CHICAGO – The market reacted favorably Thursday to Chicago’s announcement a day earlier that it would launch a new local government bonding program with its eye first on refunding up to $2.5 billion of debt.

Mayor Rahm Emanuel’s announcement at the city’s annual investors’ conference on his plan to “create a new entity to issue bonds which will be backed by city’s share of Illinois sales tax collections” resulted in an improvement in spreads by “40 to 45 basis points,” said Edward Lee of IHS Markit.

The city said it plans transactions beginning later this year to refund its $515 million of existing sales tax backed bonds and up to $2 billion of general obligation bonds callable over the next couple of years.

Chicago’s general obligations in secondary market trading landed Thursday at about a spread of about 200 basis points over to the Municipal Market Data’s top-rated benchmark.

A Chicago 2036 maturity with a 5% coupon was traded at 4.53% compared to a prior trade before the announcement of 4.99 %. A 2038 maturity with a 6 % coupon was at 4.45% compared to 4.94%.

The tightening come on top of roughly the 45 to 50 basis points that were shaved off spreads just after Illinois lawmakers broke a two-year-old state budget impasse by overriding Gov. Bruce Rauner’s vetoes last month. That package authorized the new local government borrowing program and included the final piece of Mayor Rahm Emanuel’s pension funding overhaul.

Before the budget passage, Chicago GOs were hovering around a 300 basis point spread and the city paid a record high spread of more than 330 basis points on its $1.2 billion GO sale early this year.

“State revenue growth is falling short of the expenditure growth, and as a result, state budgets are under pressure,” says Conning Managing Ditector Paul Mansour.
Paul Mansour, head of municipal credit research at Conning, said the appeal of Chicago's new bond program will depend on its structural and legal sturdiness.

The improved spreads could reflect the market’s initial view that the new program will ease some pressure on the city’s GO credit and make it scarcer, with the result of reducing repricing risk and improving its value, said Paul Mansour, head of municipal credit research at Conning.

One asset management the concern is that city will issue more GO debt, diluting existing holdings. The new program eases those concerns providing some price protection, Mansour said.

The new borrowing program allows home rule units of government to create a special entity and assign a portion of its state collected revenues to the new entity that leverage the revenue in a bond financing.

It’s designed to bypass the city’s weak credit scores, which include a junk rating from Moody's Investors Service, by insulating the bonds and assigned revenues from the risk of being dragged into bankruptcy. The aim is to win higher ratings and lower interest rates.

Fitch Ratings has said similar structures in other states such as New York have garnered AAA ratings.

Mansour said the program is “clearly a positive” for the city as it provides more financial flexibility and “if structured correctly should get higher ratings and lower interest rates, but it’s got to be used judiciously and has to have a very sound, water-tight legal structure.”

Mansour said the structure and legal analysis will prove central to any recommendation he’d make on the bonds, given how investors have been burned by structures they thought were air tight in a bankruptcy proceeding -- such as Puerto Rico’s sales tax debt. “That’s a painful lesson,” he said.

The new program has other benefits. “This should bring back and attract a large number of buyers that have shunned the city’s GOs,” said Mansour, whose firm holds both Chicago GOs and sales tax paper.

It’s a new name and credit that provides asset managers with more diversity -- and given the Chicago name its yield penalties will add to the appeal, Mansour said.

The Emanuel administration has said bankers believe the new bonds will sell at yields under a 100 basis point spread. That’s still a sizeable penalty given the bonds could garner high-grade ratings of double-A or higher and will carry legal opinions backing the city’s position that they are insulated from bankruptcy.

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