Despite it All, Chicago Schools' Default Risk is Low: MMA

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CHICAGO – Peel away the layers of negative headlines and patient investors will find low default risks and underlying credit strength in this week’s $300 million Chicago Board of Education deal, according to Municipal Market Analytics.

“BOE debt is well insulated from default risk by significant 'belt and suspenders' protections,” MMA wrote in a market piece authored by Matt Posner & Kevin McGuigan Friday. “We understand that negative headlines, downgrades and Chapter 9 speculation have all damaged value but believe the case can be made for a considerable underlying credit strength that exists for patient investors.”

The market is watching to see how the financially beleaguered school district will fare in the primary this week, with its bonds trading at junk bond levels in the secondary market. 

PNC Capital Markets LLC is running the books for Tuesday’s pricing. 

Steep yield penalties are expected as the district’s long term yields have jumped 140 basis points due to recent negative news with trading of between 200 and 300 basis points above the Municipal Market Data and MMA triple-A benchmarks depending on maturities.

Preliminary pricing figures showed the deal potentially offering yields of between 5.30% and 5.60% depending on their coupons.

The double-barreled bonds carry the full faith and credit of Chicago Public Schools as well as an alternate revenue pledge in the form of a statutory lien on its state aid.

Much of the district’s $6 billion of debt carries an alternate revenue pledge. State aid goes first to the trustee to cover repayment.

The bonds’ value has been hurt by a stinging series of negative headlines, from multi-notch bond rating downgrades to Gov. Bruce Rauner’s comments that no state bailout looms and bankruptcy is an option.

The final hit came last week when the district disclosed chief executive officer Barbara Byrd-Bennett was being investigated by a federal grand jury for her role in a no-bid contract. She was placed on leave Friday pending the outcome of the probe.

“Regardless of statements by the governor, Chapter 9 is likely a low probability outcome, allowing for a less cynical reading of CPS’ otherwise strong pledged security,” MMA wrote Monday in its weekly outlook authored by Matt Fabian, Lisa Washburn, and Bob Donahue.

“This security presents only minimal payment default risk,” Monday’s outlook piece said.

In response to the news last week, several large sellers emerged as well as a large retail network with millions out for the bid daily, MMA reported.

MMA puts the emphasis on patience and an ability to tolerate more negative news due to the district’s massive financial challenges -- a $1.1 billion budget deficit and $9.5 billion of unfunded pension obligations -- with no solution in sight.

“In our opinion, holders able to tolerate more bad news, more downgrades, and worsening liquidity should consider a limited allocation to CPS bonds for incremental income,” Monday’s MMA piece said.

In preliminary pricing indications on the series for $275 million, the 2035 maturity for $194 million was initially offering yields of 5.53 with a 5.25% coupon and 5.38% with a 6 % coupon, 281 and 266 basis points, respectively, over the MMA benchmark.

The 2039 maturity for $81.5 million was offering yields of 5.62% with a 5.25% coupon and 5.32% with a 6.25% coupon, 279 and 249 basis points over MMA. 

After selling floating rate notes March 24, the board late last month delayed the second piece of the two tranches it planned to sell until Tuesday to give the market time to digest a round of multi-notch downgrades that triggered swap termination events.

Moody's on March 6 downgraded Chicago Public Schools two levels to Baa3 and assigned a negative outlook. Ahead of the new sale, the board did not seek a rating from Moody's.

Fitch Ratings in March lowered the district's GOs to BBB-minus from A-minus, assigning a negative outlook. Standard & Poor's lowered the district's rating by two notches to A-minus and assigned a negative outlook. Kroll Bond Rating Agency assigned a first-time rating of BBB-plus with a stable outlook.

A termination event on its swaps was triggered when both Moody's and Fitch lowered the district below the BBB level. The district's 10 interest rate swaps on a notional amount of $1.1 billion of debt carry a current negative valuation of $228 million. CPS is negotiating with the counterparties to stave off payments. At least one of the board’s variable rate demand issues has reset to a maximum penalty yield of 9% due to the downgrades.

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