Tax-free bonds that help municipalities control their long-term natural gas costs are gaining popularity among investors for their strong protections and high credit ratings.
The bonds were first issued in the 1990s. They fund efforts by municipal utilities to buy natural gas at a predetermined price that will be delivered over as long as 30 years. The contracts with suppliers help municipalities control soaring energy costs.
These pre-paid gas transactions have increased dramatically since 2003, when relevant tax regulations were firmed up. The popularity of the tax-free bonds has grown to the point that Standard & Poor’s now has ratings on over $16.4 billion of principal value representing 21 transactions, all completed since 2003.
How they work
Typically, a municipal utility contracts with a natural gas supplier to provide a stated amount of gas, deliverable periodically, over 20 to 30 years. The gas supplier agrees to an upfront fixed price payment for all of the gas. The utility issues tax-exempt bonds in an amount sufficient to pay the gas supplier upfront at the agreed upon price. Bondholders are then repaid over time from the revenues generated by gas sales by the utility to its customers.
Credit ratings
Rating agencies have developed sophisticated rating criteria by which they examine all aspects of a prepaid gas transaction. The key rating factor is the credit quality of the gas supplier, and the investment bank that guarantees the performance of the supplier. For example, the bond rating on a recent transaction by the Tennessee Energy Acquisition Corporation (TEAC) was mainly based on the credit strength of Goldman Sachs, which guaranteed that its supplier subsidiary, J. Aron, will provide the gas to which it has agreed. Should J. Aron be unable to meet its obligations, Goldman Sachs will be responsible to provide sufficient funds to redeem any outstanding bonds at their face value or a premium.
In fact, a key aspect of prepaid gas bonds is the requirement that bonds are to be redeemed at par or a premium if various parties to the transaction are unable to meet their future obligations. Each transaction is structured with the intent that bondholders are repaid early, if necessary, under a variety of situations, including unforeseen disruptions in the natural gas market. Further, the failure of the municipal utility to take all of the gas it contracted for is also accommodated by the gas supplier’s obligation to remarket the gas to other customers.
Numerous protections
Projections show a growing need for energy in the years ahead. Prepaid gas bonds provide a means for governmental entities to acquire a substantial supply of natural gas for many years while locking in current prices. Each transaction has numerous built-in mechanisms to ensure that bondholder interests are protected should problems occur in the future.
To date, S&P has rated all gas prepay bonds at least “A+,” reflecting the substantial credit quality of each bond issue’s structure and the strength of the credit enhancement furnished by the financial firm guaranteeing the gas supplier’s performance. Indications are that issuance of prepaid gas bonds will increase substantially in the future. With their strong bondholder protections and high credit ratings, gas prepaid transactions should be attractive investments in the tax-exempt market.