Chicago is preparing to remarket variable-rate debt as fixed-rate, requiring disclosure of its many fiscal challenges in offering documents.

CHICAGO - Chicago, preparing to remarket bonds, again has warned investors of its laundry list of fiscal challenges, newly topped by the potential blow posed by a ruling last week from the Illinois Supreme Court.

Chicago’s perilous credit standing was underscored Tuesday afternoon when Moody’s Investors Service downgraded Chicago two notches to speculative-grade Ba1, citing the reverberations of the Supreme Court ruling.

The Supreme Court's ruling, voiding the state's pension overhaul, poses dual challenges for the city: it raises questions over whether reforms adopted in 2014 for the city's municipal and laborers pension funds can withstand a pending a legal challenge, and escalates fiscal pressures on the state budget, which could distract lawmakers from helping the city tackle its steep liabilities toward police and firefighters' pension funds.

The city lays out its fiscal pressures in offering statements for two series of floating-rate general obligation bonds being remarketed as fixed-rate at the end of the month.

Mayor Rahm Emanuel previously announced the plan to convert four pieces of floating-rate GOs to a fixed rate and the termination of swaps tied to the bonds. They were included in a series of debt management changes aimed at improving the perception of its credit and reducing risks should its credit ratings fall any further.

Under the heading "Investment Considerations," the city lays out how "any one or more of the investment considerations discussed …. could lead to a decrease in the market value and liquidity of the bonds, or ultimately, a payment default on the bonds."

Chicago's credit ratings have taken a battering over its nearly $20 billion of unfunded pension obligations to a system just 35% funded. It carries ratings on its $8 billion of GOs that range from a high of A-plus with a negative outlook from Standard & Poor's to Baa2 with a negative outlook from Moody's Investors Service.

Standard & Poor's and Kroll Bond Rating Agency affirmed their ratings ahead of the deal. Kroll assigns its A-minus rating and stable outlook to the city's GOs.

The city outlines potential triggers for further credit deterioration that range from failure to implement a pension solution this year to court rulings adverse to the city's pension reforms.

A rise in the city's unfunded obligations, a widening budget gap, growth in its outstanding debt and that of overlapping taxing districts, the loss of liquidity due to defaults under credit arrangements, or a depletion of reserves also could contribute to a downgrade, the city warned.

Chicago has paid heavily for its fiscal ills through interest rates penalties; some of its debt trades at junk bond levels.

Near-term, the city faces a $550 million spike in contributions to its police and firefighters funds next year under a prior state mandate to bring its annual contributions to an actuarially based level.

The city tells potential investors it has not yet identified how to cover the higher payments and that "without further changes to the pension code, the city will have to seek increases in taxes or implement cutbacks in city services or some combination thereof to meet is obligation to such pension funds."

Tax increases and service cuts could drive residents and businesses to flee, harming the economy, the city warns.

The Standard & Poor's negative outlook reflects uncertainty over how the city will address it's the pension spike, analyst Helen Samuelson said in the agency's new review.

"We could lower the rating by more than one notch, given the magnitude of what the city faces, if the city fails to articulate and implement a plan by the end of 2015 to sustainably fund its pension contributions, or if it substantially draws down its reserves …. regardless of whatever relief the state legislature may or may not provide," she said.

The offering statement further warns of the potential impact of proposals being pushed by Gov. Bruce Rauner, including a move to slice in half the city's share of more than $120 million in income tax aid and initiatives to pursue property tax freezes and to change state law to permit Chapter 9 bankruptcies.

The city intends to remarket $182 million of 2003 bonds and $201 million of 2002 bonds as soon as May 29. Siebert Brandford Shank & Co. LLC is senior manager on the 2003 bonds and Ramirez & Co. Inc. is senior manager on the 2002 bonds. Columbia Capital Management is advising the city.

The 2002 bonds have no swaps. They were terminated in 2014. The urgency in converting the bonds sooner rather than later is the impending expiration in October of several letters of credit. The city will shed three LOCs.

On May 5 and 6, the city terminated four interest-rate swaps tied to the 2003 bonds, paying $31 million in termination fees. The city tapped its short-term borrowing program to cover the payment and will eventually roll it into long-term debt.

The termination payment advances the city's effort to resolve swap terminations triggered by Moody's latest downgrade in late February. The termination payment made last week on swaps tied to the 2003 bonds included one of three with Wells Fargo Bank in which termination events were triggered.

The city and Wells Fargo entered into a forbearance agreement on March 18 under which the bank agreed "not to exercise any remedies" including demanding a termination payment. The forbearance period on the remaining two swaps tied to the 2007 series ends on July 31.

The city as soon as next month will convert a 2005 series and 2007 series to a fixed-rate. The $220 million 2005 bonds being remarketed has six swaps negatively valued at $65 million and the $200 million issue from a 2007 deal has four swaps, including the two remaining Wells Fargo swaps, that will require a $72 million termination fee.

"The additional debt needed to finance the swap termination payments is not material relative to the level of the city's outstanding direct and overlapping general obligation debt," Kroll said in its most recent rating report.

As part of the debt policy changes, the city also intends to phase out its practice of pushing off of some debt service principal for budget relief; the phase-out will take until 2019 and Chicago will still use $220 million of proceeds from GO borrowing this year to cover debt service in 2016.

The city's 2014 overhaul of its municipal and laborers fund that took effect Jan. 1 was agreed to by 28 of 31 impacted unions. The legislation raises city contributions over five years to reach an actuarially based level, marking a shift form a statutory formula that ties payments to a percentage of what employees contribute.

The plan also calls for higher employee contributions and some benefit cuts, including a reduction in existing annual cost-of-living increases.

The city reforms differ on several fronts from the state reforms that were overturned. They resulted from a collective bargaining process and stabilized funds headed toward insolvency because of the statutory funding method in place at the state level. They offered both cuts and higher employee and employer contributions.

The state reforms were approved outside the collective bargaining process and the funding schedule eased both state and employee contributions.

"We believe our plan fully complies with the state constitution because it fundamentally preserves and protects worker pensions rather than diminishing or impairing them," Mayor Rahm Emanuel said in a statement last week.

One lawyer following the city and state reforms said the courts could give weight to those arguments, but said it's a gamble because the reforms cut benefits and the Illinois Supreme Court ruling firmly stood by the constitution's pension clause that considers membership in a state or local government public retirement system to be "an enforceable contractual relationship, the benefits of which shall not be diminished or impaired."

The city has said it wants to avoid a property tax increase, but most market participants believe it's inevitable. "In KBRA's opinion, political will is a crucial element in addressing these challenges," the agency said.

Municipal Market Analytics said while the ruling's impact on Chicago reforms is unclear, it makes the likelihood of help from the state all the more remote.

"Should the city actually move to raise property taxes in consequence, look for immediate positive action in prices and spreads," MMA said.

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