CHICAGO – High yields and a statutory lien on state aid layered over its general obligation pledge are what the junk-rated Chicago Public Schools offer investors willing to overlook its precarious cash ledger, bleak budget outlook, and downward credit spiral.
The Chicago Board of Education plans to bring an $875 million issue that includes $795 million of tax-exempt securities and $89 million of taxable paper late next week. JPMorgan is running the books and Barclays is a co-senior manager.
"We believe the various layers of protection for bondholders here provide a secure credit structure that bondholders can rely on," district treasurer Jennie Bennett tells potential investors in an online presentation.
Market participants generally believe that the district, for the time being, will continue to enjoy market access because of the bonds' structural support and its ties to the city government, as long as there are enough distressed-debt buyers.
CPS bonds have been trading at a 350 to 375 basis point spread to the Municipal Market Data's top-rated benchmark.
"Buyers are placing a high value on the statutory lien on state aid, the Chicago economy, and the need for CPS to rebuild its credit quality in order to maintain market access," says Paul Mansour, head of municipal research at Conning Asset Management. "Absent bold action, the hurdles keep growing higher and at some point a debt restructuring may be needed.
"Potential investors need to keep this in mind," Mansour said.
"Based on what we currently know, only the most speculative investors should look at CPS and they should start paying attention to dollar price, not just yield: at some point, the market will realize how distressed CPS is and start trading the name on projected recovery value, regardless of yield," writes NewOak Capital LLC in a new
CPS' offering statement lays bare the district's past fiscal sins: draining reserves and debt restructuring to balance the books, risky assumptions like relying on absent state help, and a dwindling cash position.
The district's most pressing budget strain is its budget assumption of $480 million of so far nonexistent additional state funding either through pension help or greater aid to balance the district's $5.6 billion fiscal 2016 budget.
Gov. Bruce Rauner has warned the district not to expect a bailout, although he has offered assistance if Chicago Mayor Rahm Emanuel uses his political muscle to sway Democratic lawmakers to support his governance and policy proposals.
The district's chief executive officer, Forrest Claypool, tells investors in the presentation that he's confident state lawmakers will step up, eventually, but adds: "We are prepared to make whatever reductions are necessary including in the classroom" to address the shortfall.
Without the expected state help, says Ron DeNard, the district's top fiscal officer, "CPS will use short term financing to address the remaining budget gap" in addition to cuts that would include an administrative overhaul and teacher layoffs.
The Numbers
About $393 million of the bond proceeds will fund capital projects; $135 million will refund variable-rate debt that is being shifted to a fixed rate; $86 million will retire short-term debt used to cover swap termination payments; and $206 million represents a scoop-and-toss restructuring in which the district borrows to pay off maturing bonds. The deal capitalizes $46 million of interest, and folds in $8.8 million of issuance costs.
Underscoring the district's fiscal strains, principal amortization is pushed off far into the future beginning in 2035 on the tax-exempt series and in 2033 on the taxable series, with most repaid in the final maturities.
The floating-rate conversion eases the district's floating-rate risks and its need to find new bank support to replace letters of credit that are expiring in the coming months. The district has more than $1 billion of variable-rate paper with additional letters of credit expiring in 2017, 2018, 2031, and 2034, according to the offering statement.
The district no longer faces any swap risks after terminating its 10 interest-rate swaps, paying a total of $242 million in termination fees, after downgrades last year triggered termination events.
The district originally faced a negative valuation of $275 million on the swaps, which was reduced through negotiation and shifting market winds. The district dipped into its debt stabilization fund for $142 million of the costs and drew on a short-term credit line issuance of tax and anticipation notes, according to bond documents.
The district faces no other potential default triggers on its bank-related contracts should its credit fall further.
The district has not been shy about highlighting it precarious liquidity having last year released a fiscal update from consultant Ernst & Young warning that warned the district was on course to run out of cash early this year.
The offering statement and investor presentation illustrate just how deeply CPS relies on its short-term lines to stay afloat.
The district has several credit lines in the form of tax and anticipation note issues for the current fiscal year that are due Dec. 27. The district tapped $565 million in TANs initially purchased by JPMorgan late last year and has an up to $370 million line with Barclays. The district has tapped out the Barclays line but will repay $170 million with the bond proceeds.
The district expects to maintain monthly cash flow of $500 million until June when it will drop to a narrow $33 million when its $600 million teachers' pension payment is due. A deposit of $260 million is due next month to cover future debt service. CPS is gambling that it will have new fiscal 2017 lines in place ahead of the teachers' pension payment.
The balance sheet projections anticipate a line of credit draw of $174 million next month and a $370 million draw in June. The numbers assume state aid comes in on time and do not assume additional state help or that proposed cost cutting measures are achieved.
"We have put plans in place to assure the liquidity we need in the near term," Claypool said.
