As the tax-exempt prepay energy bond sector balloons, some participants warn that the corporate credit exposure built into the debt could pose a systemic risk to the municipal bond market.

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Structures that one firm dubbed “municipal bonds wrapped with a corporate guarantor” have blown up before. Lehman Brothers’ 2008 bankruptcy triggered default on more than $700 million in prepay gas bonds. Four years later, bondholders had recovered around 50 cents on the dollar.

“The sector was tiny at the time but now it’s at $125 billion and we’ll probably end up at $150 billion before too long,” said a muni analyst. “The impact this time around is going to be much more substantial if anything happens with these financial institutions. Even a hiccup with the bank or insurance company would have a more noticeable impact on our market.”

Investors interested in the additional yield offered in prepay energy deals should be aware of their corporate exposure in their portfolios as well as the sector’s broader risk to the muni market, participants said.

The energy prepay bond market has seen compounded growth in recent years amid a sharp rise in the demand for energy related to the artificial intelligence buildout, among other factors.

Prepay energy bonds allow municipal utilities to lock in discounted, long-term energy prices through structured deals backed by a corporate counterparty, whose creditworthiness dictates the bond’s rating and who covers the debt service.

“There is absolutely corporate counterparty risk embedded in all of these deals,” said Pat Luby, senior municipal strategist at CreditSights. “It’s important to keep track of who the various corporate counterparties are that you’re adding exposure to and making sure that it’s diversified.”

The sector now accounts for a significant chunk of municipal indices, bringing with it broader market risk if there is another 2008-type event.

Within the Bloomberg Muni Index, the gas prepay sector now accounts for 5.6% of the entire benchmark, according to J.P. Morgan strategists.

In some intermediate indices, the bonds make up to 13% to 15%, said Jamie Iselin, managing director and head of municipal fixed income at Neuberger. The increased presence in the indices forces managers to take a view on it, and more people are getting involved in the sector, Iselin said.

In 2016, prepay energy primary market issuance totaled $1.1 billion, the bulk of which was prepay gas bonds, according to Luby. By 2025, issuance had grown to $31.4 billion of issuance, or 5% of new-issue volume. Through the end of May this year, issuance has totaled $15 billion, or 6% of new issuance.

In June, Google’s parent company Alphabet, Inc. tapped the muni market for a $1.2 billion prepaid deal. Investors met the deal with enthusiasm, putting in more than 10 billion in orders from around 100 accounts.

“Once Alphabet entered the market it opened the door and I think it’s only the beginning,” the muni analyst said. “The size of these financings is mind-boggling.”

Unlike most tax-exempt municipal bonds, the rating on prepay energy bonds hinges on the credit profile of the funding recipient, often a large, well-rated bank or insurance company. Common counterparties are Goldman Sachs, Morgan Stanley and New York Life Insurance Company, among others. The funding recipient invests the tax-exempt proceeds at taxable rates to create an arbitrage spread that funds the discount that’s passed along to the utility, investment firm Payden & Rygel said in a July client note on the sector.

The utilities typically sign contracts for 20 to 30 years but the bonds often mature in seven or 10 years, a structure that introduces an additional remarketing risk.

The buyer base, which used to be more skewed toward institutional or mutual funds, has broadened significantly in the last three to four years to include more separately managed account managers, Iselin said.

The transaction’s complexity as well as the counterparty risk typically means more yield than the typical A or AA-rated bond.

The bonds tend to bring about 80bps of additional yield, Payden & Rygel said.

The average yield pickup since December 2022 has been plus 88bps, said the firm, which called the debt “municipal bonds wrapped with a corporate guarantor.”

For investors who are “equipped to underwrite corporate guarantor credit and structural risk alongside traditional municipal credit work, energy prepay bonds offer a differentiated way to capture incremental tax-exempt yield in an otherwise low-spread municipal market,” the firm said.

Markets get in trouble when risk is not priced appropriately, Iselin said, adding that he thinks the spread that investors are getting is sufficient. If the demand wasn’t there, the deals wouldn’t get done, he said.

“The risk is being priced, at least from my vantage point, fairly in these deals,” Iselin said.

For now, there are relatively few counterparties that account for the bulk of the supply but that’s likely to change as the market continues to grow.

“I do expect that issuers will be looking to expand the number of counterparties because the funding recipients don’t have a bottomless risk budget of their own,” Luby said.

“You have to assume that investment bankers have started with the lowest-hanging fruit, who are the largest, most recognized high-quality rated counterparties,” he said. “If those companies are getting full of their risk, you have to go look farther down the list, so that probably means smaller providers, lower-rated providers or off-shore providers or some combination of all of them,” he said.

Ratings analysts tend to view the transactions as “mildly positive” for municipal utilities, said Fitch Ratings analyst Dennis Pidherny during a recent webinar on the sector. The transactions pose little risk to the municipal utility — or to investors who hold general municipal utility debt, Pidherny said.

“The structures have evolved over the years,” he added. “Each one has to be looked at individually in terms of where the cash flow is coming from and where it’s going.”

Investors should also be aware of potential regulatory scrutiny. The tax exemption gives the corporate entities access to cheaper capital and the arbitrage spread, but the exemption is meant to benefit the municipal utility and ratepayers, not a private entity, participants noted.

Dave Sanchez, director of the Securities and Exchange Commission’s Office of Municipal Securities, said in June that regulators are monitoring the deals to gauge whether bond-issuing governments are aware of the potential for unrealized or smaller-than-expected savings from megadeals.

“On prepays, we are looking at it from the perspective of looking at the overall economics” of large borrowings that can total $1.2 billion or $1.5 billion but “where the net benefit to the [municipal] entity is a very small fraction of that,” Sanchez said.

Jessica Lerner contributed to this story.