CHICAGO – Chicago Mayor Rahm Emanuel will have some progress to report as he welcomes the buyside back to town for the city’s annual investors’ conference on Aug. 9.
The city is now assigned a stable outlook by three of the four main rating agencies, and has several state budget victories in hand, along with good news on corporate relocations and tourism.
Those strides are set against a backdrop of lingering buyside concerns over the city pension system’s long term health and funding burden, and possible contagion from Chicago Public Schools’ fiscal ills as well as ongoing state pressures.
Investors will also have fresh fiscal data to digest. The city is set to release on Monday its annual financial analysis, which provides an overview of its structural budget gap, revenue forecast, and status of debt levels and pension obligations. That follows the release earlier this month of the city’s 2016 comprehensive annual financial report.
Though the city is benefiting from passage of a state budget and items in the budget, “obviously the credit is still under pressure. Longer term not much has changed,” said Michael Pietronico, chief executive officer of Miller Tabak Asset Management. The city also remains at risk as the state tackles lingering fiscal challenges, led by its $126.5 billion pension tab.
Chicago reaped several victories from the break in the state’s two-year-old budget impasse, and that’s helped trim the city’s spread penalties in secondary market trading.
Lawmakers passed and then overrode Gov. Bruce Rauner’s veto of a 9-1-1 emergency fee hike. Democratic leaders tucked the city’s overhaul of its municipal and laborers’ pension funds in the budget implementation bill, as well as a new local government borrowing program for home rule units sought by Chicago as a means to bypass its own weak ratings.
The city is expected to use the new borrowing program as a primary vehicle for new money and to refund higher interest rate debt, although chief financial officer Carole Brown has not yet laid out Chicago's plans.
Fitch Ratings last week weighed in, saying Chicago and others that opt to take advantage of the program could win high-grade ratings if the deals are properly structured.
The new program allows the state’s 200 home rule municipalities to dedicate tax revenues they receive from the state to a special limited use entity with a statutory lien attached. That entity in turn would leverage those revenues in a financing. The structure allows municipalities to bypass their own coffers and shields them from the threat of being dragged into a bankruptcy proceeding.
“Since operating risk resides with the transferring unit rather than the issuing entity, the issuing entity debt would be rated without consideration of operating risk, as represented by the issuer default rating,” Fitch wrote. The rating service said the Illinois program resembles those of several authorities in New York, all of which are rated AAA. Chicago's general obligation ratings range from junk to BBB-plus.
Revenue streams that municipalities could tap include their share of personal property replacement taxes, gambling, sales tax, local government distributive fund revenue, and motor fuel tax revenues.
The new structure raises concern for some market participants, who say diversion of revenues may undercut the value of existing debt and the positives of lowering interest rates are erased if the city adds significantly to its debt load.
The 9-1-1 override allows Chicago to increase its emergency communications surcharge to $5.00 per month from $3.90. The new funding will help cover the costs of upgrades and operational expenses for the emergency communications system, freeing up funds for other costs such as pensions.
The insertion of the city’s overhaul of the municipal and laborers funds allowed the city to bypass a threatened veto of the individual bill. Without passage in the coming months, the city was at risk of losing ratings ground it had gained last year. Fitch last August revised its outlook on the city’s BBB-minus credit to stable. S&P which rates the city’s GOs BBB-plus followed in October.
Chicago spreads are benefiting “against that backdrop,” Triet Nguyen, head of public finance credit at New Oak, said in the firm’s MuniCredit Insights report.
Following passage of the budget, the spread for a tax-exempt 2040 maturity has narrowed about 60 basis points to 230 basis points over the Municipal Market Data’s top benchmark although that is “based on very few sizable trades,” the report read.
IHS Markit’s Edward Lee said Chicago spreads have generally narrowed by about 50 basis points, while Illinois spreads have narrowed by more than 100 basis points. The spread on a 17-year Chicago bond was at 246 basis points with a yield of 5.06% compared to about 300 basis points before the budget passed.
Trading on some maturities on the taxable side have seen even greater narrowing, market participants said.
Secondary Chicago spread penalties had narrowed in recent months to about 300 bp after hitting a new primary market peak on its $1.2 billion January general obligation sale of between 339 and 347 basis points. Market participants attributed some of that penalty to contagion from the state impasse and CPS' rocky finances.
Chicago’s finance team calls the comprehensive annual financial report a sign of “significant progress the city has made over the past six years to improve our long-term financial stability and enhance our financial reporting.”
The 2016 fund balance rose to $297 million from $215 million in 2015, with the available portion increasing to $154 million from $93 million in 2015.
The city’s net position of governmental activities, which provides a fuller overall picture of the city’s financial health, worsened by $3.4 billion bringing its net position deficit to $27.5 billion. The CAFR primarily attributed the change to “an increase in the pension liability due to assumption and plan changes.” That brings the city’s unrestricted net position to a deficit of $29.7 billion.
Chicago is far from out of the woods in dealing with its more than $35 billion of net pension liabilities, even with funding increases and benefit changes for new employees.
“Chicago will still face large and growing liabilities for many years to come, and more change is necessary if these plans are to reach healthy and sustainable funded levels,” S&P said in a recent report.
Moody’s Investors Service is not expected to lift the city out of junk until progress is made in trimming unfunded liabilities, and that’s more than a decade off under the city funding plan and could be set back by poor returns.
Higher contributions are coming from a water/sewer tax for the larger municipal fund and the 9-1-1 fees for laborers, and a big property tax hike for police and firefighter funds. Additional revenue will be needed in 2023 when actuarially based payments take effect for all four.
In a new report, Kroll Bond Rating Agency takes a deep dive into the future burden and finds that roughly $1.6 billion of cuts or new revenue are needed to meet the growing pension and debt obligations of the city and overlapping governments by 2023. Kroll believes the “potential needs for new revenue are substantial and politically sensitive” and “will be political painful.”
But the needs are affordable, the report concluded. Based on a review of current debt and taxation levels, overlapping governmental burdens, and economic trends, Kroll believes the “underlying economy has the ability to absorb and afford the transition needed to fund the city’s growing pension and debt burdens.”
City leaders have also “have demonstrated the political will necessary to execute their plans and protect bondholder interests despite numerous obstacles” by controlling spending and identifying revenue streams to bolster funding.
“If current or future city leaders do not demonstrate similar commitment, then KBRA will revisit the city’s credit rating,” Kroll wrote in the 32 page report, “Chicago’s Pension Liabilities: A look Beyond the Headlines.”
Chicago Public Schools is banking on $300 million in higher state aid and pension help from the state to whittle down a $544 million deficit ahead of its Aug. 7 release of a fiscal 2018 budget. Gov. Bruce Rauner has threatened to cut that funding in half, and distribution of any state aid is hung up in a dispute between Rauner and Democrats that will be the subject of a special session beginning Wednesday.
Emanuel has pledged to help the district but has not specified whether that help would come in the form of more tax increment financing surplus dollars or a new tax or fee on high net worth individuals or downtown businesses. Emanuel has said he doesn’t want to show his hand until state action is final.
Rating agencies are increasingly citing the district’s financial woes as a risk to the city’s credit profile. Moody’s Investors Service, which is no longer asked to rate city deals, recently put its Ba1 rating on review for a downgrade over CPS’ problems and the potential burden any future help might pose. Moody’s also has the district’s junk rating, now in the single-B category, on review for a downgrade.