Claypool reiterates the district's case for state help, arguing that it accounts for 20% of Illinois' students but gets just 15% of aid, resulting in a funding disparity that is worsened by the high number of impoverished students educated by the district. Equitable funding would provide an infusion of $450 million annually.
The district's fiscal mess grew out of its use of non-recurring moves like debt restructuring, reserves, and a three-year partial pension holiday as its teacher pension contribution and debt load continued to rise. That's driven up its structural deficit to $1 billion with one-shots exhausted. The district has $9 billion of unfunded pension liabilities.
The district's fund balance – which helped prop up its ratings in the double-A category just a few years ago – was $1 billion as recently as 2012. The fund balance was down to $360 million in fiscal 2015, about $138 million better than expected.
The district's cost to service its $6.1 billion debt load hit $534 million in fiscal 2015, accounting for 9.5% of expenses, and hits a high of $602 million in 2025. Those numbers don't factor in the upcoming issuance.
School officials warned that the help of the Chicago Teachers Union, the city, and state would be needed to eliminate a $1 billion deficit in fiscal 2017 beginning July 1. The district says it can balance the budget with $272 million of cuts and $450 million in additional state help.
The district also wants to raise $170 million in additional property taxes by reinstating a .26% property tax levy for pensions that was eliminated in 1996. The district also wants to shift its $170 million price tag for covering a portion of the teacher's pension contribution on to teachers.
Both have uncertain prospects as the first requires state approval and the latter must be approved by the union, which has warned CPS demands could prompt a strike, another of the investor risks outlined in the offering statement.
New Oak says state help is no panacea.
"A state bailout and/or takeover of the school district's pension system would certainly help but would not obviate the need for structural change via new revenue sources, or radical cost-cutting and cost-sharing measures," the firm's blog post says.
"The tipping point is when the market can't see a solution and I would say between the state and the city you are getting closer to that," says John Mousseau, director of fixed income Cumberland Advisors Inc. "The one saving grace is that you still have a city and a state whose problems are solvable from a resource standpoint but where the politics are overwhelming any chance to get to a solution."
The statutory lien, which wouldn't stave off a debt service default but would help recovery rates in a bankruptcy, shouldn't fully calm investors. Rauner has suggested CPS is a candidate for bankruptcy if the state were to approve enacting a general Chapter 9 statute as he's promoted.
"Our thought is that the statutory lien is just a lien on appropriations. We don't know how that statutory lien can be enforced if money isn't appropriated," says Michael Comes, portfolio manager at Cumberland.
Ratings
Standard & Poor's hit the district with two notch downgrade ahead of this deal, pushing it further down on the speculative grade scale to B-plus from BB, leaving it on CreditWatch with negative implications "while it continues to monitor the board's efforts to maintain sufficient liquidity to meet its financial obligations."
The district's S&P rating is now four levels into speculative grade territory, at the same level as Moody's Investors Service, which lowered its rating to B1 from Ba3 in December and is also reviewing the credit for a downgrade. It is no longer asked to rate CPS' new borrowing.
Fitch Ratings rates CPS bonds at junk BB-plus, with a negative watch; it hasn't yet rated the new deal, and neither has Kroll Bond Rating Agency, which rates CPS at the lowest investment grade level of BBB-minus with a negative outlook.
Public Financial Management Inc. and Sycamore Advisors LLC are advising the district. Chapman and Cutler LLP and Charity & Associates PC are bond counsel.
Adding to the negative headlines CPS faces, the Republican minority leaders of the General Assembly will unveil a legislative initiative Wednesday that would pave the way for a state takeover of the district and provide a potential path to bankruptcy, according to legislative sources.
Senate Minority Leader Christine Radogno and House Minority Leader Jim Durkin will hold a news conference to announce the proposals that would also pave the way for an eventual shift to an elected school board. Chicago Mayor Rahm Emanuel currently holds sway over board appointments. Emanuel and Claypool have rejected past calls for the district to consider Chapter 9 and Democrats who control the General Assembly are opposed to bankruptcy legislation. A published report said the legislation would also allow Chicago the ability to pursue Chapter 9.
CPS came under state oversight after a financial collapse in the late 1970s. Sweeping school reform legislation handed control of the schools back to then Chicago Mayor Richard Daley in 1995.
CPS issued a statement late Tuesday in response to comments from Rauner, a Republican, earlier in the day criticizing the district's request for nearly $500 million in help and his hint of the announcement coming Wednesday. "Not only that, the governor's comments are deeply irresponsible as CPS and the CTU are working feverishly to reach a deal that would cut costs while preventing midyear layoffs, and the district prepares for even deeper cuts to the bureaucracy," Claypool said in the statement.
Emanuel's administration issued a statement late Tuesday reiterating his opposition to any measure promoting bankruptcy for CPS.
"The mayor is 100% opposed to Gov. Rauner's 'plan' to drive CPS bankrupt. If the governor was serious about helping Chicago students, he should start by proposing – and passing – a budget that fully funds education and treats CPS students like every other child in the state," the statement read.
