Chicago Public Schools offer yield for investors willing to digest junk paper

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CHICAGO – Chicago Public Schools returns to the market next week with a “belt and suspenders” structure to refund $260 million of debt, shedding some potentially costly floating-rate risk and generating savings for near-term budget relief.

The fixed-rate, tax-exempt general obligation deal is slated to price with insurance on some maturities May 22. Investors calls are offered through May 21 and meetings were held in Chicago last week and in New York Tuesday.

The district is highlighting fiscal gains from new state aid approved last summer, and the bond structure’s special revenue opinion and state aid default intercept mechanism, but the district's ratings remain deep in junk and investors believe the depth of the district’s fiscal strains threaten its long term fiscal prospects.

“The market accepted their terms and conditions and structure in November and it demonstrated improved market access so that’s good. It isn’t novel now,” said Brian Battle, director of trading at Performance Trust Capital Partners.

The district faces some additional uncertainty over whether the state government will return to budget gridlock, or state leaders will put aside their partisan bickering to get a budget out of the way ahead of the November elections.

Gov. Bruce Rauner has also proposed stripping CPS of its new teachers’ pension funding as part of a larger plan to shift some of the state’s burden on to school districts but the Democratic majorities in the legislature are unlikely to go along with that proposal.

“State issues hang over the heads of all issuers” in Illinois but they weigh more heavily on distressed borrowers like CPS, Battle said, adding he doesn’t expect the deal to run into trouble but “it may have offer” more concession on pricing depending on market conditions next week.

Battle said the insurance too will help with some investors not swayed by the structural protections like the intercept, with one serving as a “belt” and the other as “suspenders.”

The district also faces a higher yield environment than its last sale in mid-November. The Municipal Market Data 10-year benchmark was around 2.45% Monday, compared to 2% in November, but CPS secondary trading spreads remain in line or are better than the November pricing with current spreads ranging from 205 basis points to 235 bp, said MMD strategist Dan Berger.

The November sale saw strong demand from a yield-hungry market with 10-year maturities landing at 4.55%, a 255 bp spread, and the long 2046 maturity landing at 4.80%, a 212 bp spread. That compared to roughly 480 bp spreads in the July issue before new state aid was finalized.

While rates are up, the good news for the district is supply remains scant with strong demand for municipal paper and investors on the lookout for yield, Battle said.

A $251 million series matures from 2024 to 2035, with maturities in 2026, 2027, and 2028 tentatively scheduled to carry coverage from Assured Guaranty Municipal Corp. Proceeds will refund the 2013A-3 and 2006B and 2007D bonds, a portion of which were insured by Assured Guaranty.

Assured is rated A2 by Moody’s AA-plus by Kroll, and AA by S&P.

The 2013A-3 bonds are among the district’s $589 million of floating-rate debt. Those bonds total $157 million and are up for remarketing on June 1. If not refunded or remarketed, the rate hits 7.5% and increases to 9% in September.

A $10 million series matures in 2020, 2021, and 2022 with proceeds refunding the board’s 2002A bonds.

The district has said there’s no scoop-and-toss debt restructuring in the deal. The sale will have economic savings throughout maturities, but with “larger immediate budget relief in the upcoming two fiscal years,” S&P Global Ratings said in its review.

The Board of Education earlier this year signed off on up to $600 million of refunding.

The district lays out eight pages of bondholder risks in the preliminary official statement, from investment suitability issues to the district’s fiscal pressures.

They include an ongoing structural deficit and liquidity woes, enforcement remedies in the event of a bankruptcy although state law does not currently allow Chapter 9, uncertainty over future rating actions and market prices, and the financial condition of the city and state.

While improved, “the board’s ongoing financial outlook will continue to be determined by factors such as labor, pension, and debt service costs as well as the ability of the board to raise revenues and reduce certain expenditures,” the offering statement says. “Pensions have been and will continue to be a significant budget pressure.”

Property tax collections could also be delayed this year due to county budget cuts.

The recorded presentation for investors offers a more positive assessment.

“The board’s financial position is much improved due to the landmark state legislation passed last year,” says Ronald DeNard, the CPS vice president of finance.

