Essential service bonds continue to be considered among the safest municipal market investments, faring better than general obligations bonds in the current economic environment, on the back of the rate-setting ability of issuers and investor perception that these bonds are more immune to fiscal stress, according to market sources.

As an example, the New York City Municipal Water Finance Authority Tuesday priced $554 million of 2042 taxable Build America Bonds, upsized from the $400 million it initially planned. The authority structured the deal as one maturity with bifurcated coupons of 5.72% for $324 million with a make-whole call and 6.12% for $230 million with a 10-year par call, which, after the federal subsidy, will cost the issuer 3.72% and 3.98%, respectively.

The bonds were rated AA-plus by Standard & Poor’s and Fitch Ratings and Aa2 by Moody’s Investors Service, and were supported by the future price increases on charges adopted by the New York Water Board, which controls the authority.

Given the inelastic demand for services such as water and sewers, public utilities are monopolies with captive users. Considered closer to the conservative end of the municipal-market risk spectrum, the bonds have covenants that specify rates and fees to be charged for maintenance and to pay for debt. Not surprisingly, there are very few municipal utility defaults on revenue bonds for water and sewer projects.

“The general sense is that these bonds have performed better. The credit spreads have widened out for most other bonds, but it has widened out less on water and sewer bonds,” said Peter Bianchini, managing director of institutional sales and trading at Mesirow Financial. “There are a lot of competing demands on revenue for a municipality — labor, contracts, need for social services — but water and sewer projects do not have such pressures. Headline and budget issues do not impact these bonds much.”

In 2009, issuers sold 1,098 issues of water and sewer bonds with a par amount of $34.4 billion, compared to 915 issues with par amount of $31.3 billion in 2008. Of those, 713 issues with a par amount of $20.07 billion in 2009 were new money, compared to 635 issues totaling $14.33 billion in 2008. Refunding bonds in the sector totaled $14.35 billion in 2009, down from $16.98 billion in 2008, according to Thomson Reuters.

Chris Alwine, head of municipal bond fund operations at Vanguard, said that there has not been a surge in secondary activity in water and sewer bonds in recent months, but the investment performance has been comparable to other high-quality sectors. “They fall in the high-quality essential service revenue bond sector that has generally been immune from the fiscal stress experienced by GO tax-backed credits,” he said.

Standard & Poor’s water and sewer municipal index shows that the yield has been consistently declining during the first six months of this year, to 3.723% in May from 3.913% in January.

Other factors contributing to lower yields for all tax-exempt municipal bonds are also affecting the sector, including low money market yields, higher tax expectations, and the impact of BABs on the supply of high-grade municipal bonds, according to J.R. Rieger, Standard & Poor’s vice president of fixed-income indices.

The index includes data on more than 1,320 different bonds with a market value of more than $30 billion.

James Gebhardt, chief financial officer of the New York State Environmental Facilities Corp., which administers the state’s top-rated revolving loan funds for clean and safe drinking water, said: “The rating agencies have indicated that, as a class, water and sewer is one of the safest areas to be invested. We hold a similar view, and of course we work in the sector specifically with respect to our state revolving funds holdings.”

There are some risks in the sector, however. Gregory Baird, of Aging Water Infrastructure  and the former chief financial officer of Aurora Water of Aurora, Colo., sees risk in the fact that as much as 85% of U.S. water utilities are owned by municipal governments, which may make the process of funding the systems subject to political pressures.

“There is a risk in the governance model,” Baird said. City officials at times may choose not to increase taxes in order to get re-elected every four years, he said, adding: “Such a short-term view does not address long-term planning and funding issues.” 

An outlier of risk in the sector comes in the case of Jefferson County, Ala. In a bid to overhaul its sewer network to comply with environmental requirements, the county had entered into a complicated bond swap deal in conjunction with its floating-rate borrowings to lower interest costs. The bonds defaulted in March 2008 after rates rose as a result of the downgrades to its bond insurers.

But analysts believe Jefferson County is not emblematic of the sector as a whole.

“The stresses that took down Jefferson County were outside of sector influences,” said Tom Kozlik, vice president and municipal credit analyst at Janney Capital Markets. “The county was exposed to insurers as part of interest rate swap and bond structures. When the insurers were downgraded, the county was forced to pay elevated rates as a result of the bond structure.”

The changes to the bond insurance industry and the overall strength of the sector has resulted in a significant drop in the use of insurance in the sector. In 2009, the amount of insured utility debt dropped 49% to $4.9 billion from more than $9.8 billion in 2008 and $23 billion in 2007, according to Thomson Reuters.

The year-to-date insurance penetration has plummeted to below 7%. But even without insurance, “the essential nature and demand inelasticity of such services has ensured that these bonds have remained in favor with investors seeking credit stability,” said Philip Villaluz, head of muni strategy at Advisors Asset Management.

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