Poor’s view that operation and maintenance expens-
es must be paid in order for a system to be a viable,
ongoing concern that will generate revenues for debt
service, whether pledged on a net or gross-lien basis.
Standard & Poor’s will review the security pledge to
ensure that ongoing revenues are available for debt
service payments. If the pledge allows prior period
revenues through the use of a rate stabilization fund
then it is better that those revenues provide the rev-
enue cushion stated in the rate covenant and that
revenues derived from the operation of the utility
alone provide at least one times annual debt service
coverage. If an issuer intends to use tap fees, system
development fees, or connection fees as part of the
pledged revenue stream it is important that the sys-
tem has at least sufficient coverage from operating
revenues alone. If operating revenues are insufficient
it may be necessary to demonstrate that operating
revenues are intended to cover annual debt service
within a few years.
While the typical senior-lien pledge of an enter-
prise’s net revenues is considered to be the most
secure, junior-lien debt need not always be rated
below senior obligations. In cases where the senior
lien has been legally closed and the creditworthiness
of the issuer supports the higher rating, an argu-
ment can be made to rate both the senior lien and
subordinate lien at the same level. Also, if an issuer
has a proportionately smaller amount of senior lien
debt versus subordinate lien debt and if the general
creditworthiness of the issuer warrants it then the
two liens can be rated on par.
Finally, in some cases the general creditworthi-
ness of the issuer is strong enough to allow the sen-
ior and subordinate debt to be rated on par. Many
issuers have set internal policies to operate the
water and/or sewer systems at coverage levels well
above the rate covenant to generate sufficient rev-
enues to fund a large portion of the capital
improvement plan. When an issuer consistently
operates in excess of the legal rate covenants of
both the senior and subordinate debt, this could
justify the support of equivalent ratings.
Rate covenants
The rate covenant, actual coverage, and the ability
to raise rates are factors that provide credit strength
to water and sewer utility revenue bonds. With
most utility financing, the rate covenant requires
management to set rates for service that will gener-
ate net revenues sufficient to provide a defined min-
imum level of debt service coverage—typically
1.10x to 1.20x. While this range is the norm, rate
covenants as low as 1x are acceptable in situations
with limited operating risk. While a 1x (sufficiency)
rate covenant would be acceptable, Standard &
Poor’s expects to see higher levels of coverage inmost years. The covenanted level is the minimum
level and is considered the exception rather than the
rule over the long term.
Again, the definition of revenues providing the
coverage is as important as the covenanted level of
required coverage. Generally, recurring revenues
from operations should be sufficient to cover debt
service, and only such revenues should be defined as
“net revenues”. Cash balances and nonoperating or
nonrecurring revenues such as developer fees, system
development charges, and connection fees are some-
times included, but cause additional concerns. Often,
these resources are available for use only once, and
depletion of those resources can put significant pres-
sure on rates. Although “rolling coverage” is becom-
ing increasingly common, operating revenues should
typically cover operating costs and Standard &
Poor’s will analyze coverage calculations both with
and without non-operating revenues.
Additional bonds tests
The additional bonds test ensures existing bond-
holders that a minimum level of coverage has been
met upon the issuance of additional parity debt.
Standard & Poor’s focuses on whether the issuer’s
right to offer senior or parity bonds at a later time
could result in a dilution of coverage. A conserva-
tive additional bonds test requires that net revenues
for a prior fiscal period (the previous fiscal year or
12 consecutive months) equal at least 125% of the
maximum annual debt service requirement, taking
into account the issuance of proposed bonds. A test
that measures historical earnings is stronger because
it is less speculative than those based on revenue
projections. Often, projected tests rely on assump-
tions that may not be realized, such as future rate
increases or revenues generated by new facilities.
Adjustments to historical net revenues to reflect
new customers or rate increases, which have been
implemented prior to the proposed bond issuance,
are common and acceptable. While a conservative
ABT helps mitigate future bondholder risk,
Standard & Poor’s also takes into account the
scope of the capital program and related risks and
impact on a system’s financial profile.
Flow of funds—transfers out
The flow of funds specifies the order and timing in
which system revenues are used to meet the obliga-
tions created by the indenture. Of critical impor-
tance to the rating is the lien position of debt
service payments in relation to other system obliga-
tions outside of ordinary operations and mainte-
nance costs. Also, Standard & Poor’s looks for
established reserve funds, such as debt service
reserve and renewal and replacement accounts to be
funded in turn, to provide additional cushion forGeneral Government Utilities118 Standard & Poor’s Public Finance Criteria 2007