Recently, the U.S. Court of Appeals for the First Circuit upheld a lower court's decision that payment of Puerto Rico Highways and Transportation Authority's special revenue secured debt is voluntary--not required--during the bankruptcy-like proceedings established under the Puerto Rico Oversight, Management and Economic Stability Act's Title III. S&P Global Ratings has received questions from many market participants following this decision regarding its view of the relationship between a general obligation (GO) rating on a local or regional government (LRG) and a revenue bond rating on an enterprise of that same LRG, such as a municipally owned waterworks and sanitary sewer utility (MOU). Specifically, we've been asked if enterprise ratings are linked to or even capped by the GO rating.
While our criteria do not contain a direct tie between an MOU and its associated LRG, the ratings on them are related and our MOU analysis takes into account our view of the LRG's creditworthiness. Historically, we have not provided any uplift for a revenue bond of an MOU carrying special revenue designation. In our view, while special revenue bond repayments might continue during a bankruptcy for a given issuer, under Chapter 9 these payments are subject to necessary operating expenditures of the MOU and, as recently supported by the First Circuit decision, are not guaranteed.
Ratings On Utilities And Their Related Governments Are Typically Close
Our municipal water and sewer utility revenue bond criteria, "U.S. Public Finance Waterworks, Sanitary Sewer, And Drainage Utility Systems: Rating Methodology And Assumptions" (published Jan. 19, 2016), and our local government GO rating criteria, "U.S. Local Governments General Obligation Ratings: Methodology And Assumptions" (published Sept. 12, 2013), consider certain factors in common, such as economic fundamentals. Therefore, in cases where the LRG has both a GO and revenue bond utility rating on it, the ratings tend to be similarly placed on the rating scale. There are, however, important factors unique to each, beyond different revenue streams, such as financial performance and available reserves.
S&P Global Ratings maintains approximately 1,600 public ratings on MOUs in the U.S. Of those, 610 are for issuers such as cities for which we also have a GO rating. The remainder are almost equally divided between issuers for which we do not maintain a GO rating, and utilities that are separate or independent political subdivisions for which there is no affiliated LRG, such as a utility authority or special district. The modal rating for these MOUs is 'A+', which is slightly below the modal rating of 'AA-' for comparable GO ratings on LRGs in the U.S. That does not mean, however, that a utility will necessary have a rating lower than its related LRG. A utility's credit fundamentals could in fact support a revenue bond rating that is higher than the GO rating on the related LRG.
In the majority of cases, the GO rating is higher than the rating on the MOU. In only about 10% of the cases, is the rating on the MOU the higher of the two; of those, three-fourths are in the same rating category (for example, both in the 'A' category). Whether supported by the enterprise profile, the financial profile, or both, for only 3.3% of the 610 public ratings is the utility in a higher rating category altogether. Simply put, a utility rating and GO rating could share similar credit drivers, such as economy or governing body; but other factors might be distinctly different, such as financial performance or debt burden. A different rating indicates our view of the relative strengths and weaknesses attributed to each entity's credit profile as analyzed by the applicable criteria. Of importance, these criteria provide for independent analytic frameworks and the municipal water and sewer utility revenue bond criteria do not set a cap based on the GO rating.
Examples of utilities rated higher than the GO include:
- MOUs whose service territory is more than just the city itself, such as Chicago's water system (A+/Stable), which also provides drinking water to over 120 suburbs; and Los Angeles' sewer system (AA+/Stable), which treats the sewer flows of most of the metropolitan statistical area;
- Utility systems that have extremely strong liquidity buoyed by strong financial and operational management, such as Philadelphia (A+/Stable); and
- Covenants that preclude the use of surplus net revenues for anything except utility purposes, such as with both Chicago water and Chicago sewer (A+/Stable).
Rate-Raising Capacity And Frequent Billing Cycles Give Utilities Revenue Stability
For both utility and GO ratings, we analyze the stability of and financial capacity created from the respective revenue streams. With utilities, we have observed that the ability to adjust utility rates tends to provide a more politically palatable tool for raising revenue than a local government's ability to adjust key revenue sources of the general fund such as through taxes, affording utility decision-makers the ability to respond to unfavorable budgetary variances more quickly. Also, because of the nature of utility billing cycles--usually monthly but generally no less frequent than quarterly--utilities generally have more predictable cash flow patterns than their affiliated LRG and, in our view, sometimes exhibit extremely strong available reserves relative to the general fund.
