With contributions from Terry J. Goode, senior portfolio manager, Tax-Exempt Fixed Income, and Brandon Pae, senior research analyst, Tax-Exempt Fixed Income.
After four years of drought, municipal water utilities in California are facing scarcer water supplies and, in turn, potentially lower revenue streams due to selling less water and spending more on capital projects for more sustainable water sources. While investors have traditionally viewed the more-than-$18-billion California water and sewer sector as high quality—the median rating is AA- from Standard & Poor’s and Aa3 from Moody’s—it will be increasingly important to differentiate between issuers to find the best investment opportunities. Successful responses to the drought crisis have allowed many utilities to keep their financial positions strong while other less-nimble issuers have seen their balance sheets weaken. Below we explain why the challenge of scarce water supplies is here to stay, how it is affecting California water and sewer bonds, and what our investment themes are within this sector.
The challenge of water scarcity is here to stay
Virtually the entire state is in drought conditions, with more than 92% of the state in severe drought or worse. The National Oceanic Atmospheric Administration (NOAA) estimates four-year rainfall amounts were between 54% and 75% of normal 2011–2014, resulting in significant precipitation deficits throughout the state. Over the past four years, NOAA reports that every region in the state is missing at least a year’s worth of precipitation and the south coast of California is missing almost two years’ worth. As a result of this deficit, more than 15 million acre-feet of groundwater and reservoirs have been depleted. Given the dire situation, Governor Jerry Brown declared a state of emergency on April 1, 2015, and issued an executive order to cut urban water use by 25%. Anecdotally, several small communities in the California Central Valley have run out of water, and prices for secondary-market sales of surplus water supplies between water customers have reached record highs.