Bad breath (halitosis) is caused by bacteria lodged in the grooves of your tongue, teeth, and gums. This buildup of bacteria causes bad smelling things called volatile sulfur compounds.
When your mouth is dry (like when you first wake up in the morning), you lack the saliva to rinse these compounds out of your mouth.
Drinking water helps flush these bacterias and keeps your mouth from having a build up the bad smelling compounds.