Despite the lack of credit spread across much of the municipal bond market, we are finding certain sectors that offer an attractive opportunity. One of those sectors is municipal bonds backed by corporate entities. Specifically, prepaid natural gas contract bonds present an intriguing investment whereby municipal investors can buy what is effectively a bank bond, without the taxes or volatility associated with corporate debt. These bonds yield 1.5-2.0x that of other similarly rated munis. As our clients who invest in strategies that own taxable bonds are aware, we have had a positive view on the credit quality of the financial sector for some time, as new capital requirements have strengthened bank balance sheets. Through these types of municipal bonds, our optimism on the financial sector can be represented in our municipal portfolios as well.
Prepaid Natural Gas Bonds are highly structured special purpose financing vehicles used by municipal gas and electric utilities to lock-in discounted natural gas prices over a set period of time. Essentially, the municipal entity borrows in the tax-exempt market and passes the proceeds to a corporate entity that provides or trades commodities, and thereby locks in a rolling discount on natural gas spot prices. This helps to ensure that it can operate profitably in the future. The corporate entity providing the gas guarantees delivery of gas on a monthly basis, guarantees the bond payments, and funds an operating account and a reserve account. Should the municipal entity run into trouble, and for any reason not be able to take or pay for delivery of the gas, the corporate entity is required to remarket the gas and still make sure that bondholders are paid. In essence, these issues are an alternate funding source for banks outside of the corporate bond market, and can provide diversity to their capital base as well as cheaper borrowing costs because of the tax exempt nature of the bond issue itself. The municipal entity benefits from having locked in a long-term discount on the gas they sell to participants in their system. It is worth noting that these deals are always complex and can involve many different counterparties. We prefer the options with the lowest number of involved parties, and conduct due diligence on all involved credits.
Sources: Barclays, Bloomberg, Moody’s