work."

The bonds are also issuedthrough special-purpose conduits, and backed by an increasing number of large and credit-healthy investment banks that've began to seek profits in the prepaid market, another feature of the transactions that help "protect everybody involved," Pidherny said.

Ratings on the bonds are often linked to the issuer default rating of those specific banks.

In November, Fitch upgraded seven separate series of prepaid gas bonds to A-plus from A, in line with an upgrade given to Morgan Stanley (MS), the guarantor and middleman of between buyer and supplier on the upgraded deals.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

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