This is the first in a series of posts explaining how I analyze municipal bonds to provide municipal bond investors a guide on what to look for. When I began analyzing municipal bonds, I was lucky enough to have co-workers to show me where to start. For the average investor, reading an official statement for a municipal bond issue can be overwhelming. Here’s part 1 of my series on how to analyze water/sewer bonds.
Water is one of the necessities of life that we often take for granted. With just a turn of the tap we have a seemingly endless supply of it. The first time a port-o-potty is your only option you have a sudden appreciation for your sewer system. Jokes aside – these municipal systems can provide a steady income stream for municipal bond investors. There are several key questions that must be answered before investing in a specific water/sewer bond.
What is the revenue source that supports the bonds?
Water/sewer bonds are typically backed by either net revenue or gross revenue. The municipality charges their customers (citizens) a fee for their services each month to generate revenue. On occasion the revenue source will be from property taxes. This information can be found in the preliminary official statement (POS) that is released prior to the bonds being issued. There will be a section labeled “SECURITY”. The POS can usually be found on the website Munios.com.
Here is the language from a recent bond issue under the SECURITY section:
The Sewer Bonds are not general obligations of the City, but are special obligations payable solely from and secured by a pledge of the net revenues derived from the Sewer System.
The POS will define what net revenue means but generally net revenue means gross revenue minus the operation and maintenance expenses of the system.
Bonds supported by gross revenue pledges means that the revenue would flow to bondholders before operations and expenses. Gross revenue is a stronger pledge. Understanding the source of revenue is essential to ensuring there will be enough cash flow to cover the debt service payments.
What is the debt service coverage?
Debt service coverage explains how much more revenue is coming in than the required debt payments. There should be schedule in the POS that shows this.
This example shows the revenues available for debt service, divided by the Maximum Annual Debt Service (MADS) requirement, to calculate the debt service coverage of 3.4x. I view water/sewer coverages above 2x as strong. Examining the debt service coverage is one of the most important factors to analyze water/sewer bonds.
What are the rate covenants?
The rate covenant explains the minimum allowable debt service coverage. In the example below, the rate covenant requires 1.1x maximum annual debt service coverage. If the debt service coverage were to fall below this level, the municipality would be required to raise the rates they charge customers in order to honor the covenant.
It is also important to be sure the municipality has the power to raise rates, preferably without voter approval. Sometimes a rate increase has to be approved by voters which could provide an extra hurdle if rates are already high. Rate covenants are designed to give bondholders some protection against the municipality issuing more debt than is sustainable.
What is the additional bonds test?
The municipality will also typically have what is called an additional bonds test. This is another covenant with bondholders to protect them from the municipality issuing too much debt. The additional bonds test will usually require the maximum annual debt service coverage (MADS) to exceed 1.1x. I like to see this rate covenant above 1.25x when I analyze water/sewer bonds.
What does the debt service schedule look like?
The debt service schedule shows the annual principal and interest payments. The schedule should show the new bonds being issued along with prior bond issues.
As you can see on the schedule below, you want to see a nice even debt service requirement each year. Look out for a schedule that shows a large debt service requirement one year, then a smaller one the next, and so forth. You can also see on the schedule the maximum annual debt service (MADS) requirement is in 2034 with $45,986,406 in debt service payments.
What are the rates being charged to citizens? Are they affordable?
The POS will show the amount that is being charged for water/sewer service each month. It is important to make sure that rates are not too high since it will make it more difficult for the municipality to raise rates if they need to in the future. Income levels of the residents should be taken into account. If the median household income is higher than the national average, then these households could afford above average water/sewer charges.
I view a water/sewer bill around $100 to be high. I would prefer to see the combined bill below $75 a month. Municipalities sometimes separate water/sewer bills and often there are other utilities such as power, gas, or garbage collection included all in one bill.
To analyze water/sewer bonds, the questions listed above are some of the first ones that should be answered in order to understand the revenue source, the debt service coverage, and the covenants protecting bondholders. If there are issues with the answers to these questions, you might be able to save yourself time by moving on to another bond to analyze. If all of these questions are answered and you are satisfied with the answers, then you can move on to more of the financial details.
In part 2 of this series on how to analyze water/sewer bonds I will examine the financial statements of a water/sewer municipality in detail and provide examples of potential problems to look for.