OREANDA-NEWS. Fitch Ratings has assigned a 'AA' rating to the following San Antonio, TX water system junior lien bonds, issued for the benefit of the San Antonio Water System (SAWS):

--$303.9 million water system junior lien revenue and refunding bonds, series 2016C (no reserve fund);

--$12.5 million water system junior lien revenue bonds, series 2016D (TWDB DWSRF);

--$14.4 million water system junior lien revenue bonds, series 2016E (TWDB CWSRF).

The series 2016C bonds will be sold via negotiation during the week of Oct. 3. The series 2016D and 2016E bonds will be privately placed with the Texas Water Development Board. Proceeds of the bonds will be used for system improvements and to refund commercial paper that was initially issued to fund system projects. A portion of the series 2016C bonds will be used to refund outstanding series 2007 and 2009 bonds for savings.

In addition, Fitch affirms the following ratings (pre-refunding):

--$1.1 billion in outstanding water system revenue bonds (senior lien) at 'AA+';

--$1.4 billion in outstanding water system junior lien revenue bonds at 'AA'.

The Rating Outlook is Stable.

SECURITY

Repayment security of the water system senior lien revenue bonds is provided by a pledge of net revenues of SAWS' water and wastewater system (the system). The junior lien revenue bonds are paid subsequent to the senior lien bonds. The series 2016C bonds will be issued without a reserve fund.

KEY RATING DRIVERS

SUSTAINED FINANCIAL PERFORMANCE: Although audited 2015 results posted a modest decline to 1.5x DSC, as expected due to the extreme wet weather, all-in debt service coverage (DSC) ranged from 1.6x to 1.7x over the last four years despite severe drought conditions. Fitch expects that SAWS' strong financial planning, as well as recent and future rate increases, will continue to support adequate coverage levels over the long term while keeping pace with ongoing capital needs.

STRONG MANAGEMENT WITH EXTENSIVE PLANNING: SAWS maintains strong management practices, including a 20-year long-range financial and rate forecasting model that incorporates future capital investment and related rising operating expenditures.

HIGH DEBT / SUBSTANTIAL CIP: The system is expected to remain highly leveraged for the rating category given its large capital plan. The system's $1.6 billion capital improvement program (CIP) over the next five years (2017 - 2021) is driven by wastewater needs to comply with regulatory standards, as well as requirements to secure future diverse water supplies.

COSTLY SUPPLY DIVERSIFICATION EFFORTS: SAWS' water supply diversification efforts continue to introduce new non-Edwards aquifer sources to its water supply inventory but at a materially higher cost.

COMPETITIVE RATES: The system's rates are competitive compared with area and state wide peer systems. A comprehensive rate study was recently completed and, despite planned rate hikes to support the system's substantial capital needs, Fitch believes rates will remain competitive and affordable relative to area wealth levels.

STRONG AND DIVERSE SERVICE AREA: San Antonio is the second largest city in the state and seventh largest in the U. S. Prominent sectors include military and government, domestic and international trade, convention and tourism, medical and healthcare, and telecommunications.

RATING SENSITIVITIES

ABILITY TO SUSTAIN FINANCIAL PROFILE: Given San Antonio Water System's substantial capital needs and growing leverage, failure to increase rates as planned and correspondingly generate solid debt service coverage as forecast, would result in financial metrics inconsistent with the current ratings and could result in downward rating pressure.

CREDIT PROFILE

SAWS is the predominant service provider to about 1.6 million residents of Bexar County, serving about 482,000 water and 429,000 wastewater retail and wholesale customers. SAWS is governed by a seven-member board of trustees and rate changes are approved by the city council. SAWS' main challenges continue to be the development of supplemental water resources given the projected doubling of population for the area by the year 2050 and the ongoing sewer system maintenance program.

