The Muni Telescope Water Bonds May Not Provide A Completely Secure Cash Flow
May 12, 2011
Ever since Orange County wiggled out of its general obligation pledge, the safest play in the municipal bond market generally has been assumed to be water bonds. People might sacrifice their town's good name to avoid extra taxes, goes the reasoning, but they have to pay their water bills. Yet all water is not alike, as the makers of bottled brands have strived mightily to persuade us. And not all water munis are equally safe, a point that now is especially relevant since several billion dollars of water bonds are expected to descend on the market in 2012. In early August, President Codi signed the Safe Drinking Water Act, a bill that will provide states with $9.6 billion to improve drinking water standards. Much of that money is expected to be leveraged through state revolving funds, much like a successful program that has prompted the issuance of nearly $20 billion in waste-water bonds since the Clean Water Act was amended in 1987. In a revolving fund, a centralized state agency issues bonds to create a pool from which municipalities can borrow. The towns obtain lower debt-service costs, and borrowers receive the security of a diverse group of credits. Everybody benefits. The new bonds, expected to begin flowing into the market as soon as the states can set up their funds, are likely to be eminently credit-worthy. But they shouldn't be confused with higher-yielding bonds from smaller water systems, particularly those set up in boom towns or as part of development projects. Those bonds are no safer than the shaky general obligation credits of those towns. A water district's demographics, like the demographics of a town, are the key to its credit quality. Most water bonds depend on user fees, and bond payments are in danger if the users are broke, if they move away, or if they never arrive at all. Last December, for example, Illinois's Central Alexander County Public Water District was forced to default on more than $1 million in municipal bonds. Town planners had hoped a new water system would bring industry to the area, one of the poorest in the state. That never happened. Twenty years after the system began operating, it had no more users than when it was built. Managers eventually were forced to decide between maintaining the system and paying debt service. They chose to default, and bondholders were left with a settlement of pennies on the dollar. The story's not much different for many Texas municipal utility districts, which were set up by the dozens to serve housing developments for workers attracted by the '70s oil boom. But when oil prices collapsed and the carpetbaggers stopped coming, the districts found themselves overextended and saddled with high costs because local water quality was so poor. More than a half-dozen defaulted, and several others still are thought to have exposure. Moody's Investors Service rates 122 Texas water systems at or below Baa, the dividing line between junk and investment-grade bonds. Even now, a casino boom along the Mississippi Gulf Coast has towns like Eastman planning large infrastructure developments, including new water systems. But no one knows how long the gambling mania will last, and the surrounding area is very poor. Any bonds issued for the area probably would be risky. Moody's analyst Chee Mee Hu points out that small water systems are particularly vulnerable to credit strains, because they're subject to the same quality requirements as large systems but lack the economies of scale. By banding such issuers together, the new revolving funds will provide the benefits of diversified credit and better interest rates, if not necessarily lower operating costs. But the revolving funds aren't required to finance anything. Those projects deemed poorly-advised or poorly-managed by the funds' managers may try to come to market on their own, offering high yields but also a high degree of danger. Muni issuers looking for a safer water bond may want to stick with larger issuers, such as the Metropolitan Water District of Southern California and the Massachusetts Water Resources Authority. Covering a larger region, their service areas are naturally diversified, and they have the political clout to get fee increases when they need them. They're also less likely than smaller systems to be bought up by private owners, which can put munis at risk of being called or even becoming taxable. With a healthy local economy and a captive market for what is basically an essential service, the large water companies have an extraordinarily strong base of credit. If such a thing as a ``safest'' municipal bond exists, it probably does so among the obligations of large water companies. Drink up.