Of note, our ratings reflect our opinion on the timely payment of principal and interest in full and do not factor in expected recovery if a default occurs. Furthermore, while our criteria consider certain credit drivers in common for revenue bonds of a utility and its associated LRG (as noted above), we do not consider municipally owned water and sewer utilities to be in scope for "Issue Credit Ratings Linked To U.S. Public Finance Obligors’ Creditworthiness" or "Rating Government-Related Entities: Methodology And Assumptions" criteria and therefore do not apply the principals in these criteria that call for linking or anchoring the rating to that of a related obligor. (Note: Tennessee Valley Authority (AA+/Stable) and Bonneville Power Administration (AA-/Stable) are the only utilities we analyze as government-related entities under our "U.S. Municipal Retail Electric And Gas Utilities" criteria.)
Our Methodology Accounts For The Relationships Between Utilities And LRGs
In our view, our criteria aligns with the decision because in analyzing pledges, whether a revenue pledge or a GO pledge, we go beyond the legal structure and look at the broader credit characteristics of the entity making the pledge. For enterprise operations like a water or sewer system, this means looking at not only the system's operations, but also the credit quality of the municipality it serves.
If an LRG's weak credit fundamentals affect the health of the associated MOU, we account for that in our analysis. This is not limited to cases in which there is distress related to the GO credit fundamentals yet the MOU is otherwise financially stable, perhaps in extremely rare cases even resulting in the MOU becoming party to municipal bankruptcy or restructuring proceedings. More commonly, we have seen instances when a utility is making large transfers to the general fund, which hinders the utility's ability to build sufficient levels of reserves or have ongoing budget certainty. As we have noted (see "Credit FAQ: All-In Coverage, Transfer Payments, And Credit Quality," published Jan. 19, 2016, on RatingsDirect), the mere existence of transfers--usually the use of surplus utility net revenues for non-utility purposes--is neutral to credit quality. If, in our view, the general fund overly relies on transfers from the MOU, it is a credit weakness to both ratings because the general fund is being subsidized and the utility fund is being limited in its ability to accumulate and maintain available reserves that it might otherwise use for programs like pay-as-you-go capital improvements. If the general fund is exhibiting characteristics of distress, such as a liquidity crisis, and we believe it is stripping the utility of cash, we would view that scenario as negative extraordinary intervention under our criteria and lower the utility rating to the lower of 'BBB' and the GO debt rating.
The all-in debt service coverage calculation (also known as fixed-charge coverage) is our adjusted coverage calculation that accounts for the use of every dollar of utility operating revenues regardless of lien or accounting treatment, and whether we rate the issue or not. This includes transfers, state loans, and even GO debt self-supported by surplus utility net revenues. The municipal water and sewer utility revenue bond criteria also account for long-term liabilities other than debt, such as contractual commitments for purchased water and fiduciary obligations such as for pension plans and postemployment benefits. We use analytic judgment to determine how material we consider these for the utility's overall financial risk profile.
Ratings ultimately reflect S&P Global Ratings' view of the obligor's capacity and willingness to meet in full its financial commitments as they come due. Although municipal bankruptcies and defaults remain rare, in our view, financial distress might motivate issuers to minimize the burden of their liabilities, including stopping payment on special revenue-secured debt. In this respect, the First Circuit decision as well as Puerto Rico's efforts at debt repudiation do not alter our approach to analyzing utility revenue bond debt or debt issued in the municipal market more broadly. We incorporate into our analysis under the premise that secured bondholders remain exposed to the obligor's operating risk. Our utility revenue bond ratings reflect the obligor's creditworthiness by incorporating the risks our criteria identify, which include but are not limited to operational and environmental requirements, financial obligations, and fiduciary responsibilities. Any perceived change in the willingness to pay would generally introduce a rating cap of 'B' consistent with paragraph 39 of the municipal water and sewer utility revenue bond criteria.