In 2012, SAWS took over operations of the former Bexar Metropolitan Water District (BMWD), operating the system as a separate component unit, District Special Project (DSP). The acquisition of the former BMWD was a legislative mandate that required SAWS to fully integrate the BMWD into SAWS' system. Earlier this year, SAWS refunded all of the outstanding debt of the DSP, which resulted in the financial dissolution of the DSP and financial integration to SAWS. The financial operations will be consolidated into SAWS financial statements beginning with the Dec. 31, 2016 financial report. The consolidated DSC and liquidity are expected to remain in line with SAWS metrics prior to consolidation. Now included in SAWS customer base are approximately 102,000 water connections that were under the DSP.

IMPROVED COVERAGE SUSTAINED

All-in DSC ranged from 1.6 to 1.7x from 2011 to 2014 despite the prolonged drought. The audited results for 2015 posted a modest decline to 1.5x DSC, but the weaker results reflect the extreme wet weather that brought an end to the four year drought. Preliminary results for 2016 should benefit from water sales closer to budgeted levels, and a 7.5% rate increase, which are projected to yield 1.7x DSC.

SAWS has developed and annually updates a multiyear financing plan that includes expected capital and operational costs and incorporates its planned rate increases. The projections for fiscal years 2017 to 2020 suggest all-in coverage ranging from 1.7x to 1.8x. Moreover, SAWS has recently revised its all-in DSC target to 1.75x from the previous 1.5x. Fitch views the higher DSC target favorably, given the high leverage position of the system and expected debt issuance over the next five years.

HIGHLY LEVERAGED WITH LARGE CAPITAL NEEDS

Outstanding long term debt per customer is high at over $3,300 compared with the 'AA' category median of nearly $2,000. This has been largely driven by the system's need to reduce sanitary sewer overflows in compliance with a U. S. Environmental Protection Agency consent decree, and invest in capital projects necessary to secure future water sources.

SAWS 2017-2021 five-year CIP totals a large $1.6 billion. About 56% of the CIP will address wastewater infrastructure improvements, with the remainder addressing long-term supply and delivery projects. Moreover, roughly two thirds of the CIP is currently planned to be debt funded, and the remainder will be derived from service revenue and impact fees.

SUPPLY DIVERSIFICATION

Historically SAWS has relied on the Edwards Aquifer for the vast majority of water supply. Environmental concerns with the aquifer habitat and recharge resulted in pumping restrictions and led to substantial efforts to diversify the area's water supplies. SAWS began adding several modest non-Edwards Aquifer water sources to its portfolio in 2002. The water supply projects included in the CIP are expected to increase the composition of non-Edwards Aquifer water over time. Fitch believes that water diversification will be a long-term positive to the system despite the significant cost, which is expected to be incrementally absorbed through rate adjustments.

OFF BALANCE SHEET WATER SUPPLY PROJECT

In addition to the CIP, SAWS has entered into a contract to construct a 140 mile pipeline that will deliver 50,000 acre feet (AF) annually to SAWS' intake point from the Carrizo and Simsboro aquifers by 2020. This is projected to be the largest non-Edwards Aquifer water source in its supply portfolio. The pipeline project will be treated as an operating expense (prior to all debt service per the flow of funds) at an estimated cost of $1,600 per AF plus operating expenses. This will result in an increase of an estimated 20% in operating expenditures in 2020 when the project is expected to begin water deliveries. The term of the contract is for 30 years (from completion of the project), at which time the pipeline is turned over to SAWS and is expected to have a useful life of 30-50 years remaining.

The project is currently in the development phase. Certain contract provisions protect SAWS from significant financial exposure during the development phase.

AFFORDABILITY SOMEWHAT MITIGATES COST PRESSURES

SAWS has recently completed a rate study and adopted a new rate structure geared to recover a higher percentage of cost at base service tiers, while maintaining a low life line rate for water use under 3,000 gallons per month. The new rate structure also has eight water tiers instead of four enabling SAWS to recoup base cost at lower tiers and sending conservation signals sooner than the previous rate structure. A 7.5% rate increase for the average residential connection took effect January 2016. Planned rate hikes for total water and wastewater service from 2017-2020 average about 9.1% annually. The average monthly residential bill currently totals $59 (including pass through fees), which is lower than all other Texas urban systems except El Paso, affording the system significant rate flexibility, an important credit strength.