Deal in Focus

Paying a Penalty For Illinois

CHICAGO — With a water revenue deal pricing Wednesday and a pending general obligation deal, Chicago has stepped up its investor-relation efforts as it seeks to minimize the premium demanded by buyers of paper from Illinois-based borrowers due to the state’s liquidity and budget crisis.

The city took retail orders Tuesday on its water revenue issue that includes $33 million of refunding debt, $423 million of Build America Bonds, and $30 million of qualified energy conservation bonds.

The water bonds are secured by net-system revenues that come from consumer payments on a second-lien basis. The bonds are rated AA by Fitch Ratings, Aa3 by Moody’s Investors Service, and AA-minus by Standard & Poor’s. Cabrera Capital Markets LLC is senior manager and TKG & Associates is advising.

Chicago was scheduled to enter the market next week with $804 million of new-money and restructuring bonds that also include BABs, but has decided to postpone the sale in hopes of capturing better interest rates. Loop Capital Markets LLC is senior manager and Wells Fargo Securities is co-senior. Gardner, Underwood & Bacon LLC is financial adviser.
“We are trying to minimize the perceived Illinois penalty by showing investors that the city’s exposure to state payment delays is limited and that we don’t have the same risk as some other borrowers because of Chicago’s home-rule status,” said city chief financial officer Gene Saffold. “The state collects our share of income taxes and sales taxes but it is pretty well caught up.”

A commercial paper program provides Chicago with access to liquidity.

On the GO deal, Saffold hopes to convey to investors that despite the city’s challenges, its financial position is solid. Fitch and Moody’s have downgraded the city over its mounting budgetary woes and reliance on reserves to balance recent budgets.

Chicago’s original reserve of $500 million set up with proceeds from its landmark 2005 Skyway toll-bridge lease deal remains untouched even as the city has nearly drained other reserve accounts.

“Our reserves remain strong and we continue to look at ways to address the structural deficit,” Saffold said. “We have a lot of assets and tools to address investor concerns. Yes, we have a long-term pension problem, but we are addressing it.”

The city is holding additional investor calls and the CFO is making himself available for one-on-one conversations.

The “Illinois penalty” or “Illinois effect” adds a premium of around 50 basis points to a long bond’s yield. The impact is lower for higher rated credits and higher for those with more exposure to the state’s budget and liquidity crisis.

Several local bankers said the penalty can run as high as 100 basis points on BABs and from 25 to 50 basis points on tax-exempts. They also said several funds have told them they won’t purchase any paper from Illinois issuers but will reverse that position if the price cheapens.

“Everyone has to pay for heavy supply, but only Illinois borrowers have to pay for the Illinois effect,” one local banker said. 

The sales follow Chicago’s issue last week of $280 million of second-lien wastewater revenue bonds using the BAB program and refunding debt. George K. Baum & Co. ran the books. The 30-year BAB maturity was priced to yield 6.90%, 290 basis points over the 30-year Treasury that closed at 4% that day and about 50 basis points more than city officials had anticipated earlier in the month.

The wastewater bonds were rated from the high single-A to mid-double-A category. A review of 30-year maturities in several other deals last week of similar size, call features, and ratings carried yields of 150 basis points to 225 basis points over comparable Treasuries.

The Illinois link impacts even sturdy triple-A credits like DuPage County. Its 25-year BAB maturity priced 185 basis points over comparable Treasury yields last week. A 30-year, triple-A rated University of Michigan Regents BAB maturity was priced to yield 155 basis points over corresponding Treasuries.

City officials and several market participants said they believed investors would have little excuse to extract a penalty for either the state’s or the city’s budget struggles on the wastewater and water revenue bond issues. That’s because they are enterprise systems supported by rates paid by system users that cannot be siphoned off to the general fund.

“It is concerning to me and points to the need for more investor education and communication,” Saffold said. “The wastewater and water systems don’t derive any revenues from the state. I thought those would all be favorable attributes that would mitigate the Illinois penalty.”

Illinois is struggling with $6 billion in overdue bills and faces an up to $15 billion deficit going into fiscal 2011, according to state Comptroller Dan Hynes. Democratic Gov. Pat Quinn faced Republican challenger Bill Brady, a state senator, in the governor’s race that was decided Tuesday. At press time, it was not known who won the race.

The Illinois penalty comes on top of the roughly 30 basis point increase in taxable Build America Bonds in general over the last month. The market is absorbing an onslaught of supply as investors worry over the product’s status given the federal government’s delay in extending some form of the program that expires this year.

Market participants suggested other factors also hurt Chicago’s wastewater deal, like market weakness early last week and the city’s decision to siphon the $10 million in interest-rate subsidies expected from the federal government in 2011 for the wastewater and water issues to reduce a $654 million budget deficit.

When Mayor Richard Daley unveiled his $6.15 billion budget for 2011 last month, he announced the city’s intention to divert the subsidies to the corporate fund instead of using them to help pay interest on the bonds next year.

