Is Muni Bond Credit Quality Drought Tolerant? | Lord Abbett
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Fixed-Income Insights

The challenges of water supply-stress extend beyond utilities to other areas of the municipal bond market. Here’s how issuers are taking steps to mitigate the impact.

Read time: 4 minutes

[This article is from the forthcoming edition of the Lord Abbett Muni Quarterly.]

Drought conditions have become more prevalent in recent years, particularly across the western United States. Water scarcity and drought will remain both short- and long-term credit considerations for affected utilities, but also for cities, school districts, and other entities in areas dependent on agriculture or other water-intensive economies. Still, we believe stakeholders are generally prepared to meet these challenges and reduce the risk of longer-term negative credit impact.

Record Drought and Its Impact

As of August 31, 2021, 30 U.S. states were experiencing moderate or worse drought conditions.  In the United States, 46.6% of the lower 48 states, 74.6 million people, and 207.5 million acres of crops were experiencing or affected by drought conditions.

Parched conditions have been exacerbated by high temperatures. Much of the West experienced record or near-record heat in July. The issue is particularly acute across California, Nevada, and Arizona. In California, 88% of the population is experiencing extreme or exceptional drought. Over two-thirds of Nevada is experiencing similar conditions. Drought conditions come on rapidly: much of the West was not under drought conditions before May 2020, when the La Niña weather pattern brought record temperatures and low rainfall to California and the Southwest. Dry conditions in early summer 2021 accelerated declines in the Northwest.

Persistent drought conditions have resulted in lower water levels for key reservoirs supporting major population centers, hydroelectric generation, and heavy agricultural regions. Total storage across 28 Western Sierra reservoirs was 8.6 million acre-feet[i] in July 2021, still above 2015-drought lows (7.8 million AF) but well below usual summer averages of 10 million AF. As of August 31, water levels at California’s two largest reservoirs, Lake Shasta and Lake Oroville, were at 43% and 34% of respective historical averages. In the Colorado River Basin, Lake Meade is 35% full, and Lake Powell is 31% full.

Potential Effects on Issuer Credit

In times of severe drought, water utilities and local governments often focus on conservation, which puts pressure on revenue generation. At the same time, higher pumpage and purchase costs, as well as, in some cases, electricity costs, increase operating expenses for utilities, further constricting margins. In the immediate term, utilities may at least partially offset revenue loss from lower consumption by implementing drought charges or fixed-rate fee increases. While important—these measures help address near-term operational imbalances and alleviate immediate credit impact—they do not solve for longer-term risks associated with climate change.

Over the longer term, tangible mitigation efforts are more consequential. Utilities and other stakeholders will need to focus on more efficient water delivery methods as well as alternative water sources. Robust storage infrastructure provides critical relief in times of drought, underscoring the need for capital projects to enhance storage. For example, storage alone accounts for 14% of California’s total water infrastructure, according to Moody’s. System interconnection also relieves pressure on hard-hit areas, while innovative technologies, including desalination and recycled water, may also serve to diversify water supply.

The impact of worsening drought conditions extends beyond water utilities. Electric utilities also come under stress as they are forced to shift away from hydroelectric production in times of severe drought. Lower water levels yield less hydroelectric production, forcing utilities to supplement hydro power with more expensive and environmentally damaging, conventional generation.

Addressing the Risks

In terms of credit risk, we think utilities are in a strong position to weather the challenges posed by severe drought, as the sector is defined by generally stable revenues, strong debt-service coverage, and robust liquidity. Lessons learned from prior periods of stress with respect to rate structure, conservation, and storage will also help to blunt immediate impact. In response to drought conditions, the Los Angeles Department of Water and Power (LADWP), for example, has implemented a tiered rate structure that scales with water usage. In addition to a base rate with automatic annual increases, the program passes through purchased water and other variable costs to alleviate pressure during periods of stress. Many California utilities have drought or similar charges as part of their fee structures.

Utilities have also steadily increased water storage capacity. The Southern Nevada Water Authority, which supplies water to Clark County, has steadily banked unused water supply and, through several mechanisms, has stored enough water for eight years of use. In California, MWD[ii], which supplies 40% of California’s water and serves 19 million people, has stored water equivalent to 2.5 times annual supply, up from 1.5 times in 2011.

Longer-term conservation and diversification projects are in also in the works. Phoenix’s city-owned water utility, which serves over 1.5 million people, derives the bulk of its water from the Salt River and Central Arizona Projects and actively diverts a third of its allocation from the Colorado River to groundwater recharge.[iii] The city also reports that it is recycling 89% of its wastewater for alternative use, including irrigation cooling for a nuclear power plant. In August, the city of San Diego formally launched a multi-phase “Pure Water” recycling program. The system, which is the largest infrastructure project in city history, includes construction of a sewage purification plant and associated infrastructure and aims to supply 40% of needs by 2035.

Desalination[iv] is another effective diversifier that coastal regions can employ to combat long-term drought impacts. While expensive and somewhat environmentally taxing, given production of brine byproduct and threat to marine life during intake, the process is reliable. The Carlsbad (Calif.) Desalination Plant, launched in 2015 as the product of a public-private partnership (P3) between Poseidon Water and the San Diego County Water Authority, is the largest plant of its kind in the nation and provided 8% of the county’s water supply in 2020. Combined with recycled water, alternative water sources represented 15% of the total supply in 2020. Plans for other desalination plants have followed, including another Poseidon P3 at Huntington Beach in Orange County, which is in development and working through regulatory approval.

Summing Up

Drought has emerged as an increasingly relevant credit and environmental consideration for many utilities, cities, and other local governments, particularly across the Western United States. But water stress is only one of many credit and ESG themes investors must consider as part of a robust analysis of a municipal issuer. We believe a mix of generally strong operating and financial profiles, as well as a heightened focus on drought mitigation efforts, positions issuers well to address the immediate impact of water supply stress, as well as longer-term challenges.

 

i A measure of water volume. One acre-foot represents enough water to cover an acre of land one foot deep. Equivalent to approximately 326,000 gallons.

iiMetropolitan Water District of Southern California.

iiiGroundwater recharge involved flooding an area to replenish underground aquifers, which can be utilized for future supply.

iv Desalination is the process by which seawater (or brackish water) is converted to fresh water. Desalination is commonly accomplished through reverse osmosis, which involves passing seawater over a membrane at high pressure to remove mineral content.

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest-rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially- conscious investors use to screen potential investments.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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