As the district grappled with a $1.1 billion deficit, measures over the last two years have resulted in about $900 million in new recurring revenues.

The 2017 state package provided $221 million in new help on pension contributions, $93 million in annual aid and grants, and approval to raise its property tax levy to raise about $130 million for pensions. The city also pitched in funds to cover CPS safety costs. Those funds were on top of a $250 million special pension levy lawmakers approved a year earlier.

The district owes nearly $800 million in pension contributions this year. The district is carrying $10.9 billion of unfunded liabilities and faces a state mandate to reach a 90% funded ratio from its current 50.1% level by 2059.

The gains have eased but not erased investor worries over the district’s long-term prospects; CPS has little additional room to further raise new revenue after the city and state came through with added funding.

The district’s fiscal pains are most evident in its ongoing reliance on costly short-term borrowing through tax anticipation note issues. It is paying 70% of the three-month London Interbank Offered Rate plus a spread of 330 basis points on TAN tranches sold earlier this year.

On the plus side, interest was reduced by $60 million in fiscal 2018 over fiscal 2017 and $455 million was trimmed from $1.55 billion of borrowing last year. The district had $600 million of TANs outstanding as of May 1 and plans another $250 million.

The district’s cash flow will remain negative throughout much of the fiscal year ending June 30 but it does expect some months to show a positive variance and a small ending balance is projected.

The district’s GO debt is backed up by a pledge of state aid under an alternate revenue bond structure. The state package boosted coverage levels 2.8 times. The ad valorem tax pledge calls for the automatic increase in the property tax levy if revenues are not deposited to cover debt service. The district has always abated that levy.

The offering statement includes a special bankruptcy counsel opinion from Katten Muchin Rosenman LLP that pledged property taxes under the alternate revenue structure would likely be treated as special revenues in a Chapter 9 proceeding, meaning the flow would not be subject to an automatic stay. The offering statement warns that in the event of a bankruptcy there’s no assurance revenues would not be impaired or altered in a restructuring.

The opinion outlines the challenge posed to the special revenue structure and whether an issuer can be compelled to turn over pledged special revenues by Puerto Rico Title III bankruptcy judge Laura Taylor Swain’s ruling that the island is not required to continue paying on its special revenue bonds. The ruling broke with established precedent in Jefferson County and Stockton bankruptcies and bond insurers are appealing it. A bond trustee or bondholder may have to file a motion for relief from the stay or demand adequate protections if a municipality holds its pledged special revenues, the POS says.

The district’s state aid flows through an escrow before going to CPS under a special intercept provision. In the event of a default or bankruptcy filing, the funds would be frozen and directed to a “security” account until debt service was fully covered. Remaining funds could then be released to the district.

Fitch Ratings rates CPS GOs three notches below investment grade at BB-minus with a stable outlook after a one-notch Oct. 27 upgrade.

Moody’s Investors Service was not asked to rate the bonds but rates prior issues at B3 and changed its outlook to stable from negative last September.

Kroll Bond Rating Agency assigns an investment-grade BBB-minus rating to some CPS GOs and a BBB to those with the special revenue opinion, and raised its outlook to positive in October.

S&P Global Ratings affirmed its B rating – five notches below investment grade -- ahead of the deal. It boosted its outlook to positive from stable in April after raising it from negative last fall. The district has more than $7 billion of debt.

"The rating is based on our view of the board's extremely weak cash position, which is projected to be negative throughout almost all of fiscal 2018 and likely in fiscal 2019, albeit with improvement in the most recent projections," said S&P analyst Blake Yocom.

The positive outlook reflects at least a one-in-three chance of an upgrade over a one-year outlook horizon which could occur if the 2019 budget demonstrates structural balance and TAN borrowing is reduced.

Loop Capital Markets and JPMorgan – a primary provider of CPS’ short term borrowing lines – are lead managers with another nine firms rounding out the team. PFM Financial Advisors LLC and Public Alternative Advisors LLC are advising the district. Six law firms are in bond counsel, issuer counsel and disclosure counsel roles.

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Speculative grade bonds Primary bond market School bonds Ratings Board of Education of the City of Chicago Illinois