Bonds For Indianapolis Water Company Downgraded

Here's some more bad news for Indianapolis' crumbling financial picture. Fitch today downgraded $842.5 million in bonds issued by the Indianapolis Bond Bank for the water company from AA- to A+. Here's what the rating agency had to say about its decision to downgrade the bonds' rating:

The bonds are limited obligations of the bond bank payable solely from revenues and funds pledged under the indenture. Pledged revenues are derived from net revenues of the Indianapolis Department of Waterworks (the department) waterworks system (the system). The bond bank anticipates selling two series of fixed-rate bonds within the next couple of months that will be used to refund its series 2005G and 2005H bonds, which are currently in auction-rate mode and variable-rate mode, respectively.

The downgrade to 'A+' from 'AA-' reflects the system's weakened financial performance for 2008 (the fiscal year is concurrent with the calendar year) and limitation on restoring fiscal results through timely rate relief. The department is projecting annual debt service (ADS) coverage for 2008 at 0.99 times (x) as a result of rising debt service costs on its variable-rate debt from the current market dislocation. In response, the department is taking steps to ensure a return to historical financial performance by reducing its variable-rate exposure through the refunding of the 2005G and 2005H bonds with fixed-rate bonds in the near future. The department also is proposing to implement heightened fiscal policies and is petitioning for rate relief from the Indianapolis Utility Regulatory Commission (IURC); an expedited rate hike is forecasted to take effect in June. While Fitch believes these measures ultimately will lead to fiscal improvement for the system, the timeframe to fully implement these measures and react to a changing operating environment, particularly with regard to raising rates, poses credit concerns that are more suitable at the 'A+' rating level.

The 'A+' rating reflects the system's adequate financial cushion; moderate capital requirements and above-average leverage ratios; diverse service area; and rate-setting limitation, which is subject to oversight by the IURC. While ADS coverage for 2008 was below 1.0x, other financial metrics have been favorable. Capital needs are moderate but likely will increase debt levels over the medium term, keeping leverage ratios somewhat elevated. Ongoing rate increases will be required. Consequently, it will be important for the department to achieve timely rate relief from the IURC to fund ongoing capital costs as well as restore ADS coverage.

Financial performance for audited 2007 was good overall. For the year, days cash and days working capital were around 490 and 780 days, respectively. In addition, free cash was a strong 210% of depreciation. While ADS coverage of 1.4x was relatively weak, it was consistent with historical results. For 2008 though, ADS coverage fell to just under 1.0x on an unaudited basis as deteriorating market conditions relating to MBIA and DEPFA downgrades precipitated a rise in interest costs of around $15 million more than budgeted estimates on the series 2005G and 2005H bonds.

In an effort to restore coverage margins to historical levels, the department filed a rate petition with the IURC in February for a 17.56% expedited rate adjustment. The department anticipates that the rate increase will take effect in June. With the rate hike, ADS coverage is forecasted to improve to 1.3x by 2010. However, anticipated coverage of 1.2x for 2009, with only one-half year of collections from the rate proposal, will be below the department's internal policy. While the department sets rates independent from the city/county government, rates are subject to approval by the IURC. Nevertheless, it is unlawful for the IURC to approve rates that are too low to provide sufficient revenues to maintain the utility in sound physical condition and produce financial levels adequate to meet system obligations. For typical rate adjustments (i.e. permanent rate increases), the rate recovery process generally takes around 11 months, although the department may petition for an expedited rate request for recovery of unexpected costs, as in the case of the currently pending rate request.

Additional rate hikes will be necessary to fund the department's ongoing capital expenditures. For the 2009-2011 period, the department anticipates capital outlays of around $203 million. Currently, the department has not identified funding sources for these costs, but Fitch anticipates that a combination of additional debt, along with surplus system revenues, will be used. With the February rate petition, the department also is seeking a permanent rate increase (forecasted to be effective first-quarter 2010), which is expected to boost system revenues available for identified capital expenditures.

Debt levels for the system presently are moderate at $2,600 per customer and $878 per capita. In addition, principal amortization of system debt is slow, with just 52% of debt maturing in 10 years. As additional borrowing is used to fund capital projects, debt levels are expected to rise incrementally. However, as a result of the system's extended amortization schedule, cost of service remains affordable at around 0.7% of median household income. In addition, the system should maintain adequate rate flexibility over at least the next several years even with the approval and implementation of the proposed expedited rate hike and the anticipated permanent rate adjustment.

The department is a city department created by ordinance in 2001 to facilitate the purchase of substantially all assets of the Indianapolis Water Company and five smaller subsidiaries of IWC Resources, Inc. By enabling legislation, it owns and operates the system, which serves over 960,000 people within the Indianapolis metropolitan statistical area (MSA). The department contracts for operations of the system with Veolia Water Indianapolis, LLC (formerly USFilter Indianapolis Water, LLC) through a 20-year management agreement executed in 2002 and amended in 2007.

Given the city's location as the state capital, the MSA has a sizeable government sector. The MSA also has a large retail sector as well as a large manufacturing presence, which includes pharmaceuticals and automotives. Typical of the current national recession, unemployment in the MSA spiked in recent months from historically low levels experienced over the decade. However, the area continues to post unemployment rates that are lower than the state and nation. For December 2008, the MSA unemployment rate was 6.7%, compared to 8.1% and 7.1% for the state and U.S., respectively.

Former Mayor Bart Peterson, former CCC President Beurt SerVaas, former City Controller Robert Clifford and former water company CEO Jim Morris all should be holding their heads in shame at the white elephant with which they've stuck Indianapolis' residents. These decision-makers coaxed the Indianapolis City-County Council into approving a purchase of the Indianapolis Water Company in 2002 for$525 million from NiSource, or at least double what the utility was actually worth after NiSource sold off close to $100 million worth of assets after purchasing the utility for $288 million, including Miller Pipeline and SM&P. The City then borrowed heavily to pay for needed capital improvements, entered into a costly privatization agreement with Veolia and prohibited the water company from seeking a rate increase for five years after the purchase to ensure Peterson could make it through his 2007 re-election race without having to raise water rates. The City also assumed an obligation of NiSource's to pay healthy golden parachutes to the water company's executives of a little more than $20 million, $6 million of which was to be paid to Morris.

Here's what is particularly shocking in Fitch's analysis. "For the 2009-2011 period, the department anticipates capital outlays of around $203 million," the report says. "Currently, the department has not identified funding sources for these costs, but Fitch anticipates that a combination of additional debt, along with surplus system revenues, will be used." "With the February rate petition, the department also is seeking a permanent rate increase (forecasted to be effective first-quarter 2010), which is expected to boost system revenues available for identified capital expenditures." We were told we needed an emergency water rate increase of almost 20% on top of the scheduled rate increase to pay for higher interest costs on the current bonds. That resulted in interest rates on the bonds soaring from the 3% range to over 9%. Originally, the City pledged to issue long-term, fixed rate bonds in the range of 5%. The City opted for the adjustable rate bond route in an effort to save money up front. Fitch says the water company plans another $203 million in capital improvements over the next three years. This ensures our water rates will have to double over the next several years. The currently-planned rate increase, if approved, won't come close to covering those additional obligations in the long run, particularly with a down-graded rating for our bonds.