CHICAGO – Chicago's water enterprise credit was removed from Fitch Ratings' negative watch list in recognition of its resolution of liquidity strains tied to downgrades that triggered defaults on bank contracts.
Fitch Ratings affirmed the AA-plus rating on $37 million of senior lien water revenue bonds and the AA rating on $2.2 billion of second lien bonds in a report Wednesday.
While the near-term risks have abated, Fitch's longer term concerns over the credit's health drove the assignment of a negative outlook.
Moody's Investors Service's May junking Chicago's general obligation and sales tax paper and downgrading of its water and wastewater revenue bonds to lower investment grade level ratings triggered defaults on various bank support and interest-rate swap contracts.
Banks could have demanded accelerated repayment of $2.2 billion of debt from swaps and floating-rate sales tax, wastewater, and general obligation paper as a result.
None did, and city officials have worked over the last six months to resolve the potential crisis, which itself triggered subsequent downgrades from other rating agencies. The city converted its floating-rate bonds impacted by the downgrades to a fixed rate.
The city's costly solution also involved paying off about $270 million in swaps tied to general obligation and wastewater debt, mostly with long-term debt, and it shifted much of its credit line debt to its long-term debt load.
The last remaining piece to solve was tied to water credit swap contracts with a negative valuation of $105 million.
"The removal from negative watch reflects the city's successful renegotiation and/or novation of financing and swap agreements, which have eased the liquidity risks posed by the system's variable-rate debt and swaps exposure," Fitch wrote.
Bond rating thresholds for the three swaps were either lowered to fall below investment grade from the high triple-B category through novation of the swap to a different counterparty, or the rating agency that assigned the lowest rating was removed under the revised contracts, Fitch wrote.
"While not completely eliminated, the liquidity risks associated with variable-rate debt are sufficiently lowered and, coupled with existing cash resources, provide adequate time for the city to potentially address a longer-term solution if bonds are downgraded further," Fitch said.
The bonds currently enjoy strong debt service coverage ratios but "margins in subsequent years are projected to trend downward, primarily from rising operating expenses related to pensions and increases in debt service costs," Fitch wrote. "Additional deterioration in financial expectations would be expected to result in negative rating action in the future."
The credit profile benefits from the water system's operation as an enterprise system with revenues and debt being collected and paid outside of the city's corporate fund. That, however, doesn't fully insulate the credit from the city's struggles. The city's GO ratings have been dragged down primarily over its $20 billion pension burden.
"While Fitch views the potential for spillover of financial pressures to the city's utility funds as unlikely beyond pension payments and rising indirect costs, indications of such spillover could be expected to result in negative rating action," Fitch warned.
Reimbursements to the general fund are expected to rise by more than 42% by 2017 as pension related costs ramp up.
The system serves 5.2 million city and regional residents with treated water from Lake Michigan. The City Council has full authority to set rates and they remain affordable even in the face of significant increases pushed through by Mayor Rahm Emanuel since 2012 to support an ongoing $2.1 billion capital improvement program.
Multi-year rate increases through 2015 have bolstered annual revenues by $321 million. In fiscal 2014, debt service coverage on first-lien bonds hit 18.2 times with coverage on all debt service including state loans a "healthy" 2.6 times, Fitch said. That's up from 1.5 times in 2011. Coverage is projected to dip to 2.1 times in 2016 and 1.8 times in 2017.
The capital plan to upgrade the aging system calls for replacing 450 miles of water mains and adding/updating 100,000 water meters.
A mix of debt and cash on hand financing will cover the costs. The city expects to issue approximately $1.1 billion in additional debt through a combination of revenue bonds and state revolving fund loans over the next four years.
"This more balanced approach to capital funding is viewed positively by Fitch as previous [capital improvement programs] were almost exclusively debt-financed," Fitch said.