The practice of not pledging the subsidies to bondholders on some revenue-backed transactions is not uncommon due to technical complications that can arise as a result of certain events, such as federal withholding, but most issuers say they intend to apply the funds to repay debt service.

Such a move can contribute to a “perception” problem that, coupled with news of the city’s fiscal struggles, can result in increased borrowing costs even for enterprise systems, according to Richard Ciccarone, chief research officer at McDonnell Investment Management LLC. 

“There’s an expectation you will use the subsidy to maintain or improve debt-service coverage,” he said. “One of the ongoing strengths of the city of Chicago has been the health of its enterprise systems. The city is going to be paying a higher taxable rate on the BABs and investors expect to get the subsidy. Investors may want some premium for any reduction in what they expected to get.”

However, Ciccarone said any penalty shouldn’t be too severe based on a perception problem alone. On the Illinois penalty, he said some sophisticated investors may seek to capitalize on their ability to demand a premium from credits that don’t deserve it based on their limited exposure to state payments.

Saffold defends the diversion of the BAB subsidies. It is legal because the American Recovery and Reinvestment Act of 2009 places no restrictions on subsidy uses. The city enacted a series of rate hikes in 2008 to support debt service and can seek further increases. Enterprise system surpluses can’t be siphoned off to support the general fund.

“We think it’s consistent with the ARRA program, which was intended to create jobs,” Saffold said. “The ability to use the subsidy to benefit our corporate fund allows us to avoid further layoffs or cuts that could hurt the city’s economic recovery.”

David Abel, a quantitative specialist at William Blair & Co., said he suspects “the architects of ARRA deliberately did not place a pledge restriction on the use of the subsidy to give issuers a greater degree of flexibility” in how to use it.

The decision on where to apply the subsidy will be reviewed annually, Saffold said. Mayor Daley recently announced he would not seek another term in the February election, so that decision will be left to his successor.

The upcoming GO sale includes $123 million of Series A tax-exempt refunding bonds that will restructure debt for budgetary relief by pushing off some near-term maturities. The deal includes $213.6 million of Series B BABs for the city’s capital program and $467.5 million of Series C non-BAB taxable new-money and refunding bonds.

The new money will finance various expenses not eligible for tax-exempt status, including judgments and arbitration-ordered retroactive pay. Overall, the refunding pieces will provide about $150 million in budgetary relief.

Ahead of the GO sale, Fitch downgraded Chicago’s $6.8 billion of GOs one notch to AA-minus with a stable outlook. The agency in August knocked the credit down to AA from AA-plus and assigned a negative outlook.

Moody’s in August downgraded the GOs one level to Aa3 with a stable outlook. Those actions followed Chicago’s release of a preliminary budget with a $654 million shortfall. Standard & Poor’s rates the GOs AA-minus with a stable outlook.

Daley’s proposed 2011 budget, which includes a $3.26 billion corporate fund, relies heavily on non-recurring revenues to avoid new tax, fee, and fine increases or deep cuts. The City Council will vote on the plan later this month.

The non-recurring revenues proposed include $120 million from the dwindling reserve accounts set up with proceeds from the city’s $1.15 billion lease of its parking meter system last year, $225 from other reserve accounts, $142 million from restructuring debt, and $38.5 million from surplus tax-increment financing funds. Only $76 million will remain in meter lease reserves.

Daley’s budget limits new spending and includes modest cuts with the elimination of 277 positions. Chicago will maintain a hiring freeze and require furlough days for non-union employees that will trim $96.9 million from the deficit in combination with other personnel cost reductions.

Analysts praised the cuts and also noted the city’s deep and diverse economy as a credit strength.

Saffold said he was hopeful that the city’s decision to leave the Skyway reserve intact would stave off downgrades. Officials have yet to receive the latest reports from Moody’s or Standard & Poor’s.

“We knew the importance of the Skyway reserve,” he said. “It’s what led to rating upgrades and we hoped and anticipated that not delving into it would be viewed positively from the rating agencies.”

The CFO defends the decision to use reserves and debt restructuring in order to limit cuts and layoffs and avoid tax and fee increases.

“The mayor believes that you can’t further burden property owners at a time when their property values are down and unemployment is up,” he said. “These are the steps we needed to take to continue to provide basic services in order to provide a bridge until revenues turn around.”

Saffold said the city continues to look at cutting additional expenses.

Chicago’s unfunded pension liabilities of $14.6 billion are also a credit weakness. Daley has proposed that pension-benefit changes recently enacted for new laborer and municipal employees be extended through state legislation to police and firefighters, but that move would make just a small future dent in Chicago’s liabilities. The city’s four pension funds have a collective funded ratio of just 43%.

Saffold said the city does continue to make payments at the statutory rate, although not the actuarially determined annual required contribution level, but said greater contributions from both the city and employees are on the horizon.

Michael Scarchilli contributed to this story.



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