"Chicago faces many fiscal challenges, and failure to swiftly address these issues could lead to further rating downgrades into sub-investment grade territory,” writes Nuveen’s Kristen DeJong.

CHICAGO -- Chicago could sink into speculative-grade territory if it fails to make quick headway in tackling its pension and budget mess, Nuveen Asset Management LLC warns in a new research report.

The report assesses the challenges posed by the city's precarious financial condition as Mayor Rahm Emanuel heads into his second term after winning re-election earlier this month.

"Chicago faces many fiscal challenges, and failure to swiftly address these issues could lead to further rating downgrades into sub-investment grade territory," writes Kristen DeJong, vice president and research analyst, in the report "Chicago's Fiscal Stress: New Term, Same Problems."

"How the city addresses its unfunded liabilities, including a looming pension payment spike next year, will be key to the city's fiscal trajectory," the report said.

The city's $19 billion of unfunded pension obligations, looming $550 million public safety pension payment spike, and a roughly $400 million deficit heading into next year have dragged the city's general obligation rating from Moody's Investors Service down to Baa2. That's two levels above junk and the agency assigns a negative outlook.

Moody's latest downgrade on Feb. 27 triggered termination events on four interest-rate swap contracts, exposing the city to payments totaling $60 million if demanded by the counterparties. The city has renegotiated the terms of one of the swaps, avoiding a potential $20 million payment.

Market sources say Chicago intends in the coming weeks to convert to a fixed-rate mode two tranches of multi-modal floating-rate bonds totaling about $360 million from issues in 2002 and 2003. The 2003 sale is tied to one of three unresolved swaps with Wells Fargo. As part of the transaction, the city is expected to cancel the swap and pay it off.

The swap terminations present a minor challenge when held up against the city's pension struggles and political will to tackle them. Nuveen highlights that struggle in its report.

Balancing the budget and addressing the city's massive pension strains after years of underfunding pose a formidable task and Nuveen warns with their sheer magnitude likely make a "property tax increase inevitable."

Emanuel campaigned on balancing four city budgets without a property, sales, or gasoline tax hike. He called a property tax hike a last resort if state lawmakers don't come through on a wish list that includes reform legislation that phases in the public safety spike, approval of a casino, and other tax proposals.

"Additional revenue raising opportunities such as a Chicago-based casino or expanding the sales tax to apply to services would require legislative action by the state and may take too long to implement to fund the looming pension payment," Nuveen said.

Chicago has some room to absorb higher property tax rates. The report cites a recent analysis conducted by the Chicago Civic Federation, which tracks local government and state of Illinois finances, that showed Chicago had the lowest effective tax rate among cities in Cook County and was among the lowest in a larger five-county region.

While Nuveen believes the sheer size of the city's revenue needs make a property tax a necessity, the potential hike to solve the city's problems would be "staggering" without benefit cuts adding to the political challenges.

"Even though the election is over, it may still prove difficult to obtain city council's support for tax increases given a historical reluctance to raise rates," Nuveen warns.

The size of a tax increase grows more daunting when overlapping governmental entities are factored into the equation. The Chicago homeowner of a $400,000 property with a current property tax bill for $6,873 would get socked with a $3,355 hit of 49% to fully fund its local government pensions. Chicago's levy alone would rise by 155.6% and Cook County by 60.8%.

Emanuel won reform legislation for laborers' and municipal employees' pension funds that raised contributions and cut benefits, but they are the subject of a legal challenge. Negotiations with public safety unions have been on hold as all await word from the Illinois Supreme Court on the legality of state pension fund reforms approved in 2013.

The size of the unfunded liabilities raises questions over whether they can remain solvent absent benefit changes, Nuveen warned.

The city's past contributions are based on a statutory formula that has increasingly fallen short over the last decade of reaching the amount needed to cover the annual pension costs. The city's $443 million 2013 payment represented just 25% of the needed annual cost.

Under the municipal and laborers' reforms, the city would phase in a shift to an actuarially required contribution with an increase of $89 million due next year.

"This payment is accounted for in the 2015 budget, but it is not funded with a recurring revenue source so additional resources will be needed to fund future contribution increases," the report says.

Under prior state legislation, the city faces the $550 million contribution spike to move to an ARC funding level on its police and fire pensions, bringing its total payment for the two to $839 million. That shift applies to local governments across the state.

Nuveen notes that the city has failed to ready itself for the higher payment over the last five years.

Chicago's $8.3 billion of GOs are rated A-plus by Standard & Poor's. Fitch Ratings and Kroll Bond Rating Agency rate them A-minus. All but Kroll assign a negative outlook. Kroll assigns a stable outlook.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.