We stated in our 2019 sector outlook (see "U.S. Municipal Water And Sewer Utilities 2019 Sector Outlook: Stable, Although Potential Disruptions Are Not Making Planning Easy," published Jan. 15, 2019) that the potential disruptors of credit quality have not changed much from past years. This opinion has not changed because of the First Circuit decision. Chief among the potential disruptors of credit quality we've noted an expected increase in borrowing to address infrastructure renewal and replacement, and wage pressures on the operating budget, both of which we expect will push rates and charges higher. We would expect these disruptors to present themselves by way of stress on both all-in debt service coverage and affordability (as measured in the market position assessment). In our Industry Risk assessment within the criteria, MOUs are very low-risk operations, but not risk-free. Therefore, regardless of how federal law and court decisions could shape market participant discussions toward and risk appetites for the rare instances of distressed issuers, MOUs are monopolistic providers of an essential service and--with only a handful of exceptions--are not subject to rate regulation by their state. Even for those that are rate-regulated, we would view such a framework as neutral to credit quality save for situations in which it appears that the timing or magnitude of requested versus granted is materially different. Ultimately, the level of autonomy that provides local communities the discretion to act--or not act--under both normal conditions and in times of financial distress is one fundamental factor in our credit rating analysis.
|Examples Of Cities For Which The Utility Rating Is Higher Than The Related GO Rating|
|City||State||Water-sewer utility revenue bond rating||GO bond/issuer credit rating||Key credit observations|
|IL||A+/Stable (water)||BBB+/Stable||Long-term contracts with over 120 suburbs greatly diversifies operating revenues; surplus net revenues can only be used for utility purposes.|
|IL||A+/Stable (sewer)||BBB+/Stable||Generally 1.5x or better all-in DSC and very strong available reserves; Lower risk collection-only system with no environmental infractions; Surplus net revenues can only be used for utility purposes|
|OH||AA+/Stable (water)||A/Stable||Nearly 75% of operating revenues come from outside the city; all-in DSC typically 1.6x or better; almost 700 days cash|
|TX||AAA/Stable||AA-/Stable||Long-term contracts to serve nearly all of Dallas County on a wholesale basis; extremely small exposure to police and fire pension obligations|
Great Lakes Water Authority (GLWA)
|MI||AA-/Stable (water)||BB-/Stable||GLWA provides water service to nearly 40% of Michigan, limiting exposure to Detroit; strong management and governance framework|
Great Lakes Water Authority
|MI||A+/Positive (sewer)||BB-/Stable||GLWA provides sewer service to 30% of Michigan, limiting exposure to Detroit; strong management and governance framework|
|TN||AAA/Stable||AA/Stable||The utility serves much of Shelby County; water system has extremely low debt burden|
|PA||A+/Stable (water)||A/Stable||A service area that includes the city, 11 neighboring townships, and a number of wholesale customers; available reserves generally equivalent to 7-9 months of operating expenses|
|CA||AA-/Stable (sewer)||A-/Stable||Almost two years' cash on hand and extremely strong all-in DSC; history of multi-year pre-approved rate adjustments|
|CA||A/Positive (water)||BB+/Positive||Over 600 days' cash on hand at fiscal year-end 2018 and a recent history of outperforming forecast all-in DSC, in part due to preapproved rate adjustments through 2021|
|CA||A/Stable (sewer)||BB+/Positive||Extremely strong all-in DSC and available reserves, even after a write-down of $11.7 million from the general fund we never expected the utility to receive after the Chapter 9, and even with expected additional debt to fund capital expenditures|
|CA||A+/Stable (water)||BBB+/Stable||All-in DSC of 1.5x-2.0x each year since 2011; steady available reserves equivalent to about nine months of operating expenses|
|Source: S&P Global Ratings. DSC--Debt service coverage. GO--General obligation.|
- Has S&P Global Ratings' View On Special Revenue Debt Changed Following The First Circuit Decision?, May 1, 2019
- Issuer Credit Quality Remains Key To Assessing Priority-Lien Debt Whether In Puerto Rico Or The U.S. States, April 2, 2019
This report does not constitute a rating action.
|Primary Credit Analyst:||Theodore A Chapman, Dallas (1) 214-871-1401;|
|Secondary Contacts:||Jenny Poree, San Francisco (1) 415-371-5044;|
|Melody W Vinje, Centennial + 1 (303) 721 4163;|
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