Chicago Schools Face Market-Access Reckoning

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The Chicago Public Schools' last-minute delay in pricing $875 million of bonds puts even more of an onus on the district to demonstrate its ability to access the bond market.

That's the assessment of a range of market participants after the 11th-hour decision on the scheduled pricing date to move the issue to the day-to-day calendar.

Schools chief Forrest Claypool said Thursday the district plans to hit the market by early next week at the latest.

It's a move finance officials said gives them and the underwriting syndicate led by JPMorgan more time to build the order book, answer investor questions, and to tinker with the structure and terms to accommodate buyer demands.

But the delay raises questions over just how high a yield CPS needs to offer to sell its junk-rated paper and at what point it will be shut out amid a barrage of headlines about its rating deterioration, solvency crisis, and a state GOP takeover effort that would offer a path to bankruptcy.

Convincing Narrative

"Chicago needs to create a convincing narrative that they have sufficient buyers and that they do have market access," said Matt Fabian, partner at Municipal Market Analytics. "Delaying creates a question over whether CPS can access the market" and whether its paper is liquid.

The need to delay "is not good for CPS," said Brian Battle, director of trading at Performance Trust Capital Partners. "The facts are: they started to bring the deal, the sequence was interrupted, and the deal didn't come. The fact that they didn't get to placement of the bonds is a sign they didn't have a willing market."

Chicago's chief financial officer, Carole Brown, took the lead, alongside CPS' vice president of finance Ronald DeNard, in explaining the decision to the market in a conference call with reporters.

"The process just wasn't finished" of finalizing pricing, structure, or terms and of building the order book, Brown said.

Finance officials, financial advisors, and underwriters decided to postpone the sale "to give everyone more time to work on this important deal in a somewhat difficult market. We felt it was important to give investors more time to look at credit, structure and terms" with the goal of attracting "deep investor participation." CPS is stressing the bonds' security features, which include a statutory lien on state aid and a tax pledge.

"We were asked by a couple of investors to just wait a couple of days and give them more time" to evaluate the issue, Brown said.

Fabian said it could be expected that some previously interested buyers were rattled after a new round of downgrades and GOP talk of legislation to allow the district to file for Chapter 9, even though the legislature's Democratic majority called it dead on arrival. Illinois lacks a Chapter 9 statute.

If some additional large buyers come around, then others might feel more comfort that a degree of oversubscription can be achieved to ensure at least near-term liquidity, Fabian said.

"Once you have sufficient demand, buyers become more comfortable," he added.

A big enough jump in orders could materially push down yields but the delay fuels questions over CPS' rocky market access and creates the opportunity for new negative headlines to emerge.

Wednesday's postponement decision came with the market awaiting the deal following the Tuesday release of a pre-marketing pricing scale that offered rich yield premiums, with spreads of more than 500 basis points to the Municipal Market Data's benchmark. That's 200 basis points up from the district's April sale results.

CPS announced the decision as trading desks were questioning when the pricing wire would arrive. Syndicate members continued to insist with investors that the issue would be priced as planned.

The pricing talk had many market participants believing the deal would clear the market.

Several buyside representatives stressed that indications of interest at a certain price level don't always pan out, especially on a speculative-grade credit reliant on a high-yield audience where buyers are all the more willing capitalize on an issuer's weakened position.

While demand is strong for high-yielding municipal debt, the district faces a narrower investor base with many traditional buyers gun shy or shut out by the district's junk-level ratings.

DeNard on Wednesday insisted CPS "absolutely" had indications of interest to get the deal done and that the delay won't materially push off the planned closing date, scheduled in early February.

Market participants questioned that confidence.

"It looks to us JPM may have gotten some indications of interest that obviously didn't turn into orders. As a former HY manager, I would've put in an order 'subject' to the entire deal getting done, just to protect myself," said Triet Nguyen, a managing director at NewOak Capital LLC.

"Once again, as in Puerto Rico's case, issuers who rely on borrowing for operating purposes will live and die on 'market access'…CPS is very close to losing it, if it hasn't already," Nguyen added.

