Drought: California Water Agencies Face Bond Defaults

REusable water_SECVPF
Newport Beach, CA

The prices of California’s water and sewer bonds are beginning to take a nose-dive after Governor Jerry Brown issued the first-ever mandatory statewide cut-backs to agricultural and residential water use. By curtailing water and sewer volumes, the once highly-secure cash-flow to pay municipal bond interest and principal is evaporating on municipal agencies’ gargantuan amount of outstanding debt.

Water and sewer bonds have been considered the safest and most liquid sector of the $3.7 trillion municipal-bond market, because they are typically backed by residents’ payments for essential services. Despite the drought, California water and sewer agencies since 2010 were still able to sell an all-time-record $28.8 billion in municipal bonds, mostly to individual investors, according to Thomson Reuters.

The U.S. Federal Reserve’s lower interest rate policy, and President Barack Obama’s higher tax rates, had seemed to make owning municipal bonds much more attractive. Especially since during the first three years of the drought, credit rating agencies gave stellar positive reviews to California municipal water agencies’ ability to handle the latest challenge.

But Moody’s Investors Services warned bondholders in a late April report that the scope of the new mandatory water restrictions issued by Governor Brown on April 2 could curb revenue at water agencies. Moody’s stated that although the agencies have the right to initiate customer rate increases to offset declining volume use, further increases might discourage consumption.

Fitch Ratings, which rates California as the third worst state for credit quality due to huge pension liability, heavy debt load and business unfriendly regulatory structure, warned that water bond ratings downgrades will occur as politicians hesitate to increase rates.

Sen. Dianne Feinstein (D-CA) told CNN that the cut-backs are so severe they will lead to “mandatory rationing” as well as “the fallowing of large amounts of agricultural land.”

Those comments sent shudders through the brokerage community over concerns that the state’s water restrictions would seriously hammer water and sewer districts’ revenue. The brokers also voiced concerns that it can take time for a municipal water or sewer agency to follow the administrative steps and hold hearings to justify implementing rate increases.

Water and sewer bonds have already been leading the across-the-board price losses for all California municipal bonds since January, according to Barclays Bank. Brokerage sources confirmed to Breitbart News that the losses accelerated in April. Brokers also believe that actual prices of many municipal water and sewer bonds are over-stated, because dealer bids to buy municipal bonds are so far below the last transaction price that trading has “dried up”.

Some California water and sewer district bonds could face the same type of bankruptcy risk as the $3.7 billion in Jefferson County, Alabama sewer bonds that were listed in a Chapter 9 filing in 2011. Despite jacking up local water costs by almost 40 percent in the 2013 bankruptcy reorganization, municipal bondholders only recovered 60 cents on the dollar and JPMorgan Chase & Co. bank only received 31 cents on the dollar.

California is famous for having voters pass wildly expensive spending initiatives that have contributed to the state’s $600 billion in bond, pension and retirement healthcare obligations. Governor Brown convinced voters to pass Proposition 1 on the November 2014 ballot by claiming that there would be tremendous demand to buy the $7 billion in general obligation bonds he planned to sell to build infrastructure.

But with bond ratings starting to evaporate, Brown may have hit a dry spell for running up more state debt.