CHICAGO – With high-grade ratings in hand and offering documents in circulation, Chicago has begun the job of selling investors on its new sales tax securitization as it seeks to limit the spread penalties from its own blemished credit.

The city plans investor meetings from November 27 to 29 and aims to sell its inaugural $575 million issue on Dec. 5 and 6.

“The city of Chicago is using its new authority….to sell and convey to the sales tax securitization corporation, a bankruptcy-remote special purpose entity, all of its state-collected sales taxes received by the city,” Carole Brown, Chicago’s chief financial officer and president of the corporation, tells potential buyers in a recorded investor presentation.

Chicago sales tax securitization cash flow

Bankers told the city that it can keep spreads to less than 100 basis points above Municipal Market Data’s top-rated benchmark. City GOs have been trading at just under a 200bp spread, and it paid a record spread of more than 300bp on its last GO sale.

A small block of 12-year GOs recently traded at a 170bp spread, said IHS Markit’s Edward Lee.

Chicago’s proposed 2018 budget relies on about $90 million of upfront debt service savings from the new bond program that will be used to refund up to $3 billion of debt for savings and to level out the city’s GO debt service costs.

The city still has some convincing to do with its pitch. While many agree the city will gain fiscally by lowering its debt service costs, not all investors are convinced of the bankruptcy-proof structure that garnered two triple-A ratings because it’s untested in court. Some investors also worry over the negative impact on the value of existing GO bonds and whether the city will show restraint and not over-leverage the program adding to its debt burden.

“Passage of this legislation was a huge accomplishment for the city,” said Paul Mansour, head of municipal credit research at Conning. “It gives them financial flexibility, access to new investors, lower debt service – they just can’t over leverage it. To retain a lot of its benefits, they have to be judicious.”

The pitch begins with the borrower’s name – the Sales Tax Securitization Corporation – which lacks Chicago in the title, investors noted.

Jefferies and Rice Financial Products Co. are senior managers. Columbia Capital Management LLC and Swap Financial Group LLC are advisors. Nixon Peabody LLP is transaction counsel. Mayer Brown LLP is counsel to the corporation and Charity & Associates is special counsel and Chapman and Cutler LLP is special counsel to the city.

The city ordinance establishing the new special purpose entity authorizes up to $3 billion of borrowing under the new structure. State legislation allowing home rule units of government to securitize revenue streams that flow through the state passed the General Assembly over the summer at the city’s urging.

In early 2018, the city will return to refund $905 million of GOs with a tentative pricing date of Jan. 9 and 10. The city has said it plans to mostly refund callable, high coupon GOs. Officials have declined to comment if the provision in a tax bill pending before the U.S. House that would ban advance refundings might impact its plans if it becomes law.

In December's deal, a tax-exempt fixed-rate series for $175 million matures from 2020 to 2030 with a 10-year municipal call. The taxable, fixed-rate $400 million series includes a $100 million tranche that matures serially from 2031 to 2034 with an index eligible $300 million term bond in 2043, two years past the final maturity on the sales tax bonds being refunded. The taxable piece features a make-whole call.

The final maturity on the sales tax bonds being refunded is 2041. Interest rates on the existing sales tax bonds being refunded range from a low of 3% to a high of 6% with most in the 4% to 5% range.

“The current refunding transaction extends final bond maturity by 2 years and front-loads savings for budgetary relief,” which is a form of scoop-and-toss debt restructuring, Municipal Market Analytics noted in a recent commentary.

Brown has dismissed that assertion – also raised by some aldermen -- saying the securitization will save on debt service costs, while the city’s past practice of annually pushing off some GO debt service had raised overall costs. Mayor Rahm Emanuel previously announced the city would no longer use scoop-and toss on its GOs for budget relief.

The city is promoting the structural protections designed to insulate the new entity from a city bankruptcy, the statutory lien and various city and state non-impairment provisions on the pledged revenues. The bonds enjoy strong coverage and maximum debt service coverage must be at four times before additional debt can be sold.

