Banks’ Too-Big-to-Fail Debate Hurts Gas Securities: Muni Credit

The fading notion that the largest U.S. finance companies are too big to fail led Moody’s Investors Service to cut ratings on $5.5 billion of bank-backed debt used to buy natural gas. Investors see the bonds as too cheap to pass up.

Municipalities use the tax-free securities, dubbed prepaid gas bonds, to trim fuel costs. Moody’s reduced grades on some of the debt Nov. 18 to as low as two steps above junk. That was four days after it cut Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley on the view that the government is less likely to help the banks repay creditors in a crisis.

Gregory Steier, head of tax-exempt fixed income at Brown Brothers Harriman & Co. in New York, said he bought some gas debt in recent months, seeing an opportunity in securities with higher yields than company debt. The bonds had also been dumped by mutual funds facing record redemptions, he said.

“Forced selling by funds led to many opportunities to purchase good-quality securities at attractive levels,” said Steier, who manages $4.3 billion of munis. “These tax-exempt bonds were available at higher yields than comparable debt backed by the same underlying banks.”

Finance Crossroads

The securities are an example of how Wall Street intersects with the $3.7 trillion municipal market. Public utilities from California to Georgia used the proceeds to lock in prices and limit vulnerability to market fluctuations. The safety of the debt is linked to the creditworthiness of the banks, which typically serve as buyers-of-last-resort for resale of the bonds.

Regulators have been preparing rules and procedures that seek to allow the government to wind down even the largest financial companies without taxpayer assistance.

Moody’s this month cut the senior holding company ratings one level for Goldman Sachs, JPMorgan and Morgan Stanley. As a consequence, the company also lowered nine gas prepayment bonds tied to the banks’ credit, including issuers from California, Indiana and Texas.

There is a precedent for this corner of the municipal market to be roiled by Wall Street developments. The 2008 bankruptcy of Lehman Brothers Holdings Inc. led to the default of $709 million of bonds it guaranteed for one group of utilities, Main Street Natural Gas Inc.

Corporate Comparison

For investors, the gas debt has appeal when compared with company borrowings with a similar rating and maturity.

Prepaid gas bonds issued by Southern California Public Power Authority with backing from Goldman Sachs and maturing in November 2033 traded at an average yield of about 5 percent on Nov. 25, data compiled by Bloomberg show. For top earners, that’s a taxable equivalent of about 8.3 percent, Bloomberg data show. A comparable corporate bond would yield about 5.3 percent, according to Moody’s data.

“They’re still cheaper than corporates,” said Mikhail Foux, a credit analyst at Citigroup Inc. in New York. He co-wrote a report in January recommending investors consider buying gas bonds.

Investors such as Brown Brothers have also been lured as some funds sold the bonds during the worst performance for local debt in five years. Munis have lost 2.3 percent in 2013, on pace for their first losing year since 2008, Standard & Poor’s data show. Fixed-income assets have sold off amid bets that a growing economy will lead the Federal Reserve to slow the pace of its monthly bond buying.

Funds Yanked

Individual investors have yanked $52.5 billion this year from muni mutual funds, compared with an addition of of $48.5 billion in the same period of 2012, according to Lipper US Fund Flows data.

For some bondholders, the additional scrutiny banks are receiving is also a reason to favor the gas debt.

The government is working on ways to ensure that creditors take the hit from banks’ losses rather than public funds, seeking to assure taxpayers that banks aren’t too big to fail. At the same time, regulators have been passing rules that ensure banks improve the amount and quality of their capital as a cushion against losses, according to a July press release from the Fed.

“There are other things driving the credit fundamentals of banks,” said Lyle Fitterer, who helps manage $31 billion of munis at Wells Capital Management in Menomonee Falls, Wisconsin. The bonds “could perform well,” he said.

Market Week

Issuers nationwide are offering about $590 million in long-term debt this week, the least since January. Benchmark yields are at a two-month high as munis are poised to decline for the fourth straight week, the longest slide since June.

The interest rate on AAA 10-year munis is 2.89 percent, compared with about 2.74 percent on similar-maturity Treasuries.

The ratio of the yields, a measure of relative value, is about 105 percent. It compares with an average of 94 percent since 2001. The larger the number, the cheaper munis are compared with federal securities.

Following is a pending sale:

New York’s Tobacco Settlement Financing Corp. plans to sell $1.2 billion of revenue bonds as soon as next week, according to Bloomberg data. Proceeds will refinance debt sold in 2003, according to bond documents. The securities are backed by payments from cigarette manufacturers as part of a 1998 multi-state settlement to resolve liabilities for health-care costs associated with smoking.

Before it's here, it's on the Bloomberg Terminal.