Why a Cleveland rating took collateral damage from Puerto Rico

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Cleveland’s water revenue bonds joined the list of credits to feel the impact of Puerto Rico’s special revenue court ruling.

Moody’s Investors Service downgraded $431 million of outstanding senior lien revenue bonds to Aa2 from Aa1 and $61 million of outstanding second lien revenue bonds to Aa3 from Aa2 after reviewing their alignment with the city's general obligation bond rating in light of two court rulings that Puerto Rico is not required to pay debt service on "special revenue" bonds during its Title III bankruptcy proceedings.

Cleveland's water bonds were among eight ratings Moody's placed on review for downgrade on May 13 following the appellate court ruling related to Puerto Rico’s bankruptcy that challenged longstanding beliefs held by the municipal market that special revenue bonds were insulated from repayment risks during bankruptcy proceedings. The district and appellate court have said the commonwealth may, but is not required to, repay a portion the portion of its revenue debt in question as its case proceeds.

The U.S. Court of Appeals for the 1st Circuit upheld the lower court decision related to the Puerto Rico Highways and Transportation Authority bonds. The appellate court released its decision on March 26 in a case brought by Assured Guaranty Corp. and three other bond insurers challenging the decision from the district court judge overseeing Puerto Rico Title III proceedings.

The judge had ruled payment of special revenues are voluntary, rather than mandatory as has been the long-standing tradition in Chapter 9 proceedings. The 1st Circuit affirmed that decision and held that special revenues pledged to revenue bondholders are only exempt from the automatic stay that halts payments to creditors if the municipality voluntarily pays the special revenues to the bondholders.

“Our credit view of the system reflects close alignment of the city of Cleveland's general obligation rating because of the strong legal and governance linkages as a department of the city,” the rating agency wrote about Monday's downgrade. "In the event of serious fiscal stress of the city, there is greater risk for system creditors that the city could impair pledged revenue than if the system were legally independent of the city.”

Moody’s also affirmed the city’s A1 issuer and general obligation limited tax rating, its A2 rating on the city’s non-tax revenue bonds and the A3 rating on the city’s refunding certificates of participation. Outlooks are stable. Moody’s said that with the downgrade the rating on the water revenue bonds is better aligned with Cleveland’s general obligation rating.

Cleveland Water’s capital improvement plan assumes $349 million in projects through 2023, of which $328 million is expected to be paid from system revenue and $21 million from bond sales anticipated to take place in 2023.

Only Chicago’s senior water/sewer bond Baa1 rating remains on review for downgrade, Moody’s said on Tuesday. The rating agency downgraded the Illinois State Toll Highway Authority to A1 from Aa3 on May 31 as a result of the ruling. In June it downgraded the Dallas Waterworks & Sewer Enterprise revenue bonds to Aa2 from Aa1.

Fitch Ratings in April put seven credits on watch including several California school districts, two healthcare credits, the Chicago Public Schools capital improvement tax levy-backed rating, and Chicago water utility rating, all of which are six or more notches above the issuer rating.