California's three-year drought has entered a new phase of concern, as the state moves on from its driest year in 119 years of record keeping and enters an unrelenting 2014. Land isn't the only thing drying up, however, as the drought's economic impacts are dangerously closing in on the state's financial resources.

With the 4th highest state income tax rate (13.3%), one of the highest average sales tax rates (8.4%) and the 17th highest property tax rates in the nation, there are very few sensible stop-gap revenue raising options left for the government to consider.

With no end to the drought in sight, ratings agencies may be visiting the Golden State soon to review its "A/A1 positive" credit evaluation. Investors are well advised to review their California municipal and mutual fund investments to assess credit-risk exposure during the state's hobbled economic recovery.

While the state has deep roots in technology and manufacturing, the agricultural sector - the most productive in the U.S. - is particularly vulnerable. Investors should carefully consider the consequences of these conditions on municipal credits in their portfolio, the response measures those issuers may have implemented and the risk-based returns they now offer.

Rural Communities Exposed
In a state with a $2 trillion gross domestic product, which exceeds every other state and would appear between Russia and Italy on an international top 10 list, the drought has broad significance. California is no stranger to water shortages, but the unique conditions of this drought have strangled areas that typically export water to drier regions.

Under the best conditions, the distribution of water throughout the state is managed by a complex system of municipal, state and federal water suppliers. The severity of the current drought has forced some of these suppliers to drastically reduce the amount of water they will be delivering to customers this year.

The shortage is expected to have a disparate impact across the state. Metropolitan areas are generally more capable of combating the drought than smaller municipalities and rural communities without the financial resources.

Los Angeles is a model of a well-prepared metropolitan area, with water supply plans designed around three and four-year drought cycles and adequate reserves of both water and financial resources to weather years of reduced water allocations.

Tempering the effects of the drought is key in this region, as over one third of California's GDP is produced here.

Although the majority of California's GDP comes from sectors that are modest water users or located in areas near water supplies, the water-reliant agricultural economy is suffering.  The California Farm Bureau Federation has projected that hundreds of thousands of acres of fertile farmland will go unplanted this year due to water shortages. With six percent of California's total economy tied to agriculture, the drought is jeopardizing up to $11 billion in revenue

Credit Reevaluation
The debt service coverage ratio is one reliable way to evaluate municipalities' ability to handle financial strain. While most local water agencies in California are experiencing a reduction in capacity, there is a growing disparity between stronger and weaker credits. The median debt service coverage ratio of California local water agencies is the highest ratio since 2008 at 2.7 times.

While the current median ratios remain healthy, select credits have shown a reduction in debt coverage ratios over the past several years. For instance, the Central Basin Municipal Water District ( Aa3) with a .65 ratio, Central Coast Water Authority (Aa3) with a .97 coverage ratio and Kern County Water Agency Improvement district 4 (Aa3) with a 1.07 coverage ratio have all exhibited declining revenues with increasing debt liabilities over the last couple years which has led to a declining debt service coverage ratio.

Agencies can either raise rates, putting an additional, unpopular burden on the community, or adjust budgets to closely match future anticipated revenues. There are two problems with the second scenario though. Debt costs are typically already set, so only an increase in revenues can improve the ratio, and as consumers acclimate to new water restrictions consumers' demand may not return to previous levels.

An additional factor to consider is tourism, which is California's third largest employer and the fifth largest contributor to its GDP. The industry is already experiencing the consequences of the drought and ski resorts that normally open in December are still closed due to low snowfall levels and unusually high temperatures. These business closures are affecting the tax bases of these communities, and without improved conditions, further damage may be unavoidable.

Not Just California
California's wet season extends from roughly November through March, and relief may come soon, but 2013's historical drought is daunting. While California is attracting the most attention, a large portion of the Western U.S. is experiencing similar conditions with lower economic consequences.

It is increasingly important that investors consider the consequences of drought conditions to municipal credits in their portfolio and weigh those risks against both the response measures those municipalities may have implemented and return premium they expect to earn by investing in these at-risk credits.

Robert G. Smith, an investment manager with over 30 years of industry experience,
is President, Chief Investment Officer and Co-Founder at Sage Advisory Services.