LOS ANGELES — The bankrupt city of Stockton, Calif., will hit the market next week with $55 million of water revenue bonds, issued by its Public Financing Authority.
Facing an expiring letter of credit, the city will instead convert outstanding variable rate demand water revenue bonds to fixed rate in a deal that will make the city water system's debt entirely fixed rate.
The variable rate bonds are backed by a letter of credit from Union Bank, which has extended the expiration date from Oct. 18 to Dec. 17. Upon an event of default, such as a bankruptcy filing, the bank is permitted to require a mandatory tender of the bonds.
"If the bank were to declare an event of default the bonds would become immediately due and payable," said Ken Dieker of Del Rio Advisors, LLC, Stockton's financial advisor. "The utility does not have enough cash on-hand to completely pay off the bonds causing a liquidity concern for investors."
Union Bank is not making any present demand on the city and said it does not plan to, though the risk still remains.
The city plans to price and close the deal prior to the LOC expiration date and has tentatively scheduled it for Nov. 14, Dieker said.
The deal will be priced by Citi and is structured as four term bonds, maturing in 2023, 2028, 2035, and 2040. Orrick, Herrington & Sutcliffe LLP is bond counsel.
Though the bankruptcy filing has triggered a provision under the LOC agreement, the bonds have not been directly impacted by the filing. All of the utility's bonds have been paid in full and on time, without any impairment from the city's bankruptcy proceedings, Dieker said.
"Other than the potential declaration of an event of default under the letter of credit, the ensuing liquidity concerns and several rating downgrades by Standard & Poor's, Moody's and Fitch, there have been no other impacts to the utility from the bankruptcy filing," he said.
The Chapter 9 filing and subsequent downgrades resulted in rising reset rates and LOC fees, prompting the city to approve the interest rate conversion.
Stockton's city council gave its approval in August, provided that the new interest rate does not exceed 6.75%. Dieker said the city expects to secure interest rates within this limit.
Roberto Roffo, senior vice president and portfolio manager at Advisors Asset Management, said such a deal would have to come pretty cheap in the market to meet demand.
"I don't think a retail investor would have much of an appetite for a city that's in bankruptcy," Roffo said. "There's always money, whether it's hedge funds or cross-over accounts, for a deal that comes at the right level, but I believe it would have to be higher than 6.75%."
And while the bonds are not directly impacted by the city's bankruptcy filing and proposed plan of adjustment, they are still tied to the insolvent city, which can cause concern among investors.
"As long as it carries the Stockton name I think there will be some kind of discount in the market, just because of the proximity of the new issue to the credit that is actually bankrupt," Roffo said. "There are always people worried about that."
The bonds will arrive with a split between investment-grade and speculative-grade ratings.
Moody's Investors Service, which assigns the bonds a provisional Ba1 rating and stable outlook, believes the bonds are unlikely to be affected by bankruptcy, noting that the "special revenue" status remains unchallenged.
Under the bankruptcy code, water revenues are considered "special revenues" and are neither subject to the code's automatic stay nor to adjustment in bankruptcy proceedings. And under California's Proposition 218, water rates are also considered property-related fees under the state constitution, and cannot be used for purposes other than the enterprise's operations.
"Despite these facts, bankruptcy proceedings are inherently uncertain and our rating allows for the small possibility that an unanticipated outcome could result from the city's continued bankruptcy proceeding," analysts said in the agency's credit report.
Stockton declared bankruptcy in June 2012. In September, the city proposed a bankruptcy exit plan that has been agreed to by most bond-related creditors.
The plan still needs approval from a U.S. bankruptcy judge, which came a step closer Tuesday when Stockton voters approved a measure to increase the city sales tax three-quarters of a cent in what city leaders said was a necessary part of the exit plan. Part of the revenue from the tax increase, set to take effect on Jan. 1, will go toward bankruptcy recovery and restoring the city's finances.
Moody's said the conversion of the water bonds to fixed rate will eliminate liquidity risk, as well as future renewal and interest rate risks, improving the water system's overall debt profile.
"While the enterprise remained fundamentally healthy, the city's entry into bankruptcy exposed it to the risk of immediate payment of the 2010A debt," analysts said. "This would have severely strained the system's liquidity."
Moody's said it will remove the provisional aspect of the Ba1 rating at closing when the bonds have been successfully converted to fixed rate debt.
The agency also placed the Ba3 ratings on the city's outstanding water revenue bonds on review for possible upgrade due to the reduction in risk that will result from the system's elimination of its variable rate exposure.
Standard & Poor's assigned the bonds an A-minus rating and positive outlook. The outlook reflects the agency's view that during the next two years, debt service coverage will remain very strong the senior lien debt and adequate on combined senior and subordinate lien debt.
The rating reflects the water system's generally good financial performance, very strong liquidity, with $36.6 million in unrestricted cash on hand, and the city's historical willingness and ability to implement rate increases.
Challenges include the city's continued weak economics, including a weak housing market and high unemployment, as well as uncertainty regarding the impact of the city's plan of adjustment.
The city operates two independent water systems, one serving the northern area of the city and one serving the southern portion. The system serves approximately 55% of the greater Stockton metropolitan area, with California Water Services Co. and the county providing the rest.
Fitch Ratings recently upgraded the Series 2010A bonds to BBB from BB-plus, with a stable outlook, based on the system's lower risk profile stemming from the planned fixed-rate conversion.
The Series 2010A bonds were originally issued in variable-rate mode to finance a portion of the city's Delta Water Supply Project, a $221.5 million surface water system to provide the city with an additional, more reliable water source to meet future growth and demand, which has been completed.
After this deal, the authority does not plan to issue any more debt in the near future, Dieker said.
