Are Utility Bonds Vulnerable to a Municipal Raid?
A reader who saw our recent article, “Navigating Rocky Municipal Bond Markets,” asked whether any essential service bonds were downgraded this year, and suggested that municipal bond issuers might load up, or even hide, excess debt in its water districts. Here’s the reply from Joseph Rosenblum and our municipal credit team.
It is always possible that a municipality would try to ease its general fiscal pressures by tapping (forgive the pun) into the resources of its water or sewer utility, if any. However, this is not particularly common in the universe of medium- to large-sized utilities that we follow.
Furthermore, when municipalities do try to raid the utility kitty, they typically don’t issue debt. Rather, they transfer money from the utility to the general fund. Fortunately, such tactics are often limited by law.
As a class, US municipal utilities remain high-quality credits. While they may face challenges, such as drought conditions, federal environmental regulations and political pressures to keep rates down, downgrades generally reflect issues related to the particular utility system. Here are a few examples that quickly came to the minds of our municipal credit team:
Benicia, California: This is a very small issuer with roughly $6 million in water revenue bonds outstanding. A failure to raise rates over an extended period, combined with rising costs, led to weaker coverage and its downgrade by S&P to A+ in late November.
Metropolitan Water District of Southern California: This is one of the largest wholesale water systems in the US. Fitch recently downgraded it from AAA to AA+ because of weak finances over an extended period of time related to drought-like conditions and a desire to hold down rates.
San Francisco Public Utilities Commission: The downgrade of its Water Enterprise bonds from Aa2 to Aa3 by Moody’s reflected eroding but still-solid debt coverage levels.
Detroit Sewage Dispostal System: Downgraded from Aa3 to A1 (Negative Outlook) by Moody’s last year. Here, too, we have seen narrowing debt coverage and high leverage related to an aging system.
Indianapolis Department of Waterworks: First downgraded two notches in 2009 and then recalibrated up two notches in 2010. The driving credit factor here was heavy reliance on variable-rate debt. Also, unlike most municipal utilities, Indianapolis is subject to an outside rate-setting entity.
DeKalb County, Georgia: Its water and sewerage revenue bonds were downgraded one notch because of a new $1 billion capital improvement plan and drought conditions that affected usage, which in turn narrowed debt service coverage margins.
Finally, there is Jefferson County, Alabama. Its recent bankruptcy filing—the largest municipal bankruptcy ever—was related to poor management within its sewer system, as we have previously written. In our view, it is not representative of the sector.
As for the frequency of downgrades of essential-service bonds, it is difficult getting a detailed list from the rating agencies. Based on a quick search, Moody’s downgraded only one water, sewer or solid waste system in the first three quarters of 2011, which affected $1.8 billion of bonds. During the first three quarters of 2010, Moody’s upgraded six systems, which affected $1.5 billion in bonds, and downgraded 23, which affected $7.8 billion in bonds.
On the other hand, S&P upgraded 166 utilities and downgraded 16 in the first two quarters of 2011, including water, sewer, solid waste and electric systems.
These are small numbers in the context of the $3.73 trillion municipal bond market. In our view, it attests to the stability of the sector.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income and Joseph Rosenblum is Director of Municipal Credit Research, both at AllianceBernstein.