Lower Alabama Gas District Has US$638m Gas Revenue Bond in the Pipeline
While investors in the U.S. municipal bond market continue to benefit from healthy supply and demand dynamics, interest in the asset class may soon increase amid higher regulatory capital requirements.
As risk-based capital (RBC) essentially limits the amount of risk a company can take, higher at-risk companies are required to hold higher amounts of capital, which is intended to provide a cushion against insolvency.
Wells Fargo Asset Management (WFAM) analysts Edwin Martin and Gabriel Diederich pointed out that the National Association of Insurance Commissioners’ (NAIC’s) recent proposal to align RBC more closely with the structures used by credit rating agencies – expanding the number of credit tiers, for example, to 20 from 6 – would result in fewer incentives to invest in lower-quality bonds and increase the amount of required capital at most insurance companies.
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WFAM suggested that ahead of the full implementation these new rules, an allocation to municipal bonds “may be an idea for insurance companies to consider,” as corporate bonds become more expensive to hold.
For instance, the cost of extra capital due to the new RBC factors is 10 bps more for an ‘A’-rated corporate bond and 23 bps more for a ‘BBB’-rated bond than for an ‘AA’-rated taxable muni.
Martin and Diederich also highlighted how municipal credit metrics have been “more favorable” compared with corporate bonds, as muni defaults occur at “a very small rate.” In fact, the historical ‘BBB’-rated municipal bond default rate (1.03%) is less than the top-tier, ‘AAA’-rated corporate bond default rate (1.16%).
Moreover, yields on municipal bonds have been less volatile—measured by both basis-point change and percent change—than U.S. Treasuries across the yield curve, driven in part by larger participation by retail investors.
High(er) Supply to Meet Swelling Demand
Against this backdrop, the supply of municipal bonds has ticked up slightly in August 2019.
A total of a little more than US$38bn of new issuance priced, a rise of US$1bn and US$4bn over the same month in 2017 and 2018, respectively, while new offerings were up almost 35% over the prior month.
The momentum in the primary market is likely to continue, as demand for the yield offered by new muni deals remains squarely intact.
Blackrock municipal strategists Peter Hayes, James Schwartz, and Sean Carney recently noted they anticipate that the “favorable supply-and-demand environment is likely to persist,” due in large part to the dearth of advance refunding bonds created by the new tax law.
Hayes, Schwartz and Carney added that these bonds are no longer tax-free under the law, which “has made it more difficult for the market to find balance when muted supply and robust demand are creating a strong market dynamic as we are seeing today and expect to continue.”
Demand among investors has been reflected in Thomson Reuters/Lipper U.S. Fund Flows, which, for the week ended August 28, reported net inflows of more than US$1.24bn, albeit gradually receding from the previous three weeks of inflows, which totaled roughly US$1.35bn, US$1.5bn and US$2.07bn.
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Although these flows do not include ETFs such as the iShares National Muni Bond fund (NYSEARCA: MUB) and the Vanguard Tax-Exempt Bond fund (NYSEARCA: VTEB), those ETFs remain at lofty heights as prices tick higher on U.S. government debt – having soared by nearly 10% and a little over 8%, respectively, since their most recent 52-week lows in early November 2018.
Barclays analysts noted that the supply level in August was higher than the average for the past five years, bringing year-to-date issuance to US$238bn, an increase of 5% year-over-year.
They also said they expect new issuance to rise over the next few months, with both refunding and new money deals likely picking up, as issuers look to take advantage of lower rates.
While the yield on the 10-year U.S. Treasury note climbed to around 1.57% intraday Thursday, government bond rates had fallen by around 45-55 basis points in August, amid intensified jitters about a potential global recession, spurred by ongoing U.S.-China trade skirmishes.
The 10-year muni / U.S. Treasury ratio stood at around 86%, with the year-to-date return in the municipal market underperforming (7.67%) that of U.S. Treasuries (8.98%), according to the Bloomberg/Barclays Index.
Barclays also said it continues to expect a pickup in tax-exempt refundings of callable Build America Bonds (BABs) and will likely see more taxable muni issuance as a result of taxable advance refundings, “which have been getting more attention in the recent low rate environment.”
Alabama’s Deal in the Pipe
Among the muni offerings on the near-term radar, the Lower Alabama Gas District is poised to sell around US$638.4m worth of Gas Project Revenue Bonds (Project No. 2, Series 2019).
Proceeds from the transaction will be applied to prepay the costs of acquiring and delivering a fixed, 30-year supply of natural gas under a Prepaid Natural Gas Sale Agreement between Aron Energy Prepay 2 LLC and LA Gas.
The prepayment costs will be loaned by Aron Energy to Goldman Sachs pursuant to a loan agreement, where Goldman will make monthly payments.
Bond proceeds will also be used to fund reserve accounts, including for a commodity swap arrangement, as well as the debt service account.
Goldman Sachs and Stifel Nicolaus are jointly lead-managing the deal, which received an investment-grade ‘A3’ rating by Moody’s Investors Service.
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Moody’s analyst Joann Hempel noted that the rating was based in large part on the credit quality of Goldman Sachs (‘A3’, Stable Outlook) as borrower under the term loan agreement and guarantor for payments due under the deal’s Gas, Purchase, Sale & Service Agreement, as well as the creditworthiness of the providers of the guaranteed investment contracts (GICs) provided for the debt service account, debt service reserve account and the commodity swap reserve account.
Moody’s also considered the structure and mechanics of the transaction, which provide for the payment of debt service, when assigning its rating.
More than four-fifths of the natural gas entering Alabama continues through the state, mainly to Florida, Georgia, and Mississippi via interstate pipelines. These pipes mainly originate from Mississippi, but the Energy Information Administration (EIA) notes that increasing volumes are shipped south through Tennessee from Pennsylvania and Ohio natural gas fields in the Marcellus and Utica shales.
The EIA also noted that Alabama’s proved reserves of natural gas have fallen to about one-fourth of their peak estimate in 1992 and now comprise less than 0.5% of total U.S. economically recoverable natural gas reserves.
In fact, the state’s annual natural gas production has steadily declined for the past two decades and output is down about three-fourths from its peak in 1996. Although prices of natural gas have plunged considerably, the current contract has risen somewhat along with the broader market, amid optimism over U.S.-China trade negotiations.
Under the terms of the Lower Alabama Gas District’s gas supply contracts in its latest bond offering, LA Gas will sell to the transaction’s project participants, including Clarke-Mobile Counties Gas District, AL; Municipal Utilities Board of Decatur, AL, City of Lexington, NC, and Laurens Commission of Public Works, SC, among others.
The deal is similar to the Public Energy Authority of Kentucky’s, or “PEAK’s”, recent US$536m worth of gas supply revenue bond offering, which was intended to finance prepayment costs for a 30-year supply of natural gas from BP Energy.
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