CASE STUDIES IN BLENDED FINANCE FOR WATER AND SANITATION Municipal Bond Issue by the Municipality of Tlalnepantla de Baz (Mexico) August 2016 UNITED STATES Summary Overview Location: Tlalnepantla de Baz, Mexico Approach to Blended Finance: To support a local water conservation project, the Municipality of Tlalnepantla de Baz (Mexico) and its Municipal Water MEXICO Company (OPDM) issued unsecured revenue bonds on the local capital market through a specially created Trust. The bond, issued in local currency was bought by Tlalnepantla de Baz domestic institutional investors. BELIZE Strong and reliable revenue sources from the investment, combined with several credit enhancement mechanisms, GUATEMALA allowed for expanding the borrowing capacity of the HONDURAS municipality and its water utility by reducing interest rates EL SALVADOR and extending the tenor. Credit enhancement mecha- nisms included a partial credit guarantee provided by IFC, and a letter of credit provided by a local bank. IBRD 424XX | AUGUST 2016 Financial Structure and Approach to Context Blended Finance During the 1990s and early 2000s, institutional and In 2003, the Municipality of Tlalnepantla de Baz and regulatory reforms in Mexico’s financial markets facilitated its Municipal Water Company (OPDM) issued a bond the growth of a sub-national securitization market. The through a Mexican trust. This was the first municipal Government of Mexico provided increased autonomy bond in Mexico to finance infrastructure investments by to municipalities and started to explore better options using the project’s revenues instead of depending directly to finance investments by state and local governments. on federal transfers. The bond was intended to sup- The development of the sub-national bond market was port capital expenditure for water conservation projects further supported by the reform of the pension fund sys- undertaken by the municipally owned water utility. There tem, which brought new investors looking for long-term was a pressing need for longer-term financing to better investment opportunities. In the early 2000s the Mexican match the life of the water utility’s assets, and to expand market registered a number of bond issues launched by its financing options for infrastructure. As the municipality, municipalities or state administrations that had no prior home to approximately 800,000 people, is located in one experience with issuance. of the most industrialized areas of Mexico, specific works included the construction and operation of a wastewater treatment plant, so as to reuse residential and industrial Case Studies in Blended Finance for Water and Sanitation: Municipal Bond Issue by the Municipality of Tlalnepantla de Baz (Mexico) wastewater, and an assessment and rehabilitation of the usually has minimal management responsibility and is water distribution network to reduce losses. All these frequently used for financial transactions. The selection of works were for activities that could eventually generate a trust as the conduit offered many advantages, including savings or revenues to reimburse associated costs. fiscal discipline for the Municipality and OPDM. The revenue bond was issued in local currency for the The external credit enhancements provided by IFC and equivalent of approximately US$9.1 million, with a tenor Dexia were administered in Mexican Pesos for close of 10 years (extendable by one year). Normal tenors to the amount of the borrowed capital, and were to be in Mexico at that time were three to six years; such issued on behalf of the bondholders in the case that lengthening in tenor was achieved through transparently funding was insufficient. The enhancements took the assigning OPDM’s revenues to service the debt, com- form of a letter of credit issued by Dexia Crédit Local, bined with credit enhancement mechanisms. and a partial credit guarantee from IFC to cover part of Dexia’s exposure under the letter. The International Finance Corporation (IFC) and Dexia Crédit Local (a development bank subsidiary of the Dexia While the bond issue was chiefly backed by the OPDM Group—a large financial group in Europe), acted as co- revenue pledge, additional reinforcement was provided guarantors. In Mexico, subnational governments could through a second municipal revenue pledge in the event not borrow from non-Mexican based financial institutions, that the water revenues proved insufficient. The addi- and this included guaranteeing bonds sold directly by tional revenue pledge came from municipal tax revenues municipalities. The issue was resolved with the estab- from the parent municipality. This double-barreled pledge lishment of a trust to conduct the bond sale, while the of revenues has been regularly used for municipal bond proceeds were on-lent to OPDM, with the Municipality as issues in the U.S. market, and guarantees an additional joint obligors to finance the water conservation project. level of security to the trust. Figure 1 shows the financial A trust is a type of special purpose vehicle (SPV) that structure for the water conservation project. FIGURE 1  Municipal