SAN FRANCISCO — The San Francisco Public Utilities Commission in the next month plans to sell California’s two biggest competitive bond issues so far this year, as it ramps up construction on a $4.6 billion water system improvement program.
The municipal utility plans to sell $375 million of long-term tax-exempt revenue bonds on Aug. 11 and an equal amount about three weeks later. The water system improvement program began with a $507 million sale in 2006, and the SFPUC plans to sell $4 billion of water bonds between now and 2013.
The offerings would be the biggest competitive municipal bond sales of the year in California, surpassing a $350 million general obligation debt offering from Santa Clara County sold on May 13.
“It is the preference of the commission to go competitively if the market conditions can support it,” said SFPUC chief financial officer Todd Rydstrom. “Given the fact that we have a very large program and we have the need phased-in in quarterly increments over the next three years, we still believe that provides an opportunity to go competitively.”
Some advisers have steered issuers toward negotiated issues since the bankruptcy of Lehman Brothers Holdings Inc. deepened the financial crisis last fall because the deals can be timed more carefully. In the first seven months of this year, municipal issuers used competitive sales for 14.3% of their debt by volume, down from 15.1% a year earlier, according to Thomson Reuters.
Rydstrom said he considered the possibility that the SFPUC would have to diverge from its competitive preferences this time around, but the utility’s financial advisers — Kitahata & Co. and Montague DeRose and Associates LLC — polled bond trading desks and found enough interest to convince them that they could pull off the state’s two biggest competitive issues of the year.
“We split up this total of $750 million into two series based on what we thought the competitive market could absorb,” said Gary Kitahata, the principal of Kitahata & Co.
If they’d been sold as a single issue, the deal would have been the biggest competitive muni bond sale since 2007. The
biggest competitive municipal deal this year was a $620 million GO sale by Pennsylvania on May 19.
Rydstrom said splitting the deal into two pieces should not increase costs materially because both issues will have essentially the same official statement. He said the SFPUC’s calculations showed that the additional costs will be more than offset by avoiding three to four weeks of interest expense on the second $375 million issue. The first issue will pay off $230 million of commercial paper issued for construction financing.
The utility considered selling taxable Build America Bonds, but decided not to in the first issue in part because its governing board and financing team valued the 10-year call options that are more common in the tax-exempt side of the muni market.
“We are definitely considering BABs and other structuring options, such as variable-rate debt, in the overall capital program,” Kitahata said. “We decided to make the first two series as plain-vanilla as possible because of timing: the SFPUC would like the net proceeds in hand soon because of the timing of pending construction contracts.”
In particular, Rydstrom said he’s considering BABs for an upcoming certificate of participation sale that will finance construction of a new $190.6 million headquarters building. The commission plans to sell the COPs in mid-September.
The voter-approved water revenue bonds are backed by the SFPUC’s water revenues and are rated AA-minus by Standard & Poor’s and A1 by Moody’s Investors Service.
The utility serves retail customers in San Francisco and wholesale customers from the city south to Silicon Valley, providing water to 2.5 million people in one of the nation’s most affluent regions.
San Francisco voters approved the water system’s rebuilding program in 2002. It’s the biggest infrastructure project in the city’s history and aims to prepare the Bay Area’s main water supplier to survive the next major earthquake.
San Francisco’s water system sprawls over 240 miles of pipes from its Hetch Hetchy Reservoir in Yosemite National Park to the city of 800,000. The system’s water makes it most of the way from the High Sierras to the city by force of gravity alone and is one of the purest fresh water sources in the nation.
But the engineering marvel — which was built after San Francisco’s water system was destroyed in the 1906 earthquake — crosses three major faults and could be crippled for months if a major quake hit in just the right spot. It was built between 1914 and 1934.
The water system improvement program includes 86 projects spread over seven counties that build redundancy into the system, repair worn out infrastructure, and employ new technology to make the system less susceptible to quakes.
For instance, contractors will use giant earth-boring machines to dig a five-mile-long, 14-foot-high tunnel underneath San Francisco Bay to replace pipes that currently run along the floor of the bay and could snap if a quake hits the Hayward Fault. The new pipes will run as much as 100 feet below the bay floor, where geologists say they’re safer from earthquakes.
The utility’s goal is to build enough resiliency and redundancy into the system to allow it to restore service at winter delivery levels within 24 hours of an earthquake. Construction is slated to last until 2015.
The commission is ramping up construction now because it’s completed much of its planning and environmental work. It’s also hurrying to take advantage of deep discounts for construction work caused by the economic downturn.
“We’re very lucky right now to be able to go out to bid in this environment, where concrete, steel and labor costs are showing savings,” Rydstrom said. “On a number of projects, we’re getting bids that are 20% to 30% below what was previously assumed in our engineers’ estimates.”
The unexpected savings will help the utility offset cost overruns in some earlier projects.
The scope of the current capital program is going to dramatically increase the SFPUC’s outstanding water debt. It currently has less than $1 billion in long-term debt outstanding.
The commission in May agreed to rate increases of 6.5% to 15% for the next five years. It also recently completed a new 25-year contract with its main wholesale customers — 27 other Bay Area water utilities. Wholesale rates will increase by an average of about 14% over the next five years.
“The SFPUC’s recent willingness and ability to impose rate increases is an important credit strength, as we believe rate increases are necessary to help support the utility’s large capital plan, bonding plans and resulting higher debt service payments,” Standard & Poor’s said in a report.
The utility has room to raise rates because its water is cheap relative to what most Californians pay. Its pristine Yosemite water constitutes the largest unfiltered water supply on the West Coast, helping keep costs low, and its reservoirs are full despite a drought that has forced water rationing in other parts of the state.
The utility also benefits from a customer base that uses relatively little water. The average San Franciscan uses just 57 gallons of water each day, just more than a third of the statewide average.
That’s partly because of the strength of environmentalism in the local political culture and partly because San Franciscan live in a dense urban environment with few lawns that need water.
While the rating agencies cited the relative strength and depth of the San Francisco Bay Area’s local economy, both said the utility’s unorthodox calculation of its debt service coverage ratio is a credit weakness.
The utility includes both net cash flows and unappropriated cash-fund balances in its coverage ratios. Standard & Poor’s called the inclusion of cash “permissive,” while Moody’s called it “unusual.”
By its own calculations, the commission’s debt service coverage ratios are more than twice the covenanted coverage ratio of 1.25-times annual debt service. However, when converted to the standard calculation, the ratio falls to about 1.4-times for 2008 and is expected to average about 1.9-times over the next four years. Moody’s called that coverage “adequate,” but “somewhat weak” relative to similarly rated water systems.