The city’s share of sales taxes that flow from the state -- $660 million in 2016 – will now go directly to the corporation. After deductions to cover debt service and operations, the revenue will flow to a residual account that can be returned to the city.

Nixon Peabody partner Robert Christmas outlines in the presentation how the firm concluded the structural features in the city, state, and transaction documents insulate the corporation and its assets – the pledged sales tax revenues – from a city bankruptcy.

Under current law “a court exercising reasonable judgment and after full consideration of all relevant factors would not hold that the money paid or payable --including after the petition date -- by the state to the city as assigned to the corporation is property of the city or property of the estate and would not hold that the rights of the corporation to that money are subject to the automatic stay in the bankruptcy code,” Christmas said.

Fitch Ratings and Kroll Bond Rating Agency assigned AAA ratings to the bonds and S&P Global Ratings assigned its AA rating. All three rating agencies rate Chicago’s GOs in the triple-B category. Moody’s Investors Service which was not asked to rate the new corporation has the city’s GO in junk territory.

The city's perilous finances and massive pension obligations made some investors and analysts concerned about bankruptcy, even though current Illinois law would not permit a Chapter 9 filing.

Some market participants – burned by the efforts to impair structures they once thought air tight in Detroit and Puerto Rico’s bankruptcies -- have warned that no legal opinion can guarantee the sturdiness of a structure until it’s tested.

“The assignment of AA & AAA ratings to this structure weakens the investor value of AA & AAA ratings, particularly when those ratings rely almost entirely on structural protections that have provided questionable benefit in previous distressed situations,” wrote MMA’s Lisa Washburn, a managing director.

Legal counsel also did not deliver an opinion that the state legislation was duly authorized or constitutional, Kroll noted.

Mansour, who plans to attend one of the city’s investor meetings in New York, said so far it looks like the city has “checked all the boxes” from the legislation, ratings, and legal opinions on the structure. “That gives me some comfort,” he said.

Future revenue performance risk -- because sales taxes fluctuate with the economy, because of the expectation that the city will further leverage the program, the program's new name and link to a weak underlying credit – all has to be factored into the bonds’ valuation, Mansour added.

Some market participants worry that the diversion of sales taxes could damage the value of existing bonds because the pool of revenues that flow directly to the city’s corporate fund will shrink.

Others have said easing pressures on the GO credit – as long as the city doesn’t turn around and add to that load – could improve existing values and in the market had a favorable response to the announcement of the borrowing plans by narrowing the city’s trading spreads.

“Existing city of Chicago GO bondholders should expect credit and price weakening over time: resources available to service their bonds will be diluted as the city (almost surely) levers up on the new, superior lien,” Washburn wrote.

“The rate of recovery for GO bondholders in the event of a city bankruptcy may be lower as a result of the sale of certain revenues to the corporation, and the availability in a city bankruptcy of only the residual flows,” Fitch wrote in a special commentary addressing questions over the impact on the city’s GOs.

The securitization offers the city a means to “access the capital markets without paying overly burdensome borrowing levels,” said Richard Ciccarone, president at Merritt Research Services. But the diversion of a revenue stream also heightens the need for the city to make additional strides toward getting its “fiscal house in order” as it’s hard to replace given the demands on the local tax base by overlapping governments, he added.

S&P, in a report issued Tuesday, said it doesn't expect the securitization will pressure the city's cash flow or rating.

The securitization plans also have now produced concerns among some that sit on the city’s pension funds, which did not challenge the state legislation or the city ordinance, over whether the diversion of revenues would hurt their position in a bankruptcy.

“There’s a growing worry that pensioners are harmed and funds are looking into what their options are to fight this,” said on pension fund member who suggested that one option may to seek state legislation limited the revenues that could be securitized.

Brown has left the door open to tapping other revenue streams and said the city could consider using the structure to raise new money although she has stressed there are no plans on either front at this time. The city also could turn to a subordinate pledge to meet a lower coverage threshold on the sales tax.

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