Christopher Mauro of Merrill Lynch & Co. was elected to the first team in the All-American water and sewer revenue bond sector.

"We certainly don't have any overcapacity problems," Mr. Mauro quipped. Nothing in the past year has dramatically changed the credit quality of the entire sector, he noted.

The themes of recent years continue to apply:

Federal mandates for upgrading wastewater treatment facilities.

Mandates for drinking water.

On the horizon, Mr. Mauro expects to see more mandates for storm water discharges and sludge disposal, as well as combined sewer overflow regulations.

It continues to be a case of increasing federally mandated regulation and the ability of these credits to meet these regulated demands, Mr. Mauro said.

Uncertain Future Paths

Political uncertainty about the presidential as well as congressional turnover make it less clear about the future of regulations. A lot of congressmen who played a powerful role in setting federal levels have retired or face tough challenges in November, Mr. Mauro noted.

"We still don't have clean-water legislation that was supposed to be passed earlier this year. No one knows what changes will mandated under the new legislation," he added.

The new mandates could bode for rapid escalation of charges at the retail level, as well as operation and maintenance expenditures for rehabilitation (other than construction of facilities).

Many Cupboards Still Bare

From the state and local point of view, there is still no money; at the federal level, though there is a perception that lots of money exists. Clearly, conflicting views, but the lion's share of costs must be funded by state and local government.

State revolving funds are a drop in the bucket compared with the overall costs of financing a mandated improvement. That's because a lot of funding in past years was well below what was initially authorized; only recently has the federal government provided more funds.

"Even if all the federal funds for state revolving funds were provided, they wouldn't have met the needs of the sector," Mr. Mauro said.

State Revolving Funds Recommended

While declining to name any specific credits, Mr. Mauro recommends the purchase of bonds used to finance state revolving funds. "You have a basket of names that diversifies the bondholders' risks and the funds typically have strong reserves in the event a loan isn't repaid. Moreover, the management of the projects financed by the state funds keeps tight control and monitors these projects closely."

Key Word: "Independence"

Another area of interest would be bonds issued by any regional authority, with "independence" as the key word. As long as the authority has the mandate to provide the services, they have the power to set rates as needed. The rate setting at the regional authorities is ~depoliticized' whereas, in some cities, the process is political.

"I am concerned that pressure will grow on the issuers, not only because of the already mandated changes in secondary treatment and drinking water standards, but also new regulations on storm-water discharges and combined sewer overflows," Mr. Mauro said. "These are increasing the costs for these systems and projects from the trade groups the costs will continue to grow which puts pressure on rates."

Political Balancing Act

A political balancing act occurs with trade-offs between strong debt ratings and social concerns, such as the ability of the elderly to pay for services, that can lead to political debate.

Ultimately, quality of the water and sewer credits will be viewed more like the electric utilities' sector focus on quality of management. This will be driven by a recognition that these credits cannot control the regulatory environment.

Instead, analysts will focus on how well the management does in areas it can control. For example, look for more credit analysis of billing methods, the ability of management to negotiate modern operating and service agreements (quasi-regionalization), and investor relations.

Additional areas to examine would be rate-stabilization agreements in terms of gauging how up-to-date the management of the system is.

Where Homework is Indispensible

The areas in which investors should be selective and do their homework are the very highly rated water and sewer utility revenue bonds, Mr. Mauro cautioned. "If federal mandates become more severe, some of the very high ratings will not be sustainable over time," he warned.

Another area of concern are cities and regions that have experienced very rapid growth over the past 10 years, where the growth has stopped or slowed significantly. The result can be a lot of significant capital requirements that are still not met and the connection fees are no longer rolling in. "Some of these issuers still are very highly rated," Mr. Mauro added.

A Bright Spot on the Horizon

The only bright spot on the regulatory horizon would be a significant change in Washington.

He believes a Clinton administration may be more sensitive to state and local issues.

"I would hope that if Gov. Clinton wins the election that we would have a more enlightened approach to sharing the pain and cost of these improvements.

"For example, I believe the concept of the state revolving fund will be used on a more selective basis, e.g., to finance storm-water improvements or help rural water districts."

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