Water and sewer systems will rely more on debt issuance than pay-as-you-go financing for their growing capital needs this year, a trend that's expected to continue in coming years, Fitch Ratings analysts said in a report issued this week giving the sector a stable outlook.

In addition, issuers will use more subordinate-lien debt and stick to traditional debt instruments such as long-term fixed-rate debt during the next year or two, the analysts predicted.

But the utilities will have to carefully manage their capital programs' finances to avoid negative rating actions, the analysts warned in the report.

Fitch will "place greater weight in its rating analysis on management's ability to prudently execute its [capital improvement program], given the sector's immediate capital and financial needs," they said.

"The greatest threat to sector stability over the next few years will likely be political unwillingness to raise rates as local government officials seek to limit utility increases in the face of rising taxes and fees to support other governmental functions," Fitch said.

Water and sewer utilities are weathering the current economic storm relatively well because they are essential and therefore have a strong ability to collect from customers even when overdue charges are necessary, according to the report. They also head into this year with financial flexibility and extremely low delinquency rates, the analysts said, adding, they should be able to raise capital.

In fact, volatile capital markets, a housing downturn, and the recession "have had little discernible effect on the sector overall," according to the report.

The analysts' remarks come as state and local infrastructure is deteriorating and customer demand is growing.

The report projects utilities will turn to more debt issuance because they currently are taking in lower revenues from connection fees because of plummeting new housing construction. Increased borrowing will force utilities to consider raising rates for customers, according to the report.

However, utilities' overall liquidity will remain healthy in the medium-term, Fitch said.

"Certainly, there's the potential there for the economic recession to be more pronounced" than in years past, said Fitch analyst Chris Hessenthaler. However, utilities retain two stabilizing qualities, he said. They provide a necessary service and have strong enforcement mechanisms to collect revenues.

"They've been able to cope to date, and we expect that to continue," he said.

In assessments of utilities on a regional basis, the analysts said that those in far Western states will be able to maintain their credit ratings if they develop new water supplies and protect those they already have. Some issuers may need to undertake challenging and expensive projects, such as water reuse or desalination, and they will face "long-term cost pressure" on debt service coverage and liquidity, according to the report.

Midwestern issuers, during the next three to five years, will have to deal with wastewater system rehabilitation programs requiring sizeable funding as well as pollution-reduction projects, Fitch cautioned, adding that they will find it particularly challenging to raise rates to cover debt because of the region's weak economy.

Utilities in the Northeast will have similar challenges but are not expected to increase their borrowing as much as those in the Midwest in relation to current debt levels, the report said.

Dramatic drops in construction will impact debt service coverage for utilities in the Southeast, and nontraditional water supply development "should escalate" debt issuance over the next few years in the Southwest, the analysts noted.

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