Chicago heads into a hungry market with an upsized deal
The buy side’s hunt for yield will eclipse its worries about Chicago’s pension burden, vulnerability to a future recession, or the front-loading of refunding savings on the city's upsized $1.47 billion of borrowing this week.
Chicago heads into the market Wednesday with the general obligation bond piece of the refunding and then Thursday with second lien Sales Tax Securitization Corp. bonds to refund outstanding debt. The deal size increased primarily because of favorable replies to the invitation to tender $1.8 billion of high yielding candidates.
“The city was able to take advantage of favorable market conditions and the attractive taxable STSC interest rates through the first tender in the city’s history,” chief financial officer Jennie Huang Bennett said in a statement announcing an additional $40 million expected savings that complements the $210 million in deal savings being taken this year.
The city had intended to sell a C series of $220 million forward delivery bonds under the STSC credit next month as part of the up to $1.5 billion City Council authorization for the deal, but will now sell that later in the year. The city expects additional savings to be added to the overall deal once sold. The city will require additional council authorization.
Some investors with worries about Chicago’s long-term prospects may also be calmed by near-term stability that gives Mayor Lori Lightfoot’s new administration some time to enact plans being promoted to structurally balance the city’s books.
“I think it hasn't gotten worse, which is good, and it's a little premature to say but they've set out these goals and benchmarks and that's how they are going to be assessed and monitored from investment community,” said Howard Cure, director of municipal bond research at Evercore Wealth Management LLC.
“I think the market is such that there’s a lot of demand for paper so the expectation is there will be a lot of demand for the Chicago deals because investors are struggling to get yield in this market,” Cure, who attended the city’s investor meeting in New York City last Thursday, said of the deals.
Rating agency affirmations following approval of Lightfoot’s $11.65 billion 2020 budget in November also help.
“The city’s budget seems to have satisfied the rating agencies as they have all affirmed their ratings for Chicago’s general obligation bonds, which indicates short-term credit stability,” John Miller, Nuveen Investments’ head of municipal municipals, said in an email.
“While we recognize the city is working towards structural balance over time, there remains a hole to fill. Relying on a significant amount of one-time measures to balance the budget, including taking savings from refinancing debt up front, is not ideal but also not surprising given the magnitude of the deficit,” Miller said.
“It’s all about supply and demand and there’s still a scarcity of high yield paper,” said Vikram Rai, Citi’s head of municipal strategy group. Rai believes investors are willing to give the city time to solve its fiscal strains but also worry about Chicago’s ability to weather a downturn.
The city will sell about $350 million of general obligation bonds to refund callable GOs Wednesday. The city will take indications of interest Wednesday on the taxable portion of $466 million and price Thursday the $636 million of tax-exempt debt through its Sales Tax Securitization Corp. under the new subordinate lien to refund GOs, motor fuel tax bonds and Chicago Infrastructure Trust notes and cover the purchase of tendered bonds. Both include capitalized interest.
Fitch Ratings rates the GOs BBB-minus, Kroll Bond Rating Agency rates them A, and S&P Global Ratings rates them BBB-plus. All assign a stable outlook.
The new STSC bonds second lien was rated AA-minus by S&P, the same as the senior lien which was previously downgraded one notch due to revised criteria, and AA-plus by Kroll, one notch below the senior lien. It was unclear if Fitch would rate the deal as its revised criteria on tax supported bonds more closely linking ratings to the obligor credit was just published Friday.
The deal provides more than $200 million in upfront savings to help close an $838 million gap in the 2020 budget while additional savings would be captured in future years.
The upfront savings are among the one-time sources that made up about 40% of 2020 budget fixes with the other 60% made up of structural fixes in the form of new revenues and cuts as the city works toward a 2022 target to reach structural balance.
The structural fix relies on state legislative passage of tax changes to a proposed Chicago casino and the city’s existing real estate transfer tax that combined would eventually an estimated $300 million.
GO Bonds and the STSC
The one-two punch of the GO and STSC pricings should provide insights for both the city and the market on the STSC’s value, market participants said.
