PrintDemystifying energy prepay bonds
BY SourceMedia | MUNICIPAL | 10:07 AM EDTIngenuity, creativity, and innovation are words used to frame the municipal bond market. Historically, our market has responded admirably to wide-ranging policy shifts that altered tax dynamics, sector and credit profiles, and technical patterns. New structures and obligor diversification continue to be introduced into this demand-driven asset class.
Gas prepay bonds are not new to the public finance community, but their evolution has moved through shaky periods. While knowledge and acceptance of these securities has expanded over the past decade, the concept remains an enigma for many market participants. Gas prepay bonds are viewed as structured finance transactions that are not all crafted alike and for various stakeholders, it still may be difficult to fully trace the security package and conduct an adequate risk assessment.
My intent is to demystify the sector by outlining the mechanics of the prepay structure and identifying key participants and nuances of the transaction in a straight-forward manner. In my opinion, the structural integrity of prepay bonds greatly mitigates corporate counterparty credit risk exposure.
While prepays are structured to attain strong investment-grade ratings, bondholders are exposed to financial institution counterparty risk, par termination risk, and the potential vulnerabilities of indirect credit default swaps. Banks are routinely subject to the vagaries of regulatory oversight, statutory capital and liquidity requirements, and various structural proposals which may cause market demand for bank obligors to fall out of favor.
Having said this, the sector has expanded beyond exclusively gas prepay to a broader energy prepay basket, including electricity and renewables. Investors have grown comfortable with energy prepay bonds as they have become a popular source of credit quality, yield and income benefits and portfolio diversification for the expanding SMA platform. This niche sector may also be a provider of alpha generation, depending on spread performance. Taking on prepay exposure during periods of associated market volatility has been a successful investment strategy following a material tightening of spreads.
As mentioned, energy prepay deals are structured finance vehicles whose bonds are issued through a municipal conduit. They are not secured by municipalities, even though the commodity offtaker is a municipality or municipal authority. The conduit structure passes the federal tax-exemption directly to bondholders. In order to qualify for tax-exemption, U.S. Treasury regulations require that at least 90% of the prepaid energy be used by a municipal entity.
Under the prepayment structure, municipal utilities can lock in a reliable long-term supply of natural gas ? or other commodity ? purchased at a discount to the spot market, thus hedging against commodity price volatility and reducing overall energy supply costs. If the transaction is structured efficiently, semiannual debt service can be significantly less than the monthly natural gas payments the municipality would otherwise pay.
The prepayment structure alleviates the administrative burden associated with daily commodity purchases and helps to protect utility financial margins and ratings. Energy costs are spiking ? thanks to growing electricity demands to operate new data center development and general energy shocks tied to the Iranian crisis. However, domestic natural gas production is somewhat insulated from Middle East events, given tight export restrictions and global infrastructure constraints that deter adequate accommodation of the commodity.
This structure exposes the bonds to corporate credit risk. Typically, prepay deals involve multiple counterparties: a special purpose municipal entity; municipal utilities; a gas supplier (and its guarantor, typically an investment bank with the supplier being a subsidiary commodities arm of the financial institution); and a commodity swap provider. Commonly, the financial institution absorbs the credit risk through a guarantee to deliver the commodity and/or a guarantee of payments pursuant to a purchase and sale agreement. In certain transactions, a guaranteed investment contract provider, an interest rate swap provider and/or a surety provider may be present.
Bond ratings are linked to the ultimate guarantor of the cash flows underlying the transaction, even when there are cash flow failures on the part of other transaction counterparties. However, a weakest link rating methodology is applied. These structures are specifically crafted to tie such cash flows back to the guarantor. Success of the transaction requires the functionality and performance of the counterparties working in sync, which could have a direct impact on ratings. The corporate obligor/financial intermediary construct heavily insulates exposure to municipal obligor-related credit.
