Cleveland Water trading in floating for fixed rate bonds
Cleveland will shed some of its floating-rate risk and bank exposure in its water enterprise system with its $95 million sale set for Thursday.
The city is selling the fixed-rate, water revenue bonds to refund some outstanding variable rate debt and terminate its interest rate swap agreements.
Betsy Hruby, debt manager for the city said that the refunding is expected to achieve a lower debt service and the termination of the swap agreements will mitigate the risk of fluctuations in interest rates in the city’s outstanding variable rate debt.
J.P. Morgan provides two interest rate swaps in the amounts of $54.7 million and $16.5 million. Morgan Stanley provides two interest rates swaps in the amounts of $9.3 million and $26.2 million.
Hruby said that the bond and swap market fixed rates are lower today than they were when the swap was executed in 2004.
“Because of this, there will be a negative market value for the city which will result in a termination payment funded with bond proceeds,” Hruby said. This value, she said, changes every day and throughout the day but the most recent estimation is a swap termination payment of about $8 million on the part of the city.
Hruby said that if at pricing there are no debt service savings from the refunding of the hedged bonds and the termination of the swap, the city will opt to postpone that portion of the issue.
“The city decided that the market presented us with the opportunity to lock in low fixed rates and completely eliminate all risks related to the Water System’s hedged debt,” Hruby said. “We plan on executing the transaction as long as there is no cost to the city.”
Hruby said the city had estimated at least 3% savings for the portion of the transaction that is a traditional refunding.
Moody’s Investors Service rates the bonds Aa1 and S&P Global Ratings rated the bonds AA-plus. The outlook is stable. Cleveland Water has $527 million of outstanding debt and 33% of it is variable rate debt. After the 2019 bonds 16% of the debt outstanding will be variable rate.
Hruby said that based on the ratings the city opted not to structure the bonds with a debt service reserve fund, a feature that is on some of the outstanding debt held by the city. “We didn’t feel that it was necessary to increase the size of the bond deal to cover these bonds with a debt service reserve fund since water is an Aa1 rated credit,” she said.
The system's financial operations are a key credit strength, as management has maintained healthy debt service coverage, ample cash reserves and a moderate debt burden while continuing to address long-term capital needs,” Moody’s said. “These strengths largely outweigh the system's credit challenges, which include absence of a debt service reserve fund for some series, some exposure to variable rate debt and a demographic profile that trails other highly rated entities.”
Moody’s noted that the rating also considers the stable outlook on Cleveland's A1 general obligation rating. The water enterprise serves 70 communities in Northeast Ohio.
“We expect the system will maintain a strong financial profile supported by conservative management and unlimited rate setting authority,” Moody's said.
The system generated $136 million of net revenue in fiscal 2017 and unaudited results for fiscal 2018 reflect a 5% decline in net revenue, which Moody’s said “could modestly reduce total annual debt service coverage to 1.6x.” but the annual rate increases of 5% for 2019 and 2020 are expected to stabilize coverage levels.
Stifel and RBC Capital Markets are senior managers. JP Morgan, Morgan Stanley, PNC Capital Markets LLC and Siebert Cisneros Shank & Co. LLC, are co-managers. Phoenix Capital Partners and Government Capital Management are the municipal advisors. Squire Patton Boggs is bond counsel.