“The idea of bringing them together is a good one as it will lead to good price discovery and they will get a better view on how viable the strategy” is to use the STSC as a borrowing mechanism, Rai said.
The 10-year maturity in the city’s November 2018 STSC bonds landed at an 87 basis point spread to the Municipal Market Data top benchmark. Chicago’s last GO sale in March saw the 10-year in the deal land at a spread of 170 basis points.
“There is nothing fundamentally different about either the Sales Tax Securitization Corporation Bonds or Chicago’s credit” since the last pricings, “therefore, any change in spread levels is more about the municipal bond market’s lower interest rates and quest for yield,” Daniel Berger, senior market strategist at MMD-Refinitiv, wrote in a column this week.
"I think it does a service to the municipal market and to the city" that allows them to gauge the value of the STSC credit verse the traditional GO, said Richard Ciccarone, president of Merritt Research Services.
Weighing on the credit
The reliance on the state government for action, pension strains, and the city’s weak position to weather the next recession stand out as top market concerns, Cure said.
“Political willingness to make sound budget choices over the next few years and the local economy’s ability to absorb rising fixed costs will impact the city’s credit direction. In the short-term, however, the credit picture is stable,” Miller said. “Significant long-term challenges around pension funding remain, and this is a key area of analysis for us and for other market participants.”
Miller questions whether, even with state action this year, the city can count on the revenue being in hand to achieve structural balance by the 2022 target since “it takes time to build and open a casino.”
A weaker economy could make it “more difficult to raise property taxes or other revenues to balance the budget,” Miller said. “Aside from casino revenues, the city has provided few clues on how it will work toward structural balance.”
The U.S. Supreme Court’s decision Monday not to consider bond insurers’ appeal of a First Circuit Court of Appeals decision involving the Puerto Rico Highways and Transportation Authority’s special revenue bonds could bolster the appeal of the STSC bonds, said Rai.
The original ruling rocked the market’s long-held believe that special revenue bond repayment would continue through bankruptcy proceedings.
The decision is a blow to traditional revenue bond structures even with strong security features like a priority lien, but the STSC represents a sale of the sale tax assets that, in theory, is protected from a city bankruptcy if the state were to allow Chapter 11 filings. “They are truly protected because they are bankruptcy remote,” Rai said.
Some counter that the structure has not yet been legally tested.
The effect of an expected Fitch downgrade of the senior lien STSC bonds on the pricings may be muted, said Municipal Market Analytics in its weekly outlook. The revised criteria caps tax supported rating to six notches above a GO. Fitch rates Chicago GOs at BBB-minus.
“The changes suggest that Fitch’s rating on outstanding STSC debt rated by the agency will be downgraded to, at best, AA-minus, in the near term,” MMA said. “Any anticipated rating action is unlikely to negatively affect pricing of the securities, given market conditions and the significant amount of debate and scrutiny the structure has endured since its creation in 2017.”
Kroll assigned its AA-plus rating to the second lien issuance by the bankruptcy-remote special purpose entity.
Scoop, no tossing
Market participants frown on the city’s use of capitalized interest in the deal to bolster upfront savings, especially given that the deal is a refunding and not funding new projects with a construction period, but some see it as reasonable to achieve the city’s goals.
“Funding capitalized interest when there is no project is a poor practice, but this will provide budget relief,” Miller said.
“It’s a scoop” because they are avoiding near-term debt service “but they aren’t tossing,” Cure said. “Capitalizing interest for operational relief is not a reason ordinarily used to capitalize interest.”
Cure was referencing the scooping and tossing of debt repayment. The city long engage in the practice for budgetary relief and former Mayor Rahm Emanuel halted the practice late in his term. Bennett has been careful in structuring the deal to highlight that maturities are not pushed out and savings are achieved in every maturity. Chicago has long capitalized interest which Bennett acknowledged would provide upfront relief but also eliminated the need to revise the 2020 property levy.
"Capitalized interest is a deferral of debts" and the city and state should be moving away from any practices that defer any liabilities, Ciccarone said.