The first municipal bond issue in Mexico without a federal government guarantee, the Tlalnepantla water project has already provided the template for further, and much bigger, mandates. The deal is also the first time that the IFC has taken on direct municipal risk - albeit it small at $3.3 million.

Closed in July 2003, the deal is an $8.8 milion triple-A rated local currency financing guaranteed by Dexia and partially guaranteed by IFC to fund a wastewater treatment plant - the first in Tlalnepantla - that will recycle untreated residential and industrial wastewater for industrial reuse.

The project will be operated by Organismo Publico Descentralizado de Carácter Municipal para la Prestacion de Servicios de Agua Potable, Alcantarillado y Saneamiento del Municipio de Tlalnepantla de Baz (AMT). Tlalnepantla has until now lightly treated its sewerage and let it flow into a drainage canal of the Rio San Javier. Furthermore, the Tlalnepantla municipal water supply system relies primarily on Mexico Valley groundwater aquifers, whose levels have been sinking in recent years because of overexploitation.

The new wastewater treatment plant will recycle untreated residential and industrial wastewater for industrial reuse. The use of the recycled water will also free up drinkable water to meet the growing drinking water demands for residential and business customers. This is a long overdue step for a municipality that accounts for 23% and 2.9% of state and national GDP, respectively. The new plant will have a capacity of 200 litres per second and uses proven technology.

While the contract for the plant is still in the final stages of negotiations, it will contain a detailed schedule of works and be tightly monitored, as will disbursement. AMT has already been forced to improve its management and controls in preparation for the new project. The bond structure backing the deal is itself backed by end-user fees flowing directly to a Trust. The end-users are local industrials - a mixed but relatively healthy bag of credits - and payments, made through local banks, will be transferred to the Trust under order of the municipality.

The $8.8 million peso denominated issue carries a coupon of 5.5%, and is of 29,311,000 UDIs (the inflation-adjusted unit, equivalent to MXP95.9 million) with maturity in 2013. The bonds were issued through Deutsche Securities and Banco Santander Mexicano, while Protego advised the municipality. By going local the project is not exposed to foreign currency risk.. But more importantly, the Dexia and IFC guarantees enable the municipality to secure financing from a whole new funding base - local pension funds for example - at a cost that a monoline-backed deal cannot match.

Monolines have expressed interest in local currency deals but as is the norm with a monoline deal - the credit needs to be very strong in the first place and the wrap is both expensive and way beyond the cover required at local level. In simple terms Dexia's letter of credit on Tlalneplanta is cheaper, and enough to raise the issue's rating from Mx.AA to Mx.AAA on the national rating scale.

Despite being small, uptake on Tlalnepantla was strong, pulling in eight retail investors. Mexican pension funds have large sums of money to invest (they are expected to be the mainstay of the government's road programme), and the deal demonstrates appetite for more substantial assets in the future. The project also marks a departure in funding strategy for both the Mexican state and the IFC. The federal government has until recently had a strong hand in local fiscal affairs and traditionally takes charge of public works. Federal participations usually finance infrastructure investment and a municipal bond issue normally relies on central government credits. The Tlalnepantla structure enables a municipality to finance public works entirely through its own future revenues and rmoves debt from the central government balance sheet.

Similarly, IFC involvement indicates a change of tack at the multilateral. The IFC exists to aid private sector involvement in emerging markets. But aside from construction work, there is little direct private investment in the Tlalnepantla project. The IFC appears to be realising that the sub-sovereign sector is a safer bet in getting local infrastructure development off the ground. Tlalnepantla is small but perfectly formed and its significance will be in other future deals. In one potential adaptation, many bankers want to see financings take in multiple sets of assets, in a number of different states. The north, for instance, has water infrastructure wholly inadequate to serving the needs of its growing industrial population. And provided local governments can coordinate, there is little reason why deals cannot break the $100 million mark.

Tlalnepantla Water Company

Status: Closed July 2003

Size: $8.8 million

Location: Tlalnepantla, Mexico State, Mexico

Description: 200 litres per second wastewater treatment plant

Debt: UDI, peso-denominated issue backed by a letter of credit and IFC guarantee

Letter of credit provider: Dexia

Partial guarantor: IFC

Placement agent: Deutsche; Banco Santander Mexicano

Financial advisor: Protego

Technical advisor: Halcrow

Legal counsel: Curtis Mallet-Prevost