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Capital Funding 17 grade, or lower quality. Lower rating levels exist, but the investor market for these credits is significantly smaller. In looking at water and sewer credits, we find almost 90 per- cent of public water and sewer utilities are "AA-" or better, meaning these are good credit risks and should be able to achieve the best funding rates. Default studies performed by the rating agencies indicate water and sewer credits are some of the municipal sector's best credits. Only three larger water and sewer utility credits are rated at the bottom of the credit spectrum for institutional clients — Detroit (due to the City's Chapter 9 filing), New Orleans (post-Hurricane Katrina fallout), and Jefferson County Sewer in Alabama (due to an overly heavy reliance on synthetic debt and auction rate securities). While it is difficult to show capital funding costs for a wide range of credits and structures, we can look to generic market indices to get an idea of the borrowing rate for publicly owned water and sewer utilities. The municipal market has an index from which bonds are typically priced with a spread — or the "add on" to the index. Published by Thomson/Reuters, the index is called the Municipal Market Data (MMD) AAA Index and is considered in laymen's terms to be the equivalent of the Treasury curve for taxables (taxable bonds are typically priced with a spread to the Treasury curve). If we just look at the two basic indices — AAA MMD and the U.S. Treasury — for the 10-year maturity going back to January of 2000, we find that the tax-exempt index was on average 0.49 percent lower. Since 2000, we have had a record-setting, historically low interest rate environment. Typically, a low-interest-rate environment causes "rate compression" — a term used when low interest rates drive tax-exempt and taxable bond yields closer to each other than they would normally be. If we look prior to 2000, or the low-interest-rate period, the tax-exempt index is 1.35 percent lower going back to its creation in 1993. In addition to the indices, the spread to the index also matters. We tend to find taxable spreads to be higher than tax-exempt spreads (the "add-on"). Spread levels are influenced by a number of factors, including differences in credit quality, state and local taxation laws, current market factors, news events, etc. While there is no proxy which incorporates spreads to compare taxable and tax-exempt rates, we can look at specific bond issues. Tucson, AZ, Raleigh, NC, and the Bay Area Water Supply and Conservation Agency, CA, all issued debt last year on both a tax-exempt and taxable basis, which we can use as indicators. Taxable spreads were higher by 0.37 percent, 0.26 percent, and 0.46 percent respectively at the 9-year maturity for each of these issuers: • Tucson, AZ (Water System Revenue Bonds) — 2022 maturity tax-exempt spread: 44 basis points (bps); taxable spread: 81 bps • Raleigh, NC (Combined Enterprise System Revenue Bonds) — 2022 tax-exempt spread: 14 bps; taxable spread: 40 bps • Bay Area Water Supply and Conservation Agency CA (Revenue Bonds) — 2022 tax-exempt spread: 29 bps; taxable spread: 75 bps. Coverage Requirements Beyond credit spreads, tax-exempt bond issues can contain items unique to the structure. Bond issues that are solely based on the util- ity's revenues as the source for debt payment tend to have coverage requirements and a debt-service reserve fund. Coverage requirements tend to require the utility to keep rates sufficient for some multiple of total debt payments either annually and/or before issuing more debt. Depending on the requirements of the bond docu- ments, coverage can be calculated on total revenues or net revenues after the payment of operating expenses. A debt-service reserve fund can be thought of as a savings account embedded in the bond issue. Again, differences exist depending on bond documents, but often the size of the reserve fund will be required to equal a full year of debt service. There are discussions as to whether these items are efficient in structuring the debt. Coverage requirements based on the utility's revenues tend not to constrain the utility, as operating expenses absorb excess dollars. Coverage models based on revenues net of operating expenses need a use for the excess dollars not needed for debt-service payments. These dollars can be used for pay-go funding of capital or to pay subordinate debt, such as a commercial paper program for construction funding. Debt-service reserve funds are savings accounts and can be invested. In higher rate environments (or a steep yield curve), reserve funds can be invested at the yield on the bonds, making them somewhat neutral to overall borrowing costs In today's water environment, we find rate increases are necessary to simply maintain revenues at current levels as consumption declines — leaving little, if any, incremental revenue to fund capital projects. wateronline.com ■ Water Online The Magazine 1 6 _ V E R T _ 0 2 1 4 E Z i n e _ R a y m o n d J a m e s _ D G . i n d d 2 16_VERT_0214 EZine_Raymond James_DG.indd 2 1 / 3 1 / 2 0 1 4 1 : 0 6 : 3 0 P M 1/31/2014 1:06:30 PM