“Chicago has the resources, the capacity to meet its obligations – through user fees, higher taxes, etc. – there are solutions. While the recent Illinois pension ruling set them back, they have what they need,” according to James Colby, Van Eck Global's senior municipal strategist. On the other hand, Colby said “this is a shot across Chicago’s bow.”

CHICAGO - Chicago's bonds lost value, some dramatically, Wednesday in the first market session following the city's fall into speculative grade territory.

The fallout also expanded to Chicago school and Illinois bonds following Moody's Investors Services' move Tuesday to strip $8.9 billion of Chicago general obligation, sales tax, and motor fuel bonds of their of its investment grade rating. Some of the city's GOs were already trading at speculative grade of at least 200 basis points over the Municipal Market Data's top-rated benchmark.

Market participants say the longer term impact may be harder to assess and value may pick up as the headlines fade. Some investors may shed the city's bonds, while others looking for yield and income opportunities will step up. The city as soon as next kicks off its planned conversion of $800 million of floating rate paper to a fixed-rate in a series of transactions over the next month.

In the immediate aftermath of the downgrade, yields on most Chicago related credits jumped 30 to 40 basis points higher, according to Interactive Data.

"For current holders, you expect to see some loss in market value as spreads widen on the Chicago name," said Michael Johnson, head of research at Gurtin Fixed Income Management LLC. "More importantly with the downgrade breaching the threshold for additional swap termination, current holders have significantly more credit risk now."

The downgrade triggered termination and default events on bank credit agreements supporting $2.2 billion of debt. The city expects to cut the exposure in half by converting floating-rate bonds to fixed and terminating swaps and is negotiating with banks to stave off demand for payment of the rest.

The downgrade followed a recent Illinois Supreme Court overturning state pension reforms as unconstitutional. Moody's believes the opinion threatens the city's efforts to solve its own $20 billion unfunded pension mess.

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

According to Markit, yields shot up on Chicago GOs. One of the most dramatic moves affects Chicago refunding series 2009A 4s of 2019, which surged to 311 basis points over the internal AAA curve per quote, from 200 basis points Tuesday. The price was last seen at 99.12 with a yield of 4.26%. Tuesday it was priced at 102.3 with a yield of 3.3%. The initial price for this CUSIP was 103.105.

The Chicago project and refunding series C 5s of 2034 was priced at 88.87 and yielding 6% Wednesday, whereas Tuesday it was priced at 96.4 and yielding 5.29%. This CUSIP had an initial price of 97.766.

Municipal Market Analytics said trades widened out as the day progressed. "While not hugely dramatic (generally in the 10 to 20 basis point range from what we can see) it is significant," MMA said in a daily market update. "The fallout from the downgrade is much wider than the downgraded credits."

The most active markets were on taxable Illinois pension bonds in 2033 trading in blocks today at 5.70% versus 5.6% Tuesday and 5.50% Monday. A Chicago Board of Education issue of 5s from 2035 traded at 5%, compared with 4.1% Tuesday.

"What isn't there to say about Chicago right now? There is a 10-20 backup generally speaking, with a new deal coming next week we will get price discovery and it will be interesting to see how it does but it is too early to tell about that right now," said a trader.

The downgrade will narrow the city's audience of buyers and some investors may shed their city GO holdings. Others say a sell-off might not be in the works as risk-averse investors don't hold much city debt.

Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said that some portfolio managers who hold the city's paper may not decide to wait around for another rating agency to cut the city into junk.

"I think they will be more concerned about further downgrades," he said. "I can't see a case being made for a quick turnaround or improvement in the city's finances. These problems are long-term liabilities. And I can't come up with a formula for improvement."

Some market participants said the downgrade came as no surprise, especially given the court's ruling, while others were caught off guard.

"I'm a little surprised at the timing of the downgrade," Heckman said. "But I think that Moody's felt it had no choice other than to act after the recent Illinois pension ruling."

He said the Windy City has its work cut out for it.

"It does put Chicago in a difficult position. Barring some change in the constitution - which will not be quick or easy - the parties have shown their unwillingness to work together on the issue," Heckman said. "And Moody's has shown it is not confident that a solution can be quickly reached."

Market participants are still banking on the city raising taxes to meet its needs and that's within its powers. "Chicago has the resources, the capacity to meet its obligations - through user fees, higher taxes, etc. - there are solutions. While the recent Illinois pension ruling set them back, they have what they need," according to James Colby, Van Eck Global's senior municipal strategist.

On the other hand, Colby said "this is a shot across Chicago's bow."

After 2008, the financial world was falling apart with auction-rate securities cratering and money funds breaking the buck - and all looked to at the rating agencies. And rightly or wrongly the harsh spotlight was placed on the raters.

"So after Puerto Rico, Detroit, San Bernardino, etc., the rating agencies were desperate to preserve their credibility. So now they are getting out in front of problems, rather than reacting to them," Colby said. "They are getting ahead, instead of being friendly to issuers and giving them time to take corrective action, which under political pressures they may or may not take."

Market participants differ, like the rating agencies, on where the city's credit should land.

"Ultimately, the ratings agencies are now getting close to where our forward looking analysis on the city was for some time...so yes, we believe the below investment grade rating is closer to where the city's credit quality actually is," Johnson said.

Matt Fabian, a partner at MMA, said he doesn't think the city's current fiscal condition warrants a non-investment grade. "I don't think at this point there is a material risk of the city defaulting," he said.

He thinks the market could settle after headlines subside, and spreads could tighten. "If market conditions erode, Chicago will feel it more than other credits," he said of the city's potential risk.

Richard Ciccarone, president of Merritt Research Services, said he was surprised and thought the rating agency should have given the city more time to complete the restructuring of its floating-rate bonds to ease liquidity pressures.

"The pension crisis doesn't cause a default immediately," Ciccarone said. He added that the downgrade moves Chicago a step closer to the liquidity crisis that the city was trying to avoid by shedding floating-rate GOs and swaps.

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