Detroit Bonds Set to Price

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DALLAS — Detroit, planning its first post-bankruptcy general obligation/distributable state aid backed bond sale, could pay a price because of the state's disruption of a similar Detroit Public Schools security, one municipal market participant suggested.

The $615 million refunding is expected to price as soon as Thursday, using the Michigan Finance Authority as issuer. Barclays is running the books and distributed potential refunding candidates Wednesday.

Municipal Market Analytics said the bonds may require "a larger-than- anticipated" penalty because of the state's disruption to the security of similarly structured Detroit Public Schools state-aid backed bonds due to the district's overhaul.

City finance director John Naglick sought to highlight the differences between the city and school district structures and the fact that the city's DSA bonds were protected during the city's historic Chapter 9 bankruptcy.

The financing team has been engaged in an aggressive and broad-based investor outreach and educational effort since early Monday, he added. "That effort continues, and is producing a very high and increasing volume of investor inquiries," Naglick said.

MMA said Detroit's short-term progress since emerging from Chapter 9 in late 2014 doesn't offset longer-term investor risks, heightening concerns over the state's position, MMA said.

"It's clear that the state can't be trusted with respect to its willingness to pay municipal bond holders especially when it comes to bonds held by Detroit," said MMA partner Matt Fabian.

"Remember that the city's economic and financial future remains far from secure, and Detroit is at serious risk of relapsing into bankruptcy within the next 10 years," MMA wrote in its weekly outlook. "Buyers of the new bond series are thus betting directly that the state will change its tack and develop a willingness to pay city of Detroit bondholders in the future.

"This is not an unreasonable speculation by risk-aggressive managers who have clearly communicated their plans to their own investors. However, this bond series should not be the province of traditional retail," MMA added.

The state aid statutory lien is central to the investment-grade ratings on the $615 million deal, which comes in four series.

They are a $247 million of taxable first lien limited tax GOs in a mix of term and serial maturities; a $125 million taxable third-lien limited tax GO in a mix of serials and terms; a $225 million fourth-lien tax-exempt unlimited tax GOs tranche with serial maturities; and a final $18.1 million taxable fourth lien unlimited tax GO tranche in serial maturities.

The state support is key because market perception of Detroit was tainted by its poor treatment of GO bondholders as it shed $7 billion of debt to emerge from Chapter 9 in late 2014. Detroit's GO ratings remain in junk.

The concerns over the DSA pledge are tied to the Detroit Public Schools restructuring and the fate of DPS' bonds secured by that pledge as the funds now will go to a newly created district free of debt. The former district remains intact to continue collecting tax revenue to retire debts.

S&P Global Ratings recently downgraded the school district's state aid bonds from 2011 and 2012 issues to BBB from A and BBB-minus from A-minus, respectively, citing concerns that the district restructuring could disrupt pledged aid. The Michigan Finance Authority recently approved a $235 million financing to restructure the bonds, but final details have not been made available.

Fabian said it's clear the MFA will take action to restructure the bonds but without more detail "bondholders holding the DPS bonds are being presented with more anxiety than they probably bargained for when they bought those."

Naglick disagrees that there is a correlation between the city's refunding and the outstanding DPS bonds.

"The distributable state aid pledged by the city is appropriated to the city under a different statute from the one under which state aid is appropriated to and pledged by school districts," he said.

"Additionally, a significant portion of the DSA is allocated to the city by the constitution, not statute. The bonds of the city and DPS are also issued under different statutes. Finally, in its bankruptcy proceedings, the city did not impair, did not attempt to impair, and throughout that process treated as secured its DSA-backed debt."

The deal's list of "risk factors" begins on page 41 of the offering statement and goes on for about four pages.

"Limitations on Remedies of Bondholders" is likely to catch the eye of investors.

If Detroit were to file for Chapter 9 again it could have "significant adverse consequences affecting bondholders," the document says. Those risks could include "immediately delaying for an indefinite period of time payment on the bonds, modifying the maturity date, interest and payment terms and conceivably modifying the security for the principal amount."

The deal is a trustee-managed structure. Set-aside payments must be funded in full before Detroit can receive any state aid for operations, and all of the collections not used for debt service will remain with the trustee to fund debt service payments.

"I don't think that the bonds are going to price at their rating levels," said Howard Cure, director of municipal bond research at Evercore Wealth Management. "There is no way investors would be interested [in these bonds] if it didn't set up structurally where the state is sending the money directly to a trustee. They want to make sure it's essentially bankruptcy remote and avoid having the city get their hand on the money first."

Moody's Investors Service and S&P Global Ratings last week affirmed the single-A to double-A ratings on Detroit bonds backed by distributable state aid and sold under the MFA's local government loan program. The city's DSA includes a portion of the 6% retail sales tax revenues collected across the state.

There are two elements of the sales tax that are distributed.

"One is sort of constitutionally protected and the other requires some sort of legislative approval," Cure said. "The risks are that the legislature makes some pretty big cuts to that program where they control the appropriation and for the lower tranches you wouldn't have coverage."

The constitutional component is mandated by the state constitution and distributed on a per capita basis to townships, cities and villages. It isn't subject to reduction by the state legislature.

The statutory component of state aid is authorized by legislative action and distribution is subject to annual state appropriation by the state legislature.

Cure said there is the additional concern that state aid payments may vary because part of the formula for distributing the sales tax is based on population. The state constitution limits the rate of sales tax to 6% and mandates that 15% of the total sales tax revenues collected from the sales tax levied at the rate of 4% be distributed on a per capita basis.

The amount of distributable state aid can therefore be adjusted based on fluctuations in the city's population.

The actual statutory and constitutional distributable state aid payments allocated to Detroit have slightly increased each year starting in fiscal 2013.

"Detroit seems to have stabilized its population but if they were to regress that sales tax amount is in jeopardy of declining," said Cure. "There is also the added layer of risk of Michigan's economy since it's a statewide sales tax. I think there are certain investors that might be leery of some of the bonds because of that element."

The stronger liens offer more insulation to those risks.

The deal is projected to generate savings of about $40 million that the city would use to provide budgetary and property tax relief.

In August 2015, in its first post-bankruptcy bond sale, the city sold $245 million of local government loan program revenue bonds through the MFA. The debt was enhanced with a statutory lien and intercept feature on the city's income taxes, which landed the deal an A rating from Standard & Poor's.

The city paid tax-exempt yields that landed 194 basis points over the Municipal Market Data's top-rated benchmark and 133 basis points over an A-level credit. The $110.28 million taxable series was priced about 300 basis points above comparable Treasuries.

— Chip Barnett contributed to this story.

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