"As a taxpayer and bond investor, it is all very disappointing," said Marilyn Cohen, chief executive officer of Envision Capital.
"As a taxpayer and bond investor, it is all very disappointing," said Marilyn Cohen, chief executive officer of Envision Capital.

LOS ANGELES -- Vallejo, Calif. is planning to sell $19 million of water revenue refunding bonds next week in its first deal since exiting bankruptcy in 2011.

Effectively the city has no choice but to go to market.

Proceeds will defease and refund the city’s variable rate demand water revenue bonds secured by a direct-pay letter of credit from JPMorgan Chase Bank that expires Dec 7.

The bank does not intend to extend the expiration date and Vallejo was not able to find another bank to provide a letter of credit, which is why it is refunding the bonds next week, said the city’s finance director, Deborah Lauchner.

“We can’t continue with the variable rate bonds and, as you can imagine, they had a very low interest rate,” Lauchner said. “We’re going to be going into a fixed rate and it’s going to cost us more money.”

The refunding will replace the outstanding $17.5 million subordinate lien variable-rate debt, 2001 Series A, with senior lien fixed-rate debt.

While the city’s water fund-backed debt was not impaired by the city’s bankruptcy and restructuring proceedings, the lack of liquidity of such bonds could serve as a hurdle for pricing, market participants say.

“The current, and likely future, municipal market is favoring liquidity over ratings—look at how the new California bonds are pricing for evidence,” said Matt Fabian, a managing director at Municipal Market Advisors. “These bonds will, forever after, be somewhat more difficult to sell than any other California water bonds.”

Fabian said the holders will need to be the kind of lender that will not need to rely on fast or easy execution if he or she decides to sell the bonds.

Marilyn Cohen, founder of Envision Capital Management in Los Angeles, said she wouldn’t buy these particular bonds, but only because it’s a small deal and there won’t be any liquidity for the bonds. Other than liquidity, she said the cash balances look good and the coverage is good.

“I think that overall the deal will probably go quite fine,” Cohen said. “These bonds never skipped a beat, they never skipped making a payment, and people didn’t feel in peril as they would have with the pension bonds.”

According to bond documents, the water system fund is an enterprise fund that is separate from the city’s general fund and was not impaired in the bankruptcy proceeding or restructuring.

“We understand the city did not miss any water fund-backed debt service payments and did not tap the water fund’s cash balance to cover general fund expenses,” Standard & Poor’s analysts said in a recent report.

Standard & Poor’s is the only agency to rate next week’s bonds, assigning an A-plus rating and stable outlook.

In 2012 the city did transfer $819,000 out of the water fund to cover bankruptcy-related employee settlement costs attributable to the water enterprise, but Standard & Poor’s views that as a manageable limited transfer, with no other additional transfers planned.

The new bonds, which will mature from 2027 through 2031, are secured by a first lien on the net revenues derived from the operation of the city’s water system. The bonds also have a reserve, funded at the lesser of maximum annual debt service, 125% of average annual debt service, and 10% of the bonds’ initial offering price.

Cohen said since these bonds are isolated from the city’s general fund problems, she believes investors will be able to view these bonds separately.

Fabian, however, said that new buyers will need to understand and appreciate the risk that Vallejo could file for bankruptcy again in the next few years. Even though its water debt was not impaired the last time it filed for bankruptcy, the value and ratings on the new bonds could be affected if it filed again, he said.

“All these points argue for substantially higher yields and buyer-friendly structures than otherwise,” Fabian said. “I’d assume the underwriting will provide enough extra yield to new bondholders to induce them to take the leap.”

Vallejo, with a population of about 117,000, filed for Chapter 9 bankruptcy protection on May 23, 2008 citing depleted general fund reserves, inflexible labor contracts, and a worsening economy.

The city exited bankruptcy on Nov. 1, 2011, during which time the city restructured general fund debt and renegotiated employee contracts. The city projected a balanced budget for the year it exited bankruptcy and thereafter. However, one year later, operating deficits returned.

Since its exit from bankruptcy, Vallejo and its municipal entities have not sold any debt in the public market.

The last time the city offered municipal bonds was in July 2006, according to Thomson Reuters data. The city sold $46 million of insured water revenue refunding bonds.

Standard & Poor’s said the water credit’s performance during the bankruptcy, in which Vallejo general fund debt was impaired, warrants the A-plus rating.

“Our water revenue bond rating is based, in part, on the treatment of water revenues as restricted special revenues during the bankruptcy, the history of timely payment of water obligations, even as general fund financial health declined, and our expectation that the separation of water enterprise finances and the general fund finances will continue,” analysts said in a report.

The water system provides service to 37,224 accounts in Vallejo, located 30 miles outside of San Francisco, and also provides a limited amount of water on a wholesale basis to three nearby cities. Standard & Poor’s views the customer base as very diverse.

Analysts also noted that the city has a history of increasing rates annually. In 2009, the city adopted five years of annual 5% to 6% rate increases through 2014. The system’s financial performance has also been stable during the last six years, with strong debt service coverage and a consistently strong liquidity position, analysts said.

Going forward, the agency said it does not anticipate raising the water system’s rating over the next few years. If rates do not keep pace with expense increases or if there is a substantial drawdown in cash, the rating could be lowered.

De La Rosa & Co. is expected to price the deal on Wednesday. Orrick, Herrington & Sutcliffe LLP is bond counsel and Public Financial Management, Inc. is financial advisor.

Lauchner said the city does not plan to issue any more debt in the immediate future.

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