The district has relied heavily over the last two years on short-term credit lines and debt restructuring to pay its bills and keep schools open as it grapples with a $1 billion deficit.

Deal Structure

Brown signaled that the finance team is working on the deal structure. The team could modify the coupons, offering a more discounted structure which offers investors some salve in the event of a default or future restructuring, but that would cut into the level of proceeds. The team also could modify or even drop call features. Brown and DeNard did not rule out a change in size.

"There is still a chance that the deal can deal work by tinkering with the borrowing rate and structure of the deal, perhaps, lowering the amount that they issue," said Richard Ciccarone, president of Merritt Research Services. "Market access is not a certainty as this is the lowest-rated, large issue state or local government borrowing deal ever."

Ciccarone said he wouldn't be surprised to see tax-exempt yields hit 8%. That's what Puerto Rico paid on its $3.5 billion GO bond issue in March 2014, which was higher rated when it came to market.

CPS is relying on cash flow help from the deal as it grapples with a $480 million shortfall in its current budget. The district is asking for additional state aid or pension relief but prospects for near-term help remain elusive with state leaders locked in a budget impasse.

If the district can't complete the full borrowing, it could seek out additional short-time lines but they are costly.

The district last fall closed on a $500 million private placement that matures this year, paying a hefty yield of 70% of one-month LIBOR plus 2.75% on one piece and a straight 3.25% on another, for such a short duration.

Senate President John Cullerton said earlier this week he's working on a school funding formula overhaul and hopes CPS can manage through the current school year with stopgap measures and teacher union concessions. "They're going to borrow. That apparently is enough to get them to May, I guess," he said.

The city of Chicago's credibility is also on the hook because Mayor Rahm Emanuel handpicks board members and the schools' CEO. "I think it's more important in the grander Chicago scheme that CPS not fail or falter," said one institutional research analyst.

Brown, who was a well-respected banker at Barclays before taking over city finances last year, sought to portray the sale's delay as a common occurrence.

Market participants said that may be the case in a traditional refunding subject to market fluctuations and does occur occasionally with difficult, speculative credits but it's still rare, especially so late in the underwriting process.

Chicago delayed a restructuring as one piece was coming up for sale last spring, retooling the issue that was to be led by smaller firms, folding the pieces into one deal and giving the books to Bank of America Merrill Lynch. The situation, market participants say, is different in that the city was seeking to lower yields after a tumultuous week and there was little question its ability to place the bonds.

Ratings

The rating agencies have underscored the district's need to maintain market access and to complete at least pieces of the transaction to fund operations.

"Reliable market access is important to near-term stability. Fitch will monitor the district's ability to access external financing for both liquidity and capital purposes," analysts there wrote in their most recent report.

Fitch Ratings last week hit CBOE with a three-notch downgrade, dropping its rating on $6.1 billion of debt and the new sale to B-plus from BB-plus, the same ratings level as Moody's Investors Service and Standard & Poor's.

Fitch assigned a negative outlook.

Moody's, which is no longer asked to rate CPS' new issues, has the credit under review for a downgrade. Standard & Poor's lowered its rating the two notches Jan. 15 and has it on watch with negative implications. S&P said the rating reflects the "district's reliance on market access, including the successful sale of a portion of the pending issuance of bonds to maintain sufficient liquidity to meet its operating and debt service obligations in fiscal 2016."

Kroll Bond Rating Agency assigned its BBB rating and negative outlook, rating the planned new issue one notch higher than existing CPS bonds.

Kroll analysts said their decision to assign the new deal a higher rating stems from the rating agency's consultation with its external counsel and a legal opinion from CPS special counsel that the pledged state aid and taxes would be treated as "special revenues" in a bankruptcy.

The deal is secured with a general obligation, unlimited tax pledge which serves as the backup to the primary pledge of unrestricted general state aid.

Fitch believes that the mechanics of the general state aid pledge do not insulate bondholders from the issuer's general credit.

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