Water Revenue Bonds With an 18% Private Off-Taker
The City of Marston (population 180,000) plans a $42 million expansion of its water treatment plant. Staff proposes pledging net revenues from water rates, with a 1.25x rate covenant and a 1.20x additional bonds test, and no general obligation backup. About 18% of plant capacity will serve a new beverage bottling plant under a 20-year take-or-pay contract; the remainder serves residential and commercial customers. The finance director wants to market the deal as a tax-exempt governmental bond and asks which structural features will drive investor demand. Water rates were raised 12% last year, and the city has $310 million of outstanding GO debt.
1. Classify the security and identify the covenants and legal features that should drive your credit analysis.
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Classification. This is a revenue bond. The pledge is net revenues of the water system only; the city's $310 million of GO debt and its taxing power are not behind this issue. If the system defaults, bondholders have a claim on rates and the flow of funds, not on the general fund.
Covenants to analyze:
- Rate covenant (1.25x): confirm whether it is measured on historical or projected net revenues, and what counts as 'net' (does it include connection fees, interest earnings, transfers?).
- Additional bonds test (1.20x): limits dilution. Check whether it is historical or projected, and whether it is a senior-lien-only test.
- Flow of funds: O&M first, then debt service, reserve, renewal and replacement, then surplus. A weak R&R provision is a slow credit erosion.
- Lien position and parity: is this senior lien? What is already outstanding on the same lien?
- Rate-setting autonomy: the 12% increase shows willingness, but also that costs are rising.
Credit view. No GO pledge means recovery depends on the system's monopoly position and the council's willingness to raise rates under stress.
2. Assess the tax-status issue created by the bottling plant contract and outline what must happen before pricing.
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Run the private business use test. For governmental bonds, private business use of proceeds-financed property must generally stay at or below 10%. An 18% allocation to a private bottler under a take-or-pay contract is over the line on its face, so the issue is presumptively a private activity bond, not a governmental bond.
Consider the private security or payment test too. A take-or-pay contract can also create a private payment stream; that test is generally 10% as well, so the contract needs to be analyzed on both dimensions, not just the use of floor space.
Possible paths:
- Exempt facility treatment. Water furnishing facilities can qualify as exempt facility bonds, which are tax-exempt but are qualified private activity bonds: they consume volume cap, require informational reporting, and the interest is an AMT preference item.
- Restructure below 10%. Resize the plant or shrink the bottler's share so private business use is under 10%, or have the bottler fund its share with taxable debt.
- Separate conduit issue. Finance the bottler's portion separately.
Before pricing: bond counsel must run the tests and issue a tax opinion. Do not market the deal as a governmental bond until the analysis is complete.
3. The finance director says the private-use finding is just a technicality. How does it affect the investor base and pricing?
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It is a pricing issue, not a technicality. If the bonds become AMT-subject private activity bonds:
- Demand shrinks. AMT-sensitive buyers - certain individuals, banks and funds - either avoid the paper or demand a concession. The investor base narrows toward buyers who are not AMT-exposed.
- Spread widens. Expect a concession to comparable governmental paper, commonly in the range of a few to several basis points and more in a thin market.
- Volume cap must be available. If the issuer needs an allocation from the state's cap, timing and availability can delay or kill the deal.
- Disclosure changes. The official statement must describe the private-use structure, the AMT status, and the take-or-pay counterparty risk.
A revenue bond with concentrated private counterparty exposure also raises the credit question the finance director should be asked: what happens if the bottler does not perform? That is a revenue concentration risk that belongs in the risk factors.