Chicago's case for issuing pension bonds

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CHICAGO — Chicago should tread cautiously as it explores selling up to $10 billion of pension obligation bonds to increase low funded ratios and ease funding spikes that threaten its efforts to lift its ratings and cut borrowing costs.

That was the advice from some analysts and market participants who attended the city’s annual investors conference Thursday during which the city disclosed it was mulling some form of pension financing.

Some investors panned the idea while others said it may offer an avenue to bring up funding ratios. Some landed in between.

“You have to tread cautiously because by going to a hard liability over a soft liability it can be seen as increasing the risk to the city’s credit quality,” said Richard Ciccarone, president of Merritt Research Services LLC. “It also becomes a credibility issue as bondholders will expect nothing less than forward progress.”

He supports the city’s exploration of the idea because “the funding ratios are so low that we have to consider all possibilities on how to bring them up.”

The city’s pension funding scheme is wired into state legislation and if it falls short state grant dollars can be diverted, but Ciccarone said that’s not as “hard” a debt as bonds that carry more severe penalties in the event of default.

Local skepticism will abound given the state’s prolonged pension funding deterioration despite its $10 billion general obligation pension issue in 2003 that only temporarily improved funded ratios. Illinois used $2.7 billion of the proceeds for near-term contributions. The state is now saddled with a $129 billion unfunded liability tab.

While public finance bankers have long pitched Chicago on a pension issue, the city made its decision to explore the idea public during Thursday's conference in a panel discussion featuring Ciccarone and Michael Sacks, a close ally, contributor, and top economic advisor to Chicago Mayor Rahm Emanuel.

Sacks pitched the idea that the city could boost funded ratios by securitizing nearly $1 billion in new revenue funding for pensions which if leveraged could generate $10 billion to pay down the obligation.

After the conference, Chicago’s chief financial officer, Carole Brown, said the city was taking a “hard look” at the “feasibility of financing as an option to further stabilize our pension funds.” The system is just 26.5% funded, with the net pension liability tab at $28 billion. The city is phasing in higher payments to reach an actuarially based payment level in the next few years.

Sacks suggested in his presentation a deal that raises $10 billion issue at about a 5.25% rate could “move the pension ratio” to 53% funded and “put to bed concerns about the looming pension cliffs.”

City contributions will total $1.18 billion next year and jump to $1.67 billion in 2021 as actuarial funding requirements hit for two funds and then $2.1 billion in 2023 when the two other funds reach the actuarial funding requirement.

Sacks and Emanuel pitched the idea after the city’s daylong efforts to build a case that its ratings — ranging from junk to single-A — are too low and that its spreads — between BBB and high-yield — too high given its fiscal strides and thriving economy.

“One of the things you bet on, one of the things you invest in, is does that city have the political will to face up to its challenges,” Emanuel said. “We have never taken a challenge and punted. We may not have kicked as far as you wanted. But we never punted.”

It’s a position that has traction with the buyside.

“I think given where things started in 2011 versus where they are today progress has been made on a certain track," said John Miller, co-head of fixed income at Chicago-based Nuveen Asset Management.

“They have made progress because their trajectory was bankruptcy,” said Howard Cure, director of municipal bond research at Evercore Wealth Management LLC.

“The economy seems to be doing well and the tax base has grown and they seem to be attracting investment. It’s never been an economic issue ... it’s that they have a ways to go on pensions which is going to consume their budget,” Cure said.

“I think the city really has done a lot of what I would want to see them do and they should get credit for attacking their problems — stabilizing their short term finances, facing the realities of the pension problem, and not taking their eye off economic development,” said John Humphrey, head of credit research at Gurtin Municipal Bond Management.

But the recognition can only go so far because of the size of pension liabilities.

“It is like being stuck at the South Pole, turning to head back north — yes you are headed in a different direction, but you are still a massive distance away from where you need to be,” Humphrey said.

The city’s fiscal progress makes it the right time to consider a pension borrowing, Brown said. The size and structure and security of a taxable issue are all on the table although she suggested that the city’s securitization structure that was used to leverage sales taxes would offer the lowest borrowing costs. That borrowing is done through a bankruptcy-remote entity and offers a statutory lien.

A high-yield market starved for paper would smooth the way for such a borrowing, but a deal's appeal will “depend on the structure and size and the security and coverage and whether it’s part of a comprehensive plan, not just something that covers increasing payments,” said one East Coast institutional investor.

“We have to find a structure that will improve the whole picture for the city’s credit quality and that means we need a manageable contribution schedule that won’t bust the city,” Ciccarone said.

