CHICAGO – With legal opinions endorsing the bankruptcy-remote structure of its next deal, and an A rating in hand, Chicago Public Schools' new tax-revenue backed credit has a clear path to market access, though yield penalties will remain, market participants say.
CPS, which borrows through the Chicago Board of Education name, is expected to price its inaugural $500 million sale of dedicated capital improvement tax bonds the week of Dec. 12. Barclays and JPMorgan are senior managers with Barclays running the books.
Fitch Ratings distributed its report assigning the bonds an A rating and stable outlook Thursday.
The Fitch rating is eight notches above its junk-bond rating of the district's general obligation bonds.
Kroll Bond Rating Agency also published its rating – a BBB and negative outlook – but a detailed report was not immediately available.
The Kroll rating is on par with its rating on the district's last GO issue in February. The district did not ask Moody's Investors Service or S&P Global Ratings to review the new credit. They both have the district's GOs in junk territory.
"These investment-grade ratings are a reflection of the strength of this credit, which have a dedicated revenue source that will be spent only on needed capital at CPS," Ronald DeNard, CPS' senior vice president for finance, said in a statement. The City Council approved the $45 million CIT property tax last year. Proceeds will help fund a $938 million fiscal 2017 capital improvement budget.
The isolation of the funds for capital is a cornerstone of the structure that secured legal opinions from the deal's bond counsel and underwriters' counsel saying tax collections would meet the U.S. bankruptcy code's definition of special revenues. Such a designation would allow for their continued flow to debt repayment in the event of a Chapter 9 filing and offers strong protection from a haircut in a confirmation plan.
The legal opinions paved the way for Fitch's consideration of the bonds under a special revenue analysis. That resulted in the A rating that should make the district's new debt more acceptable to investors worried about its precarious operations and dependence on a state government locked in political dysfunction that's prevented passage of a budget.
"They have an A rating which is a massive endorsement for the structure of the deal, not the school district. They put the revenue in a lock-box and have legal opinions from two reputable law firms," said Brian Battle, director of trading at Performance Trust Capital Partners. "That was an achievement. They went a long way to ensure an A rating and that will give them market access."
The protections won't fully shield yields or the bonds' value from the district's negative headlines, Battle said, but he called it "good financial engineering."
Battle and other municipal professionals said it's difficult to guess where yields will land given the district's tainted name, the newness of the credit, and the market's post-election volatility that saw a big jump in yields before some reversal this week. The district recently pushed off a $426 million new money and refunding GO issue due to market conditions.
"This is a new structure using a new lien from an issuer whose GOs are below investment grade in a lowly rated city in the lowest-rated state. The buyer set is still going to be limited," Battle said.
Yields could range from the mid-5% to mid -6% range, market participants suggested. The high rate on the district's February GO sale landed at 8.5%, 500 basis points over the Municipal Market's top benchmark and near a 9% state legal cap on interest. The district paid 7.25% on a GO private placement over the summer.
Its 10-year GO has been trading at 450 basis points over MMD while the city has been trading at 350 bp. The MMD AAA 10-year was at 2.29 Friday and the single A at 2.89.
"It's a well-designed concept" that takes into account that past tax collections have sometimes come in late, said Richard Ciccarone, president of Merritt Research Services.
"It is tough to predict how the market will view the new security and what market access will be," said Tom Schuette, co-head of Investment Research & Strategy at Gurtin Municipal Bond Management. "The market has a different tone now than in past months when distressed borrowers like CPS were able to get access as long as they were willing to pay a penalty. That being said, there will inevitably be some that are attracted by the high yield the deal will offer while still carrying an A rating."
The state does not have a general municipal bankruptcy statute on its books, but Gov. Bruce Rauner would like one and has said CPS would be a bankruptcy candidate. Those comments rattled investors ahead of a CPS GO bond deal this year, and contributed to the district's decision to delay the deal a week.
"The specific features of the bonds meet Fitch's criteria for rating special revenue obligation debt without consideration of the board's general credit quality," the rating agency said in a release. "Fitch believes bondholders are effectively insulated from the operating risk of the board as expressed in its issuer default rating."
Fitch gives credit to special revenue status only if, in its view, the overall legal framework renders remote a successful challenge to the status of the debt as secured by special revenues. Fitch said features of the structure that support its position include clear restrictions on the use of pledged revenues for identified projects and clear separation from the entity's operations.
The rating reflects that the levy rises by inflation then jumps up in 2033 by $142.5 million before returning to inflation-based growth. Debt service schedules are sized to the minimum levy, without assuming inflationary increases.
The rating is sensitive to declines in property tax collection rates of a scale that would materially erode the protection inherent in the expected coverage ratios, the report said.
"That's the risk," said lead analyst Arlene Bohner.
While the capital improvement tax is new, the property tax base and collection rates on Chicago property taxes are well-established, so those figures were used for the review.
Given projected coverage rates, pledged revenues could withstand a 9% decline before they would fail to fully cover debt service. Recent tax increases by Chicago-area governments could contribute to delinquencies beyond historical experience in a recession, but even so, Fitch believes collection rates would continue to support financial resilience consistent with an A rating.
The bonds are also secured by a debt service reserve requirement of 14% of maximum annual debt service which is being funded with bond proceeds.
The new structure offers multiple protections aimed at reassuring bondholders. It includes a direct intercept that sends the tax levy revenues directly from county collectors to the bond trustee.
Excess revenues are freed up after debt service payments in the current calendar year and through the following April are set aside and the district must identify and certify what projects are to be funded with the cash. The tax revenues are statutorily limited to pay for capital or for debt service on the capital levy backed bonds. Coverage with the reserve is estimated at 1.35 times coverage through 2032 and then 1.24 times.
Interest only will be paid until 2033 with the annual tab at $30 million. Principal is amortized between 2033 and 2046 when debt service rises to $55 million.
Ciccarone dislikes the delayed principal repayment structure, which mirrors most of the district's GOs and pushing off the debt burden. "This particular structure is effective in the short term range…but by deferring principal you are pushing the burden off to future taxpayers."
He also has other long-term concerns.
"You can protect bondholders but contribute to a compounded problem that impacts taxpayers down the road," Ciccarone said of his worries about the cumulative impact of new and increased taxes being imposed to deal with Chicago's, the school district's, and Cook County's pension and budget woes. "Does it have an adverse impact on Chicago and willingness of taxpayers to stick around?" he said.
The special revenue opinions included in the offering statement come from bond counsel Katten Muchin Rosenman LLP and underwriters' counsel McDermott Will & Emery LLP, saying they believe the dedicated revenue stream would qualify as "special revenues" under the U.S. Bankruptcy code.
"The new security is ultimately untested, and any investors giving CPS money should be ready for the anxiety of potential legal battles in the future," Schuette said.