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Fitch Drops $3B of Detroit Sewer Debt Ahead of New-Money Deal

CHICAGO — Fitch Ratings downgraded $3 billion of Detroit’s sewer bonds as the city prepares to enter the market with a new-money issue in mid-June, in part to cover the expense of terminating costly interest-rate swaps.

Fitch on Tuesday dropped its rating to A-minus from A on $1.4 billion of outstanding senior-lien sewer revenue bonds and lowered $1 billion of second-lien sewer to BBB-plus from A-minus.

The rating agency assigned an A-minus to the upcoming senior-lien sewer bond offering, expected to consist of at least $498 million of new money and possibly an additional refunding piece.

The Detroit Water and Sewerage Department’s shaky financial performance as well as the increase in debt from the upcoming borrowing drove the decision to downgrade, according to Fitch analyst Doug Scott.

“The financial performance has been weaker than we expected,” Scott said. “Secondly, with this transaction, the termination of the swaps is converting a contingent liability into a hard liability, and it severely weakens their debt portfolio.”

The upcoming $489 million borrowing includes $288 million that will finance the termination of swaps, as well as $185 million for various capital projects and cash for a debt-service reserve fund. The department also has the authority to refund debt for savings. The sale is set for June 14 with Goldman Sachs as senior manager.

It’s the second time in several months Detroit has borrowed to terminate interest rate swaps. In December, the city sold $500 million of senior-lien water bonds, using about half of the proceeds to finance the unwinding of 15 interest rate swaps tied to the water debt.

Moody’s Investors Service hit Detroit’s $4.6 billion of water and sewer debt with a three-notch downgrade in early April. The rating report said Gov. Rick Snyder’s appointment of a team to review Detroit finances in late December triggered a termination event for the sewer debt swaps.

Moody’s is keeping the debt on review for another downgrade, which will be decided in part on the city’s ability to terminate the sewer-bond swaps and develop a plan to pay for the increased debt-service payments from the new debt.

The water and sewer department also could face a liability tied to interest-rate swaps that hedge $800 million of Detroit pension debt. A termination event has also been triggered on the pension debt, and, if the counterparties opt to terminate the contracts, the water and sewer systems would likely have to cover part of the payment. Fitch estimated the sewer system’s payment at around $37 million.

On the plus side, terminating the swaps and shifting the debt into a fixed-rate mode will eliminate counterparty and interest-rate risk, according to analysts.

Detroit has $4.6 billion of water and sewer bonds that it has issued through the water and sewer department. Analysts have generally considered both systems to be isolated from Detroit’s fiscal problems. The city owns the systems, but they are operated as separate enterprise funds, and most of their revenues come from outside Detroit.

Despite their independence, the systems are still exposed to the Motor City’s struggles which have escalated over the past year amid a threat of a state takeover, bankruptcy, or default.

“Any change or influence by the city that negatively affects governance of operations of the system would call into question the insulation of the system from the city,” Scott wrote. “This would likely result in immediate and severe negative pressure on the system’s rating given the city’s marginal credit quality.”

Standard & Poor’s maintains A-plus and A-minus ratings on the senior-lien and subordinate-lien water and sewer debt.

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