Muni Bonds Undone by Lehman Collapse Test Latest Market Turmoil

  • Alabama districts to sell $1.7 billion of debt for gas trades
  • Backed by banks, the bonds are tied to financial sector's fate

As investors demand higher premiums to buy debt sold by financial firms, two Alabama utility districts are selling about $1.7 billion of bonds backed by decades-long natural gas trades with Goldman Sachs Group Inc. and Royal Bank of Canada.

The sales by the Lower Alabama Gas District and the Black Belt Energy Gas District will test whether the fears of a worldwide economic slowdown are seeping into a niche of the municipal market, where utilities borrow to buy fuel from banks that’s delivered years later. With investors demanding the most extra yield in 31 months to hold bank bonds, Wells Capital Management and Barclays Plc say concern about financial turmoil could lead to losses on the gas debt, which carries the same ratings as the financial firms involved.

“Recently the muni market has woken up a little bit to what’s going on in the corporate market,” said Lyle Fitterer, the head of tax-exempt debt at Wells Capital Management, which oversees $39 billion of municipal bonds. "You’re seeing people lighten up on some stuff or a little bit more nervous about corporate-backed deals in the muni market.”

Municipal utilities have issued more than $30 billion of tax-exempt bonds to buy gas under long-term contracts, according to data compiled by Bloomberg. The bonds are paid back with revenue the utilities bring in when the fuel is resold. In return for their commitment, the utilities receive a discount from the prevailing market price, which has tumbled about 42 percent since May.

Banks also benefit: They get the proceeds of the bond issue and pay it back over time through the delivery of gas. The bonds typically carry the ratings of the lowest-ranked corporate entities involved because of the risk investors won’t be repaid if the delivery contracts aren’t fulfilled.

That’s happened before. After Lehman Brothers Holdings Inc. collapsed during the 2008 credit crisis, more than $700 million of bonds issued by Main Street Natural Gas Inc. of Kennesaw, Georgia, defaulted as a result. Bondholders have recouped about 77 cents on the dollar.

The Lower Alabama district, which buys long-term natural gas for about 10,000 customers in southern Alabama, plans to sell $675 million of the fixed-rate debt as soon as this week. The bonds are rated A3 by Moody’s Investors Service, its seventh-highest investment grade, based on Goldman Sachs’s standing. Goldman Sachs guarantees that its subsidiary J. Aron & Co. will supply the gas.

Black Belt plans to issue $1 billion of such bonds next week in the biggest prepaid gas issue since 2012. The “Black Belt” is a region in Alabama known for its fertile, black topsoil and, before the Civil War, cotton plantations worked by African-American slaves.

The Black Belt bonds, which will be issued in fixed and floating rates, are rated Aa3 by Moody’s, it’s fourth-highest investment grade, because of RBC. Black Belt will sell the gas it purchases to districts in Alabama, Tennessee, Georgia and South Carolina.

“There’s a lot of demand,” said Joann Hempel, a Moody’s analyst. “These are a great opportunity for them to, one, lock down some supply and number two, they get this supply of gas at a discount to market prices.”

Albert Bean, a board member of the Lower Alabama district and co-general manager and chief operating officer of Black Belt, didn’t return calls seeking comment. John Norman, a managing director at Municipal Capital Markets Group Inc., which is advising both districts, declined to comment.

Tiffany Galvin, a Goldman Sachs spokeswoman, and Elisa Barsotti, a spokeswoman for RBC, declined to comment.

Time To Sell

On Feb. 1, Wells Capital sold $7.3 million of prepaid gas bonds issued by a San Antonio public corporation because spreads in the municipal market -- or the difference in yield between benchmark and lower-rated securities -- hadn’t widened as much as those in the corporate market, said Fitterer.

The debt maturing in 2025, which is backed by Goldman, traded at a yield of 2.55 percent, or about 0.9 percentage point more than top-rated bonds of the same maturity. Goldman Sachs corporate bonds maturing in 2022 traded on Feb. 16 at 3.29 percent, about 2.07 percentage point more than benchmark bonds.

“We sold because of where spreads were in our market relative to what’s been going on in the corporate market,” Fitterer said. “There was a buyer around and spreads actually moved quite a bit tighter.”

Municipal gas bonds are at risk of being affected by widening financial-sector credit spreads, which increased by as much as 90 basis points this year, Barclays municipal strategist Mikhail Foux wrote last week. He said the municipal debt is currently relatively expensive, with the yields the closest in more than a year to similarly rated bonds.

“While U.S. banks have not sold off in the same manner as their European counterparts, we think the sector could face near-term stress,” Foux wrote. “We recommend being cautious on this muni sub-sector in the near term. However, if yields adjust meaningfully higher, we would view it as a buying opportunity.”

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