He prefers a financing where a new dedicated tax stream is enacted to cover only the unfunded liability and not the normal or single-year service cost, which should still be covered by existing revenue.

Any deal will require “the highest level of security to bondholders,” so traditional general obligation or appropriation backing likely won’t work, Ciccarone said. A securitization of existing revenues worries him because there’s limited room to squeeze more existing revenue from the general fund to leverage.

The Government Finance Officers Association recommends against pension obligation bonds as a risky and speculative gamble that rests on the assumption that the investments purchased with the proceeds will achieve a rate of return higher than the bonds’ interest. They typically have limited flexibility because most carry corporate-style make-whole calls.

“In recent years, local jurisdictions across the country have faced increased financial stress as a result of their reliance on POBs, demonstrating the significant risks associated with these instruments for both small and large governments,” the GFOA writes.

Recent Chapter 9 bankruptcy cases have cast a pall over POBs as investors suffered greater losses than pensioners. Payments were halted on $3.2 billion of Puerto Rico pension bonds in its ongoing Title III case, but the court ordered a resumption of payments last year as holders successfully argued they have a “constitutionally-protected property interest in the form of valid and enforceable liens on pledged property.”

“I am always leery of POB issuance, but will keep an open mind,” Humphrey said, who added he was surprised the issue wasn’t the centerpiece of the conference. “The atmosphere seemed to have much more of an election-year vibe to it than addressing investor needs.” Emanuel is up for re-election in February.

Cure dislikes pension bond financings because of the risk.

“As bad as is now, it will be worse” if the arbitrage play fails, he said.

Pursuing a pension issue now ahead of the spring 2019 mayoral and city council elections has political risks. Emanuel can claim he’s tackling the looming spikes without relying too heavily on tax hikes, which may go down easier with voters. It could backfire if council members burned by the negative headlines for signing off on poor debt practices of the past push back or headlines label the borrowing another borrowing gimmick.

It also could elevate one of Emanuel’s opponents, Paul Vallas, who was a city budget and revenue director before leading Chicago Public Schools.

“Taxpayers in Illinois should well know pension obligation bonds are usually just another way of kicking the financial can down the road,” he said in a statement.

Chicago sought to highlight billions in projects underway at O’Hare International Airport, the Chicago Riverfront, and its efforts to combat violent crime in a tour of a key command center and lunch with Police Superintendent Eddie Johnson.

Investors cited concerns about whether Chicago's financial progress would survive future administrations. While pension funding plans are now set in statutes, other policies like the elimination of scoop-and-toss refundings could be reversed under a new administration.

“I think the mayor has done a good job. … I would have to reassess my favorable view of the city if the mayor is not re-elected” because the fiscal discipline of his opponents is an unknown, Cure said.

In the panel discussion, Ciccarone offered a series of charts that illustrate the city’s burdensome debts that give it “outlier” status. Chicago’s funded ratio of 26% compares to an average 66% funded ratio of other big cities. The presentations are available on the city's investor website.

Sacks argued that Chicago hasn't received enough recognition for shaving an inherited budget gap to less than $100 million from more than $600 million, building unassigned reserves to $156 million from $34 million in 2013, and a pension fund overhaul that staved off insolvency for two funds. The city also tops charts as a leading destination in the U.S. for foreign direct investment, he said.

“Our ability to solve problems hasn’t really been properly recognized by the market and those who cover it,” Sacks said.

The city’s tax-exempt GOs spreads have steadily narrowed from far into junk territory with a 2015 maturity trading last week at about 160 basis points to the AAA benchmark scale, according to IHS Markit’s Edward Lee. The city’s spreads were around 230 basis points a year ago. The single-A 10-year benchmark spread is at about a 47 bp spread and the BBB is at 82 bp. A small block of 2033 bonds traded at a spread of 128 bp Tuesday, compared to 155 bp last Wednesday, Lee said, cautioning that it was just a small block trade.

Moody’s Investors Service rates the city at the junk level of Ba1. In July it shifted its outlook to stable from negative. Fitch Ratings has the city at BBB-minus with a stable outlook and S&P Global Ratings has it at BBB-plus with a stable outlook. Kroll Bond Rating Agency rates the city at A and stable. It upgraded the city two notches earlier this year after concluding in a special pension report last year that the city can afford its growing pension costs.

“Their spreads have come in but they are still significantly wide to the BBB,” Miller said, adding that high-yield credits currently trade at about a 190 bp to 200 bp spread.

The Moody’s outlook change helped drive the latest narrowing. The outlook change is “a big deal,” Miller said.

“They’ve been super negative,” so moving the outlook to stable is meaningful, he said.

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