Deal in Focus

Detroit Schools Seeks to Free Up Ability to Borrow

CHICAGO — Detroit Public Schools will enter the market Wednesday with a $142 million bond issue that will allow the troubled district to get out of an agreement with Assured Guaranty Inc. that for years has cramped its ability to borrow.

It’s a complex deal driven by the district’s need to avoid a looming accelerated payment schedule — but one that could also, given the current market, generate some interest-rate savings.

DPS will use proceeds to redeem notes backed by a pledge of Michigan state aid that were originally issued in 2004 and refinanced into 15-year bonds in 2005. The debt was insured by Financial Security Assurance, now part of Assured.

The transaction will allow the cash-strapped system to escape Assured’s requirement that it begin making accelerated payments on the debt by June 1, a schedule that would double its annual debt payments for the next four years.

The accelerated schedule was part of a waiver Assured crafted with the district in 2010, which allowed DPS to issue additional state aid notes prohibited under the terms allowing the 2005 issuance but are desperately needed by the cash-strapped district to cover operating expenses.

With the waiver, DPS issued state aid-backed notes in 2010 and 2011 that were subordinate to the original 2005 debt.

The accelerated payment provision was triggered early last year, when the Michigan Legislature failed to pass a law that would have insulated the 2005 bonds from bankruptcy.

Lawmakers eventually did pass the law, but only after the Dec. 31, 2011, deadline set by Assured.

The insurer insisted on enforcing the accelerated payment schedule provision, requiring the district to make annual payments of $44.1 million over the next four years instead of $22 million over the next eight years.

Assured declined to comment for this story.

To avoid the accelerated schedule, DPS opted to trigger an extraordinary mandatory-redemption provision on the remaining bonds, an option provided for under the original 2005 bond documents.

Under the redemption terms, the district is required by May 21 to provide the bond trustee with enough money to make the June 1, 2012, debt payment and to redeem the remaining balance of the bonds at a redemption price of par plus interest and a premium equal to 3% of the principal amount of the bonds, according to an April notice to bondholders.

Though technically an extraordinary redemption, the deal essentially functions as a refunding.

The district leaves intact the pledge backing the bonds and the state aid intercept structure, along with the terms of the repayment agreement it has crafted with the Michigan Finance Authority, the issuer of the debt. The original 2020 final maturity will also remain the same.

With a favorable market on its side, DPS could even net some savings despite the redemption premium, according to its finance team. It paid 5% on the original 2005 bonds, which totaled $213 million.

“When we looked at this before, it came at an overall cost,” said Kari Blanchett with Public Financial Management Inc., DPS’ financial advisor. “With the favorable market conditions, the district may realize overall savings from the transaction, in addition to the main goal of the financing, which is avoiding the acceleration of the amended and restated 2004 district note, as required by the terms of the waiver agreement with Assured.”

JPMorgan is senior manager. Siebert Brandford Shank & Co. and Loop Capital Markets are also on the team. Dykema Gossett PLLC is bond counsel and Lewis & Munday PC is the district’s counsel.

DPS, which is Michigan’s largest school district with about 67,000 students, is in its fourth year of state-controlled emergency management.

Its severe financial challenges stem mostly from falling enrollment and declines in per-pupil state aid. The district is expected to suffer a fresh drop in student aid next year as a new state educational authority takes over its worst-performing schools.

DPS also faces challenges from the financial and economic problems of Detroit, which recently narrowly escaped being taken over by the state.

The 2012 bond documents outline a variety of risks to investors, including the new state educational authority, a grassroots effort to overturn Michigan’s emergency management law that governs the district, and possible trouble reaching goals outlined in its deficit-elimination plan.

DPS opted not to put on a road show for investors, though some observers say it has started to stabilize operations with a new team at the helm.

Recent budget figures also show some signs of recovery, district officials said. DPS ended its last fiscal year with an operating surplus of $43 million, chief financial officer William Aldridge noted in an email.

“This represents the district’s first operating surplus since 2002, and reflects the district’s commitment to begin to stabilize its financial conditions and reduce its deficit,” he said.

Despite the district’s ongoing struggles, the current bond issue offers several protections for bondholders, according to Standard & Poor’s, which rates the deal A-plus.

Chief among the protections is an intercept mechanism that requires the state treasurer to send all DPS’ state aid to the bond trustee, which then sets aside a sufficient amount to cover debt payments before returning the surplus to the district.

The bonds also feature strong coverage ratios, reaching 8.4 times maximum annual debt service, analysts said.

State aid payments to the district back the 2005 bonds, which will be redeemed after June 1, as well as the 2011 and 2012 state aid-backed bonds.

The 2012 bonds will be subordinate to the 2011 bonds, which were subordinate to the 2005 bonds, as required by Assured.

The bond covenants require any subsequent debt backed by the state aid pledge to be subordinate to the 2011 and 2012 bonds.

DPS said it expects to borrow additional short-term notes in fiscal 2013.

State aid revenue is well above debt-service needs, even accounting for projected ongoing enrollment decreases, Standard & Poor’s analyst John Sauter wrote in a ratings report on the deal.

“The gap between debt service and state aid revenues is marked,” he noted.

No other rating agency rates the bonds. Moody’s Investors Service maintains an underlying below-investment-grade rating of B1 on the district.

Relatively low interest rates are not the only advantage DPS may enjoy in the current market, according to one Michigan-based bond investor.

“Michigan munis always have an awful lot of maturities that happen May 1, so there is some muni cash that just came due that needs to be reinvested,” said Brad Reynolds, chief investment officer at Troy-based LJPR LLC. “That doesn’t necessarily mean you’re going to be buying Detroit bonds, but there is a little bit of money that’s in the pool now.”

Reynolds added that DPS likely faces the taint of Detroit’s well-reported fiscal problems.

“The story is the same,” he said. “Detroit isn’t DPS but it all gets lumped together. The yield will be there, but it depends in part on the maturity schedule — people are obviously not sure how things are going to look in 10 to 15 years from now.”

A block of the 2005 bonds with a 2012 maturity yielded 1.75% in recent trading, according to the Municipal Securities Rulemaking Board website. A block of the debt with a 2020 maturity yielded 2.99% in late-March trading.



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