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Chicago Faces Yield Penalty in 'Clean-Up' Deal

CHICAGO — Chicago shouldn't expect much of a break from investors for resolving its credit deterioration-driven liquidity crisis when it sells $1.1 billion of tax-exempt and taxable bonds this week.

Buyside participants expect the city, with Morgan Stanley running the books, to pay yield penalties of 250 to 300 basis points over top-rated municipal bonds in its general obligation sale slated for Thursday, as investors await a resolution of Chicago's more daunting pension funding and budgetary ills.

The bonds are rated BBB-plus by Fitch Ratings and Standard & Poor's and A-minus by Kroll Bond Rating Agency. Moody's Investors Service, which rates the city's $8 billion of GO debt at the speculative grade level of Ba1 with a negative outlook, was not asked for a rating. Chicago faces a roughly $420 million budget gap in its $3.5 billion general fund and a looming $550 million spike in police and fire contributions.

"As a buyer can it get any worse? This might be as cheap as it gets," said Brian Battle, director of trading at Performance Trust Capital Partners in Chicago, of the negative headlines over the city's pension woes, its fall to junk, a looming court decision on pension reforms, and questions over Chicago Public Schools' solvency. "Everyone knows they have to get the deal done. They are going to be price takers."

Ratings-wise, the value of the city's paper could worsen. "To the extent the Chicago?related news cycle continues to disappoint, rating trends will reasonably remain negative. Holders should assume below investment grade ratings from all four agencies are possible in the next two years," Municipal Market Analytics said in its weekly outlook.

That said, Chicago's ability to control its financial future through tax increases "is enough, in MMA's opinion, to continue to consider its GO pledge to be investment grade."

The sale offers $344 million of tax-exempt bonds and $730 million of taxable bonds, with much of the sale moving short-term debt into a longer, fixed-rate term with capitalized interest for two and a half years. William Blair & Co. and Siebert Brandford Shank & Co. are co-seniors and another eight firms rounding out the syndicate as co-managers.

With such a big chunk of taxable securities, the city is broadening its universe of buyers who may be willing to overlook the city's fiscal struggles and invest in a deal designed to clear the city's balance sheet of operating costs at the expense of its long-term debt load.

The limited amount of tax-exempt paper should help, given the market's recent absorption of more than $650 of tax-exempt city GO paper. That deal in late May converted floating-rate debt into a fixed-rate, the first phase of the city's efforts to shed risks that banks would demand repayment of up to $2.2 billion of debt due to defaults triggered by Moody's May 12 downgrade. The city struck forbearance agreements with its bank giving it time to resolve the potential draws.

"There are way more taxable buyers in the world that can look at Chicago debt," Battle said. "There should be competition for this deal, and that will help keep pricing in check. If they had to bring size, taxable is better."

The final maturity on both tranches is 2042. The taxable piece will offer term bonds for $300 million in 2033 and $388 million in 2042, which offer good liquidity. Call features were still being decided.

The city was aiming to stick with a traditional municipal call on the later term bond and a make-whole call common in the corporate market on the 2033 term. Some market participants said the traditional call would cost the city. Make-whole calls offer more investor protections against future refundings, a downside for issuers.


The city's tax-exempt sale in late May came at spreads to the Municipal Market Data's top-rated benchmark of 293 basis points on the 10-year maturity and 264 basis points on the longest 27-year maturity.

The deal didn't offer taxable securities. The spread on the city's 10-year when it last priced GOs in June 2014 was 145 basis points, and had been just 84 basis points in 2013.

On the city's 2014 sale, the city's 30-year taxable maturity landed at 265 basis points over Treasuries. On its previous sale in 2012, the city's 30-year taxable bond priced at 252.6 basis points over Treasuries.

While the city faces an even higher interest rate bill due to the use a taxable structure, it will benefit from narrow spreads between taxables and municipals. The 10-year Treasury yield was at 2.40% Monday and the 30-year yield was at 3.21%, compared with the 10-year muni yield of 2.33% and the 30 year's 3.31%.

"Overall, it is likely worth the added cost to eliminate the risks associated with swaps and bank facilities that have tripped their termination triggers," said Michael Johnson, head of fixed income research at Gurtin Fixed Income Research LLC. "It is unclear if the market would agree with our sentiment here, but we suspect the market does not fully understand these risks."

The upcoming deal further removes the remaining liquidity risks on the city's general fund by shedding bank supported credit lines in default after the Moody's GO, sales tax, and water and sewer revenue bond downgrades.

The city in late May converted more than $900 million in floating-rate GOs and sales tax bonds to a fixed-rate that shed bank support and swap terminations. After Thursday's sale is completed, the city's remaining liquidity risks stem from about $470 million of sewer and water related debts.