Bond Issue by the Municipality of Tlalnepantla de Baz, Mexico: Financial Structure IFC Dexia Local Bond Market Partial Letter Bond Bond Credit of Credit Proceeds Coupon Guarantee Repayments Legend Tlalnepantla de Baz Private Trust Supply of Finance Pledge of Municipal Loan Debt Service Revenue Repayment Flows Revenues from Pledge Property Taxes Credit Enhancement Public/Donor Municipality of Municipal Water Agencies Tlalnepantla de Baz Company (OPDM) Private Financiers Financial Water Intermediary Tariffs Service Provider Water Conservation Projects 2 Water Global Practice Case Studies in Blended Finance for Water and Sanitation: Municipal Bond Issue by the Municipality of Tlalnepantla de Baz (Mexico) Results References This was the first municipal bond issue in Mexico IFC. 2003. Summary of Project Information: Tlalnepantla designed to finance infrastructure investments and sup- Municipal Water Conservation. Washington, DC: ported through the local entities’ own revenue sources, International Finance Corporation. without using direct federal transfers. The bond issue Leigland, J. 2004. “Municipal Future-Flow Bonds in Mexico: obtained a AAA rating (by Standard and Poor’s and Lessons for Emerging Economies”. Journal of Structured Moody’s Mexico), which was higher than the municipal- Finance. Vol. 10, No. 2: pp. 24-35. ity’s AA rating, thanks to the partial guarantee. It was fully subscribed by eight domestic financial institutional Trémolet, S. 2010. Innovative Financing Mechanisms for the investors. The rating allowed the Municipality and OPDM Water Sector. Paris: OECD. to access financing at lower costs and over a longer term USAID. 2005. Case Studies of Bankable Water and Sewerage without a sovereign guarantee or backing of intergovern- Utilities. Volume II Compendium of Case Studies. mental transfers. The bond was issued in local currency, Washington, DC: USAID. http://pdf.usaid.gov/pdf_docs/ and this reduced the foreign exchange risk as the utility’s Pnade148.pdf revenues are also denominated in local currency. USAID. 2009. Financial Sector Series #1: Enabling sub- sovereign bond issuances: Primer and Diagnostic Checklist. Washington, DC: USAID. http://pdf.usaid.gov/pdf_docs/ Lessons Learned Pnadu683.pdf Legal and regulatory frameworks dictate subna- WEF OECD. 2015. Blended Finance Vol. 1: A Primer for tional governments’ capacity to engage in innova- Development Finance and Philanthropic Funders. Geneva: tive financing. In Mexico, reforms during the 2000s World Economic Forum. gave local government greater financial autonomy by allowing them to issue debt based on their own financial practices, and independent of the national government. The reforms were a large factor in the emergence of a domestic municipal credit market. Revenue streams from the investment assigned in a transparent manner proved to be an effective way to repay debt. In the case of Tlalnepantla, OPDM’s revenue stream was clearly set aside, and the municipal tax revenue pledge provided an additional guarantee. Furthermore, credit enhancements helped strengthen the deal. Mexico’s domestic capital markets benefited from the bond issue. It allowed diversification of longer-term investment opportunities. Banks have shown increased willingness to provide funding for longer maturities to better match the life span of infrastructure investments required by municipalities for water projects. This financial structure is a successful model; however, it may only work for larger and financially healthy municipal governments. It may not be eco- nomically feasible for smaller municipalities looking to issue a bond on their own. www.worldbank.org/water 3 Case Studies in Blended Finance for Water and Sanitation: Municipal Bond Issue by the Municipality of Tlalnepantla de Baz (Mexico) This case study is part of a series prepared by the World Bank’s Water Global Practice to highlight existing blended finance experiences in the water sector. Blended finance refers to “the strategic use of develop- ment finance and philanthropic funds to mobilize private capital flows to emerging and frontier markets,” as per the OECD definition (WEF OECD, 2015). Concessional funds can be used in a catalytic manner to open up new oppor- tunities for commercial financing, by providing technical assistance to borrowers and lenders to help them become more familiar with each other, help structure transactions, provide credit enhancement mechanisms, etc. Private capital flows can help with meeting immediate financing needs for investment in the water sector but ultimately need to be repaid. Repayable financing from private sources to the water sector can come in vari- ous forms, including as commercial bank loans, bonds or equity. To obtain such financing, water-sector actors need to be able to repay the borrowed amounts and the associated funding costs, which means that they need to be deemed “creditworthy” by providers of finance. Contact Us For further information please contact Joel Kolker (jkolker@worldbank.org) or Sophie Trémolet (stremolet@worldbank.org). 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