Despite California drought, returns on water bonds shouldn’t dry up

On a recent trip to California, an interesting pattern developed as we conducted a series of meetings with some of our investment partners. Several financial advisors indicated that they were avoiding water revenue bonds as investment alternatives at all costs. It was apparent to us that the headlines surrounding the drought conditions in California were having an effect on the perception of water bonds from fiduciaries. This was the case despite the sector traditionally being considered the most conservative in the municipal market based on the highly essential nature of the services provided within the sector, the monopolistic business nature of the sector, and the local rate-setting authority maintained by most water and sewer providers.

In response to the drought, Governor Jerry Brown declared a drought State of Emergency in January 2014 and issued a voluntary 20% reduction in water usage. As the drought continued and conservation efforts fell well short of expectations, the governor issued a mandatory water reduction on April 1, 2015, to reduce potable urban water usage statewide by 25% by February 2016, compared to 2013 levels. This marks the first time in history that water-use restrictions have been mandated.

While the drought in California has had a serious effect on the state’s available water supply and has led to sizeable conservation efforts, the reality for bondholders is not necessarily as dire. The potential remains for some water and sewer utilities to experience negative financial consequences from the effects of the drought and subsequent conservation efforts. However, we expect most California water and sewer utilities to remain insulated from these effects due to the fact that many utilities had stronger financial metrics heading into the drought period, they have independent rate-setting flexibility, and managements of many utilities have taken effective measures to prepare for the potential outcomes of the drought.

While the drought in California has had a serious effect on the state’s available water supply and has led to sizeable conservation efforts, the reality for bondholders is not necessarily as dire.

In fact, California water utilities have seen improved credit quality over recent years, which we expect should provide a cushion toward any potential operational weakening that may occur as a result of the drought. This was highlighted in a recent J.P. Morgan report which stated that California water utilities posted median debt service coverage of 2.71 times in 2013, the highest level of coverage since 2008. The report also noted that liquidity positions have remained adequately strong. In regards to the independent rate-setting flexibility, California water utilities have the ability to raise rates by complying with Proposition 218, in order to offset declines in usage. Management’s response to the drought and any potential cutbacks in usage also is a key to maintaining a water utility’s financial strength. Management must be willing to implement needed rate increases while successfully navigating the conservation requirements being imposed by the governor.

On the Delaware Investments Municipal Bond team, we rely on our credit research to identify the best investment opportunities in the sector. One of our holdings, the San Francisco Public Utilities Commission (SFPUC)*, which we hold in Delaware Tax-Free California Fund, Delaware Tax-Free USA Fund, and Delaware Tax-Free USA Intermediate Fund,Delaware Tax-Free California Fund, Delaware Tax-Free USA Fund, and Delaware Tax-Free USA Intermediate Fund,Delaware Tax-Free California Fund, Delaware Tax-Free USA Fund, and Delaware Tax-Free USA Intermediate Fund, was highlighted in an April 21 report issued by Standard & Poor’s, “How Will California Water Utilities Fare Amid The Long Drought And New Conservation Mandates?” The report identified SFPUC as a utility that had already met the required conservation standards in 2014, before Governor Brown’s initiative was passed in April. As a result, it requires no additional conservation to comply with the executive order in 2015.

In sum, we expect the majority of California water utilities to be largely insulated from the potential negative effects of the drought and subsequent conservation efforts as financial metrics were strong heading into the drought, the utilities have sole rate-setting authority, and we believe management teams will be well prepared to take necessary actions. The key is to avoid water utilities that had weaker financial metrics heading into the drought and those with management teams unwilling to make the necessary decisions. We are looking for any spread widening in the California water utilities we favor as an opportunity to add to our exposures.


*As of April 30, 2015, bonds issued by the City of San Francisco Public Utilities Commission represented 2.14% of the Delaware Tax-Free California Fund, 0.97% of the Delaware Tax-Free USA Fund, and 1.15%, of the Delaware Tax-Free USA Intermediate Fund.

The views expressed represent the Manager's assessment of the market environment as of June 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

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