A complicated kind of debt deal is electrifying the muni market these days: prepaid energy bonds.
Processing Content
Last year investors bought $31.4 billion worth, three times as much as in 2022. If you buy a municipal debt index fund, energy bonds currently make up from 5% to 25% of your investment.
Here’s how they differ from regular munis. In a plain-vanilla general obligation bond, investors lend money to a government and rely on its taxing authority to pay it back. Or, in revenue bonds, investors get repaid through the money generated by an important project, such as a toll road, a hospital or a subway. Munis are attractive to wealthy individuals because the interest is generally exempt from federal income tax and, if the government is in their own state, local taxes as well.
In energy bonds there’s a twist. Investors indirectly lend the money to pay in advance for a 30-year supply of energy, such as natural gas or electricity, to be delivered to a municipal utility at a discount to prevailing energy prices from suppliers. Bond buyers get a higher interest rate than on a regular muni bond—currently about a percentage point more. A California prepaid energy offering priced in January had a 4.08% yield, the equivalent of 6.5% for investors in the highest federal tax bracket and even higher for those in California because of its state tax exemption. “We look at them [the bonds] as a really good way to pick up additional yield for an investment-grade rating,” says Matthew Norton, chief investment officer for municipal bonds at AllianceBernstein Holding LP.
With electric bills soaring amid skyrocketing demand for energy to fuel the artificial intelligence boom’s voracious need for data centers, utilities are eager to make these deals, and financial firms see opportunities in backing them. “The universe is expanding,” says Mikhail Foux, head of municipal strategy at Barclays Plc.
In 2005, Congress enacted legislation that sparked the growth of prepaid energy contracts. But the financial crisis in 2008 damaged the sector. Lehman Brothers had been involved in prepaid gas bonds. After it collapsed and caused the sector’s first and only default, the product fell out of favor with investors.
In such deals a utility signs a contract to purchase discounted energy through a special entity, known in the industry as a conduit, which sells bonds to prepay for the energy supply. The proceeds flow onto the balance sheet of a bank or insurance company, which in exchange agrees to facilitate the delivery of energy to the utility.
Financial firms are eager to set up such arrangements when they can borrow more cheaply in the muni market, as is true now. It’s attractive for the financiers because they can then invest bondholders’ money for their own purposes, as long as they can meet their obligations. The financial firms purchase derivative contracts to manage energy prices’ ups and downs.
Money managers can diversify their risk by investing in deals involving a growing list of financial firms. Recently, they’ve included Canada’s Toronto-Dominion and Japan’s Nomura Holdings; Apollo Global Management’s Athene and New York Life; and billionaire Ken Griffin’s Citadel hedge fund. “It creates some level of competition,” says Joseph Natoli, a managing director in Goldman Sachs Group Inc.’s public sector and infrastructure group. “It can drive value to municipalities and bond holders.”
One conduit, the California Community Choice Financing Authority, founded by a group of the state’s energy providers, has issued more than $25 billion in prepaid electricity bonds, or 22% of all such obligations since 2014, according to data compiled by Bloomberg. The debt, which has been used to buy renewable energy, has saved $155 million annually for California ratepayers, the agency says.
Prepaid energy bonds have sold off during market turbulence, such as the 2023 crisis that started with the failure of Silicon Valley Bank, as investors grew concerned about the stability of financial companies. The bonds ultimately recovered.
Money managers say their analysts have to do a lot of homework to understand exactly how the contracts work and the potential risks. Nathan Will, head of municipal credit research at investment giant Vanguard Group, says the company has a team that goes through documents “with a fine-tooth comb.”
Ben Barber, director of municipal bonds at Franklin Templeton, says the bonds offer savings for utility customers and additional yield for investors, which is why he selects some of them for his funds. But, he says, buyers need to read the small print: “You should always be concerned about financial engineering as it pipes into any market.”