Given the unique corporate credit construct, it is not surprising that prepays are part of the IDR/PCR attribution bucket for the Bloomberg U.S. Municipal Index. The IDR/PCR contribution comprises 7% of the broad index, with prepays approximating 75% of that figure, thus nearing 5.3% of the overall index. Energy prepays account for over 10% of the Bloomberg 1-10 year Municipal Bond Index, illustrative of a mandatory put feature associated with a high percentage of today's prepay financings.
Against these weightings, episodic weakness across the prepay sector can create underperformance within the index. However, the severity and duration of the weakness as well as the range of systemic and liquidity displacement would likely determine the depth of index drag. Significant stress for prepays could derive from banking sector concerns which could pressure short-term investment vehicles, particularly those with tender option features and bank liquidity facilities, as well as disrupt investor confidence in structured municipal products.
Growth within the energy prepay space is evident looking at the issuance data. Bloomberg shows total par prepay issuance year-to-date of $14.6 billion, with a record $31.4 billion sold in 2025. I expect issuance to remain active through the balance of the year, with an anticipated new record in 2026.
SMAs are finding value in the municipal energy prepay sector as customization and active portfolio management identify additional yield opportunities for this expanding investor base. While credit diversification within the sector may present challenges, the market is seeing new entrants with insurance companies ? including some with life insurance affiliates ? absorbing the credit risk through a guarantee to deliver the commodity and/or a guarantee of payments pursuant to a purchase and sale agreement. Large money center banks continue to remain active in this space, but in my view, more guarantor diversification is a good thing.
Since the mid-2010s, transaction structures have been strengthened and there is now uniformity with 4-6 year hard puts ? with 10-year puts being the max ? on long-term 20-30 year energy contracts. The put optionality effectively reduces duration and liquidity risk and provides investors with a par exit strategy while avoiding reinvestment risk, thus contributing to tighter option-adjusted spreads.
It is common for a portfolio manager to impose account-level restrictions with respect to these investments, and active analysis and surveillance of the transaction and its corporate obligors is essential. It is important to consider individual SMA account suitability, risk tolerance and portfolio constraints.
Account restrictions allow professionals to manage periods when liquidity falls out of favor and vulnerability to spreads widening arises, even though the market has done a good job absorbing these bonds. We just have to think back to 2023, when heavy disruption within the banking sector took hold with the Silicon Valley Bank collapse, leading to immediate wider credit spreads on associated securities.
Motivating factors continue to drive issuance of tax-exempt prepay bonds. Historically, municipal electric utilities contended with natural gas price volatility as many built natural gas-fired power plants, with natural gas becoming a greater contributor to utility fuel mix. Soaring prices paid by gas and electric utilities at times produced significant customer rate increases, given the need to recover higher fuel costs.
The inherent volatility associated with natural gas prices places added pressure on municipal utility budgets, interferes with customer delivery and greatly contributes to the political debate surrounding rate increases. For many utilities, drawing down on cash reserves had been the only available option where rate hikes were not politically viable.
Prepay background
After exiting the market in the late 1990s due to specific Internal Revenue Service arbitrage challenges, natural gas prepayment bonds reemerged as new IRS regulations contained in the National Energy Policy Act of 2005 expressly allowed the issuance of tax-exempt debt to finance natural gas and electricity prepayments. With the new IRS provisions, previous arbitrage concerns were lifted and the structure witnessed growing investor popularity.
The muni market's reception to gas prepays dropped off considerably and new issuance came to a halt with the seizing of credit and liquidity, given the dislocation within the financial markets that emerged in 2008. Associated downgrades on various financial institutions and the monoline bond insurers resulted in downgrades on virtually all gas prepay bond issues.
We did see a default on certain bonds structured with long-term purchase contracts and swap arrangements with Lehman Brothers. These securities were issued through Main Street Natural Gas Inc., with bondholder claims pursued through the bankruptcy estate. In certain situations, gas delivery continued through the workout process. Generally, various levels of recovery ultimately emerged through restructurings and available collateral, with certain bondholders receiving higher distributions over time.
Since the Lehman bankruptcy, various structural bondholder protections have been built into the prepay transactions as risk mitigants to make them somewhat better secured, including use of reserve funds, a gas remarketing agreement, hard puts and stronger counterparties.
