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“Prepaid gas” may make people think of the fuel-purchase cards sold at their local convenience store, but the term also applies to bonds issued in a lesser-known, but rapidly growing, segment of the municipal bond market. Here, we explain what they are, how they work, and why we believe they can present attractive opportunities in an actively managed tax-free bond portfolio.

What are prepaid gas bonds?

These are tax-exempt bonds issued by a municipal authority that enters contracts to purchase and supply natural gas or electricity to municipal utilities. While they pay tax-free income like a municipal bond, prepaid gas bonds have the backing of a corporate credit, typically a large bank or insurance company.

How does the transaction work?

The funding recipient—generally a financial institution—receives the lump sum of bond proceeds and guarantees that a specific volume of natural gas or electricity will be delivered on a recurring basis (usually monthly) for the next 20-30 years. The gas is typically supplied by the commodity-trading subsidiary of an investment bank. 

Who is the funding recipient?

The funding recipient is also often called the guarantor because it guarantees the delivery of natural gas or electricity schedule for the term of the agreement.

Some of the larger players in this area include investment banks such as Citigroup, Goldman Sachs, Morgan Stanley, JP Morgan, Macquarie Group, RBC, TD Bank, Nomura, and Sumitomo. In more recent years, the list of firms backing prepaid gas bonds has grown to include insurance companies such as American General Life Insurance and Pacific Life Insurance.

Prepaid gas deals are structured for the risk to fall on the funding recipient if any part of the supply and delivery contracts fall through. We view the credit risk of prepaid gas bonds to be similar to unsecured, taxable debt of the guarantor. In the unlikely event that utilities are unable to receive and pay for natural gas, the gas supplier will either remarket the gas to another municipal utility or terminate the deal. In the latter instance, the firm guaranteeing the prepaid gas issue is required to make a termination payment to fully redeem the bonds.

Why is this good for the municipality?

The natural gas or electric utility is able to lock in a long-term, reliable supply of natural gas at prices that are at or below market prices. This allows them stability in budgeting costs and decreases price volatility and the need for hedging prices.

Why is this good for the funding recipient? 

The funding recipient receives significant immediate capital. Since the gas supplier is receiving the net proceeds of the bond issue, they are essentially able to borrow at lower tax-free rates than if they issued corporate debt of their own. They must, of course, absorb the cost of providing the contractually agreed-upon volume of natural gas at a discount. 

Why is this good for municipal-bond investors?

Prepaid gas bonds allow muni investors an opportunity to invest in corporate-backed credit, typically of a financial institution, within a traditional tax-exempt municipal security structure. This provides diversification and exposure to a portion of the corporate bond market that muni investors have had limited access to in the past. We believe an actively managed approach, emphasizing strong credit research and security valuation capabilities, presents clear advantages when investing in this sector.

Why does Lord Abbett invest in prepaid gas bonds?

Prepaid gas is one of the fastest-growing segments of the municipal bond market. Currently, prepaid gas bonds make up roughly 3% of the Bloomberg Municipal Bond Index, representing about $40 billion of face value as of December 31, 2023. Over $15 billion of new prepaid gas bonds were issued in 2023, up from about $7 billion in 2019, based on data from Bloomberg.

Since the underlying obligors tend to be large global investment banks and insurance companies, the bonds have good liquidity; the fact that they are backed by these large financial entities may make them more appealing to crossover buyers (i.e., buyers who otherwise invest in taxable bonds). As previously mentioned, this segment of the muni bond market allows participation in a corporate-backed sector that had been mostly uninvestable for muni buyers. 

Prepaid gas bonds also typically come with larger coupons and intermediate call dates. This structure produces yields similar to longer-maturity bonds, yet with lower duration, and thus, less interest-rate risk. 

Finally, and perhaps most significantly, prepaid gas bonds currently provide higher yields and wider spreads versus other high-quality municipal bonds of similar ratings in different sectors (see Figure 1).