Chicago Mayor Rahm Emanuel's new chief financial officer, Carole Brown, has portrayed the deal as a "cleanup" issue that lays the ground work for the city to address its $20 billion unfunded pension tab, which has dragged down its credit and driven up borrowing costs.

Brown and her team stress Emanuel's plan to phase out debt restructuring for budget relief by 2019, the city's plans to continue to build reserves, and its diverse and healthy economy and growing population, even as the offering statement lays out bleak disclosures on the city's fiscal struggles and potential for further credit deterioration.

"The city has embarked upon a series of reforms designed to build a stronger balance sheet, reduce taxpayer risks, and secure the city's long-term financial stability," Brown said in an investor presentation attached to the deal's offering statement.

Market participants characterize the "clean-up" description as a good one given that the city is sweeping so many operating costs into the deal to relieve general fund pressures, tactics that have contributed to the city's growing debt service costs. Emanuel recently announced an overhaul of the city's debt practices aimed at shedding debt restructurings for budget relief by 2019 and curtailing the use of long term debt to cover operating costs.

Proceeds will convert $677 million of debt in the city's short term borrowing program. Debt under the program being converted includes $192 million to cover GO swap termination fees and $170 million to cover a July 1 debt service payment and one in January. It also includes $152 million that helped cover the city's recent conversion of floating rate GOs, a $62 million judgment tied to its parking garage lease, $42 million for increased bank fees due to downgrades, $35 million for a lease tied to the city's failed 2016 Olympic bid, and an $18 million claim tied to its parking meter lease.

The city will use $180 million to cancel a 2005 leveraged lease transaction involving the Orange Line rapid rail transit line to Midway Airport, after the downgrade triggered a default on the city's letter of credit reimbursement contract. The city also will reimburse itself for the $24.5 million that covered swap termination fees on sales tax paper. The deal builds in $170 million of capitalized interest for the first two and a half years.

"We believe it is rarely a good idea to use long-term bond proceeds to pay current expenditures, so this portion only contributes to the problem," Johnson said of the "scoop and toss" funding. The city has pushed off principal payments coming due for budgetary relief in amounts between $90 million and $170 million beginning in 2007.

"This transaction is not the epitome of conservative financial management and illustrates just how difficult Chicago's budget crisis remains," MMA said.

Another buyside analyst said: "I wasn't thrilled with the inclusion of the capitalized interest" but it helps make an overall revenue solution more palatable on the political front.

The city will leave about $140 million outstanding in its short term program and anticipates that new agreements will allow it to maintain a program of between $500 million and $750 million. The city cannot currently tap its short-term lines without bank approval, according to the offering statement. Current providers include BMO Harris Bank, Bank of America, Morgan Stanley, Barclays, JPMorgan, and DNT Asset Trust, a division of JPMorgan.

The city plans to return later this year or in early 2016 with a $700 million of GO borrowing that will include new money, another $220 million in a scoop and toss restructuring of principal coming due in July, 2016 and January, 2017, and capitalized interest.


After the Moody's May 12 downgrade, Standard & Poor's lowered its rating two levels and Fitch lowered it by one notch due to the liquidity crisis that was trigger. Standard & Poor's then last week downgraded the city one more level to BBB-plus from A-minus, removed the rating from its CreditWatch with negative implications and assigned a negative outlook.

Fitch Ratings affirmed the city's BBB-plus rating, removed the credit from its rating watch negative and assigned a negative outlook. Kroll Bond Rating Agency affirmed the city's A-minus and stable outlook.

"The downgrade is based on our view of the city's structural imbalance, which we believe will necessitate the adoption of corrective budget measures over several years," said Standard & Poor's analyst John Kenward. "In our opinion, the city has not yet fully identified a credible plan to address the imbalance."

The rating agency said another downgrade could follow if no plan is outlined by the end of the year.

Fitch said its negative outlook reflects the uncertainty regarding the prospects for sustainable and affordable funding of pensions. "The outcome of the legal challenge to the city's pension reform legislation is still unknown and an adverse decision could cause a further downgrade," analysts said.

A lower court decision is expected on July 24 on a legal challenge to the city's overhaul of its municipal and laborers' fund. The state supreme court, however, will have the final word. "Should the court throw out that reform, expect new negative headlines, rating warnings, and spread widening," MMA said.

The weight of the city's pension burden is compounded by its substantial debt load as well as the pension burdens of other local governments that share the same tax base.

The administration has moved up release of the 2016 budget to September from October. It then plans to hold its annual investors conference to highlight the city's plans to tackle the budget gam and the spike in police and fire contributions under a 2010 mandate to move to an actuarially required contribution from one based in statutes. The city also must fund a higher $100 million payment to its other two pension funds under a previously approved reform package, although the changes face a pending legal challenge.

The city is hoping for state relief on the public safety pension front but it's unclear whether those aims will come to fruition given a state budget impasse.

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