Even as the municipal bond market
Market analysts said turmoil driven by the COVID-19 pandemic was the main culprit in the drop-off in issuance last year. But the question remains as to whether 2021 will be a comeback year for prepaid natural gas transactions, or if issuers will remain on the sidelines until market conditions become more favorable.
Prepaid gas transactions are usually structured as tax-exempt bond sales where a municipal gas or electric utility can lock in a long-term supply of natural gas at discount prices. The bonds are sold by a conduit issuer such as a special-purpose entity.
“As part of the structure of prepay gas revenue bonds, a financial institution may assume the credit risk of the transaction. It may ultimately guaranty delivery of the commodity and/or provide a guaranty of payments under a purchase and sale agreement,” said Steve Levine, senior market analyst at Interactive Brokers.
Levine noted that an institution — a bank such as Morgan Stanley, Goldman Sachs or BNP Paribas — will usually hedge its risk through arrangements like an interest-rate swap or a commodity swap to provide fixed prices of the commodity to the issuer and hedge its floating price exposures over the lifetime of the bond, which is typically long-term, from 15 to 30 years.
In 2019, prepaid gas bond issuance was on a roll, continuing a revival that began in 2018 due to favorable market conditions, Moody’s Investors Service said in a report last year. The rating agency said the increase in deal volume reflected a wider spread between tax-exempt and taxable yields, encouraging banks to serve as gas suppliers to generate their own funds.
In 2018, Moody's rated 12 prepaid gas transactions totaling $9.418 billion, breaking its previous record of 10 in 2007. And in 2019, Moody’s rated 11 deals totaling $6.339 billion.
In 2020, the deals hit a wall as a result of the market disruption caused by the coronavirus pandemic. Moody's only rated three deals for $1.385 billion.
“As volatility increased and the economy took a sharp downturn in the first quarter of 2020, amid the onset of government policies and other measures to contain the spread of COVID-19, the financial sector generally faced greater perceived credit risk,” Levine said. “In turn, this increased volatility and its impact, or potential impact, on those financial institutions assuming the credit risk in prepay gas bond deals generally led to wider spreads and lower issuance of them throughout 2020.”
Moody’s said the postponements were not entirely unexpected.
“Some gas prepayment transactions were delayed indefinitely as a result of the general market disruption caused by the coronavirus pandemic,” Moody’s said, noting however that “the financing structure remains an attractive option for banks as a cost-effective funding mechanism linked to the tax-exempt market.”
S&P Global Ratings has surveillance on 29 prepaid gas deals currently, with the last one it tracks being sold in 2017.
The agency revised its counterparty criteria on these deals in 2019. At that time, S&P affirmed the ratings and removed the under criteria observation identifier on 151 classes from 27 gas prepay transactions. S&P said the ratings on those transactions were weak-linked to the lowest counterparty rating of the multiple counterparties in each individual transaction.
Fitch rates 42 prepaid energy transactions, with aggregate issuance totaling nearly $25.5 billion. In a July 2020 report, Fitch Ratings said it considers three major factors when determining the credit rating of prepaid energy transactions — counterparty credit quality, transaction mechanics and structure, and legal issues.
In April 2020, Fitch said outlook revisions on U.S. and Canadian banks to negative from stable were putting downward pressure on prepaid energy transaction ratings. Most of Fitch’s ratings on these deals are driven by the long-term rating of the commodity supplier or its guarantor, counterparty roles usually performed by U.S. or Canadian banks. Those banks were hit by concerns related to the coronavirus pandemic.
On Tuesday, the U.S. Energy Information Administration reported that proven reserves of natural gas fell 1.9%, to 494.9 trillion cubic feet in 2019 to from 504.5 trillion Tcf in 2019.
“This is the first annual decrease in proved reserves of natural gas in the United States since 2015, but reserves remain at their second highest level ever,” the EIA said.
Total U.S. production of natural gas increased 9.8% in 2019 from 2018. This increase in supply had a downward effect on prices.
The EIA reported the annual average spot price for natural gas at the Louisiana Henry Hub fell 21.5% to $2.63 per British thermal units in 2019 from $3.35 per MMBtu in 2018.
There is some reason to believe prepaid gas deals may make a comeback this year, especially in the second half.
“We believe there is considerable pent-up demand for gas prepayment bonds in 2021, both from investors and from participants who want to purchase gas,” said Joann Hempel, Moody’s vice president and senior credit officer.
“Bankers believe markets will be more favorable no later than the second quarter of 2021,” she said.
“Persistent and robust demand will continue to drive municipal investors into whatever is available. Fundamentals, credit quality and other forward-looking indicators are all taking a back seat to just getting cash invested,” said Jeffery Timlin, principal and managing director at Sage Advisory Services.
“Similar to the real estate market, municipal investors are driven by yield, yield and yield. With cash equivalent yields at or below zero, if you include fees, anything north of that is desirable, even if it trades extremely rich from a historical perspective,” Timlin said, adding that demand for these deals will be no different.
“There is no surprise that these deals were almost nonexistent last year. Right or wrong, prepaid gas deals were probably not on most municipalities' radar,” said Sean Simko, managing director and head of global fixed income portfolio management at SEI Investments. “Many focused on oil prices that were down for the year and falling revenues. As oil prices are potentially setting the stage to climb, it wouldn’t surprise us to see a resurgence in these types of deals gaining more attention and traction.”
