Muni Sector Review: Water and Sewer

As part of our investment process, SNWAM analysts make weighting recommendations for each sector in the municipal bond market, in addition to reviewing each credit held in SNWAM managed portfolios. Each month, a specific sector is the subject of an in-depth review, which includes an analysis of the sector’s relative credit quality, issuance trends and pricing relative to other sectors in the muni market. The water and sewer sector was the focus of SNWAM analysts’ August muni sector review. Based on our analysis, we have applied a neutral weighting to the water and sewer sector. While we expect the credit quality of the sector to continue to be stronger than the overall muni market, those credit attributes are offset by expectations for higher levels of supply driven by initiatives to fund deferred capital improvements, and by the extreme richness of the sector’s prices.

The credit quality of the sector is rooted in its stability, which is supported by its strong credit attributes. Those attributes include the public health benefits of safe drinking water and the environmental benefits of high effluent reduction standards, strong bondholder protections and independent boards with rate-setting flexibility. Financial ratios, as measured by debt service coverage and days cash on hand, have been stable over the past decade (including the last recession), and have improved significantly over the last three years. This strength positions the sector well for much needed future capital spending. We expect large capital programs expenditure to dominate the near- to medium-term outlook. California issuers are expected to continue ramping up debt issuance to support water supply projects so as to mitigate the impacts of periodic drought conditions. In addition, large east coast municipal water supply systems are expected to issue more debt to modernize aging pipes. This outlook is supported by shifts in the EPA’s Drinking Water State Revolving Fund appropriation from sewage projects to water projects. By any market measure, you pay to own water and sewer bonds. On average they are the lowest yielding (or most expensive) sector within the municipal market. Given our outlook, and due to the high prices on these bonds, it is recommended that they be used as portfolio stabilizers or liquidity positions. 

Source: SNWAM Research