In a January 2014 rulemaking proposal published by the Federal Reserve Board, public commentary was solicited in regard to restricting systemically important domestic banks from owning or trading physical commodities. As proposed, the regulation would not have adversely impacted the credit and existing ratings of gas prepay bonds secured by major financial institutions acting in the capacity of gas supplier or gas supplier guarantor. Many outstanding bonds were structured with long-term contracts, highly rated guarantors, substitution provisions and strong legal protections.
To my knowledge, the proposed rulemaking was never fully adopted and systemically important banks were not forced to sever ties with their commodities arm. Opponents argued such restrictions would significantly destabilize outstanding prepay bonds with secondary market liquidity most at risk, given substitution concerns and a general shrinking of counterparty participation. While stricter rules were proposed by the Fed in 2016, nothing was ever memorialized and banks were able to further their participation in these transactions. Of course, a higher level of regulatory oversight was applied.
However, certain domestic banks, including JPMorgan
Risk management issues over trading complexities associated with physical commodities added to the decision to disband these operations. The net effect of these developments created a smaller universe of prepay participants and paved the way for new guarantors.
Even if the proposed rulemaking had gone into effect, the guarantee from the financial institution would have remained in place and according to an April 2014 Moody's special comment, "We expect that a financial institution's continued involvement in a gas prepay transaction would not violate any final adopted regulation based on the current proposal. We also do not anticipate these transactions to be unwound because of the favorable term funding they provide to banks and the limited rights of a bank to voluntarily terminate their agreements."
With rising interest rates in 2018, advantageous market conditions provided fertile ground for Natural Gas Prepayment bond issuance, given wider spreads between tax-exempt and taxable yields and, by extension, bank financing costs. This environment created incentives for financial institutions to use their subsidiary commodities energy arm to act as gas suppliers. Such favorable market conditions extended into 2019, yet the onset of the COVID-19 pandemic in 2020 created significant disruptions to issuance, with only a few natural gas prepayment bond issues entering the market.
Growing concerns, perceived or real, across the financial services industry throughout the COVID crisis marginalized investor interest and generated wider spreads within the gas prepay space. Against this backdrop, interest rate sensitivity may, at times, have greater influence over gas prepay issuance than do actual prices of natural gas, especially when upward moving commodity prices logically suggest a desire to lock in long-term rates. A higher interest rate trajectory, with widening taxable/tax-exempt ratios, should support performance and issuance activity for prepay bonds. Broadening secondary participation extended the education curve for investors.
General credit/participant structure
JAA and member utilities: In most prepay deals, a conduit Joint Action Agency (JAA), whose members are municipal utilities owned by city governments, enters into a contract with a natural gas supplier (subsidiary of a financial institution) for a fixed term (generally 20 years). The JAA, also referred to as a "special purpose municipal entity " (SPE), issues tax-exempt bonds and uses the proceeds to make an upfront one-time payment for future gas delivery offered by a gas supplier. The prepaid price is based on the forward price of the future gas deliveries when the transaction is executed, and is discounted by the supplier.
Once the prepayment is made to the gas supplier, it is essential that the gas supplier provide natural gas for the JAA to resell. Without the proceeds from the sale of gas, there would be insufficient funds to make timely debt service payments. Thus, the gas supplier must commit to certain performance obligations. JAA members are generally obligated to make payments under long-term contracts, and such obligations are several, not joint.
The municipal utilities pay the JAA for delivery of the gas at a monthly market index price, and gas prepayment transactions are not considered debt of the member utilities. Utility payments derive from natural gas system operating revenue and bondholders do not have a claim on municipal revenues. In some structures, a step-up provision may exist for non-defaulting participants. The contract between the JAA and the gas supplier forms the prepaid natural gas sales agreement.
