Deal in Focus

Raleigh to Tap Triple-A Water Debt

Raleigh, N.C., is issuing $114.5 million of triple-A-rated water and sewer revenue bonds Thursday, bolstering city utility resources that have been constrained in recent years by the national recession and a regional drought.

Based on strong demand during a retail order period Wednesday, Raleigh and its underwriters decided to accelerate the institutional sales to Wednesday as well, according to city debt manager Fred Blackwood.

The deal was originally scheduled to price on Thursday for institutional buyers.

The debt will finance improvements to the system’s water and wastewater facilities and is part of a longer-term $500 million revenue bond package that will be issued through 2019 for the utility’s capital improvement ­program.

The triple-A rated utility ­provides most Raleigh residents and businesses with their water and sewer needs, a competitive advantage that helped facilitate a 48% rate increase the past two-and-a-half years.

The utility’s pricing power also allows it to issue bonds without a debt-service reserve fund.

Those advantages help offset economic and environmental challenges that have hindered utility revenue growth in the past and threaten to do so in the future.

The 18-month national recession that ended in June 2009 and the ­implosion of the national housing market combined to slow the rapid population growth that previously characterized North Carolina’s capital city, which is also a center for banking and ­education.

Slower population growth meant slower revenue growth for Raleigh. The growth of customer water and sewer accounts slowed to about 2% in fiscal 2009 and 2010, from 6% in fiscal 2007.

Christopher Hessenthaler, the lead analyst on the credit for Fitch, indicated that the previous, faster growth rate was built into utility projections.

“I don’t think they realized the growth in new customers that they had built into a forecast,” Hessenthaler said of city officials. “The growth wasn’t there as they had planned.”

Utility revenues were also hit by a severe drought in North Carolina in fiscal 2008, and at least one research report indicates the state is prone to such events. The water utility in nearby Durham, 20 miles to the northwest, came within a few days of running out of water.

The bonds have maturities in two to 20 years, with one series maturing in 2040, according to preliminary bond documents.

The bonds carry a AAA rating from Standard & Poor’s and Fitch Ratings, while Moody’s Investors Service rates them a notch lower, at Aa1.

Citi is the senior underwriter with Robert W. Baird & Co. and Stephens Inc. serving as co-managers.

Womble Carlyle Sandridge & Rice PLLC is bond counsel and the underwriters are represented by Parker Poe Adams & Bernstein LLP. DEC Associates Inc. is the financial adviser.

The service area’s slower growth has pressured its debt-service coverage. Senior-lien debt service coverage dropped to 1.9 times in fiscal 2010, below the Aa1 median of 2.0 times, according to Moody’s.

The debt-service coverage is expected to dip to 1.7 times in fiscal 2011 before rebounding to 2.0 times in fiscal 2012. These estimates assume a 9% rate increase in fiscal 2012 and 7% rate hikes annually thereafter, plus annual customer growth of 1.5%.

“Coverage is still satisfactory, but they have been trending below some of their peers in the Aa1 category,” said Conor McEachern, the lead analyst on the credit for Moody’s.

He said Raleigh’s ability to stabilize and improve coverage levels will be an important consideration in future rating reviews.

The lack of a reserve fund does not augment the coverage concern, McEachern said.

Higher-rated water utilities across the country are scrapping a debt-service reserve fund because of negative arbitrage costs, according to Fitch.

Raleigh’s “risks associated with the lack of a debt-service reserve fund are tempered by the system’s adequate liquidity as well as [its] ability to raise rates immediately,” McEachern said.

As consumption levels improve, the city may not need to raise rates as frequently as they have the past few years, he said.

The prospect of another drought remains a wild card for utility planners. Raleigh, along with the rest of North Carolina, was hit by a severe water shortage in fiscal 2008. That year, the City Council imposed water conservation ordinances, which hindered utility revenue.

The City Council passed rate increases to compensate for the decrease in water use.

Drought restrictions “are essentially like taking a pay cut for a year” as revenues are reduced, according to Doug Scott, the lead analyst on water and wastewater utilities for Fitch.

It’s a constant concern for the sector, he said.

Utilities “try to make sure they have enough in their savings account and have their rates high enough to generate enough to pay their bills,” Scott said.

Future risks surrounding water shortages pose a broader concern about utility debt: that rating agency analysts have not given enough credence to the question of droughts.

Rating agency analysis of water utilities is more reactive than anticipatory, according to Sharlene Leurig, senior manager of the insurance program at Ceres, a national coalition of investors and public interest groups.

She consults for insurance companies that include municipal bonds in their investment portfolios.

Leurig authored a Ceres report published in October that said parts of the country will experience droughts “far more severe than anything that’s been seen in recent history.”

Rating agencies should be considering the potential drought concerns more proactively, she said.

The Southeast region, in particular, could see more severe droughts, according to Leurig.

Blackwood, the Raleigh debt manager, said the City Council is aware that rate increases are crucial to preserve the triple-A rating.

The council enacted a tiered water billing system in November that he described as a conservation measure.

A typical customer will fall in the first tier of the new system. Residents who water their lawn too many times in a month may find that their wasteful ways land them in a higher, more costly billing tier, Blackwood said.

Raleigh has $150 million in variable-rate bonds outstanding, about 22% of its debt, which is hedged with two interest-rate swaps. Citi and Wells Fargo NA are the counterparties.

The variable-rate bonds are backed by a standby purchase agreement with Wells Fargo that expires in June 2012.

The swaps had a combined negative value of $28.2 million as of October, but the city is not required to post any collateral.

The next bond issuance for the utility system is scheduled to be a $100 million deal in 2013, Blackwood said.



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