Termination risk: For purposes ofthis discussion, I will focus on gas prepays as they represent the largest subset of the sector. A major risk to municipal utilities in prepay transactions is the potential exposure of the utility to early redemption of the bonds and to the volatile spot market in the event of early termination. Under the prepaid natural gas sales agreement, the gas supplier agrees to deliver gas to designated delivery points on the pipelines serving the municipal utilities.
In the event of a commodity swap default and termination event, there is a 45-day replacement period to secure a new swap provider. If there is no replacement, the gas supplier, backed by the guarantor, is obligated to provide a termination payment made on behalf of the SPE, sufficient to pay off the bonds, directly to the Bond Trustee for deposit into the Bond Redemption Fund. Debt service would be paid under an extraordinary make-whole call at the amortized value.
Under the prepaid gas purchase agreement, the gas supplier agrees to use all reasonable efforts to remarket amounts of gas identified by the SPE. One possible scenario resulting in excess supply could be non-performance by a JAA member utility. In the event that the gas supplier is unable to remarket any portion of the gas, the gas provider will purchase such gas for its own account. The guarantee by the holding company only secures the payment obligations of the gas supplier under the agreement and does not guarantee delivery and other performance obligations of the gas supplier.
If there is any other termination event, the investment bank (holding company) would ensure there are sufficient termination payments to redeem the bonds pursuant to the previously referenced make-whole call provision. The investment bank owning the gas supplier is the guarantor of its commodities arm subsidiary.
To my knowledge, this obligation is shown in a footnote to the guarantor's financial statements as a senior unsecured long-term liability. Under no circumstances is either the gas supplier or the guarantor obligated to make payments to bondholders.
Commodity swaps: Typically, as a hedge against payment volatility by the municipal utilities due to gas price fluctuation, the JAA and the gas supplier enter into mirror commodity swap transactions with a third party financial institution which allows:
(1) the JAA to pay a floating natural gas price (monthly natural gas index approximating spot price ) and receive a fixed natural gas price for the same notional amount as that under the prepaid natural gas sales agreement.
(2) the commodity swap provider to transfer the price volatility risk to the gas supplier by swapping the monthly index price for the natural gas for a fixed price for the same notional amount that is sufficient, together with payments made by the municipal utilities and amounts received under the prepaid natural gas sales agreement, to repay the debt.
With a fixed revenue stream, the JAA can repay the bonds with a fixed coupon payment. Netting out, the commodity swap provider maintains a flat position. Effectively, a commodity swap gives the utility a specified discount from spot market prices for the gas it uses during the life of the contract, rather than locking it into a fixed price for decades.
- Other counterparties: Included in some, but not all transactions, is a guaranteed investment provider that may be used to secure investment returns on debt service or other reserve funds. In other transactions, a surety policy may be used to secure utility payments. Where a variable coupon exists, the SPE may also hedge the coupon rate volatility risk by entering into an interest rate swap with the gas supplier, whereby the SPE pays a fixed interest rate and receives a variable interest rate directly linked to the coupon rate. Current gas prepay transactions do not typically employ a variable rate structure with a liquidity provider.
- Potential concerns over the credit default swap (CDS) market: At times, market events create pressure on credit default swaps of a financial institution, such as a bank, broker-dealer or life insurance company. Prices for CDS tied to the debt of major financial institutions have, during past episodes of financial sector stress, reported to trade at levels more reflective of significantly lower quality, including speculative grade. Given the credit profile of prepay bonds, I am concerned with all material credit events that could potentially impact those ratings of associated financial institutions.
Concluding thoughts
The banking sector is under ongoing scrutiny, especially since the financial crisis of 2008-2009 and the more recent collapse in March 2023 of Silicon Valley Bank. While participating financial institutions in prepay transactions are large money-center banks with relatively strong credit quality, there tends to be a "guilt-by-association" phenomenon that seems to envelop all banks and that has caused visible spread widening across the prepay sector. Fundamentally, the structural integrity of prepay bonds has not been weakened, but bank downgrades ? and downgrades on other financial institutions ? can expose these securities to corresponding downgrades. Against this backdrop, investors may find an opportunity to acquire well-secured bonds at cheaper levels.
