Why Detroit still can't access the bond market as a standalone borrower

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DALLAS -- Almost three years after exiting bankruptcy, Detroit remains some distance from reestablishing itself as a standalone borrower despite fiscal strides that have put it on a path to exit state oversight next year.

City officials say for now Detroit has all the capital market access it needs as it contemplates a transportation-related issue that would carry added layers of security to protect investors.

John Naglick, the city's chief deputy CFO and finance director, said the city recognizes that any debt it plans to bring to market still needs a security boost from a quality revenue stream and some enhancement such as a state intercept. In its bankruptcy plan of adjustment the city did not assume the need for market access in a traditional and predictable way, without added security layers, for at least ten years. That assessment remains the same as the city approaches the third anniversary of its exit from Chapter 9.

“Everything that we have been able to do since exiting bankruptcy has an attached revenue stream to it,” said Naglick. “You secure it and bond lawyers agonize over how that will be protected in the unlikely event of another bankruptcy because everyone has to ask the question now. Then there is a strong intercept mechanism that goes to a trustee like U.S. Bank where the bondholders now know this is absolutely secure.”

Matt Fabian, a partner at Municipal Market Analytics, says that much of Detroit continues to struggle with challenges that predate the 2013 bankruptcy, and the city is unlikely to regain an ability to access the traditional capital markets on its own unenhanced credit in the near-to-medium term.

“They don’t have traditional reliable access where if they need to go to the market, you can predict with certainty that they will and they will be within a generally predictable spread,” said Fabian. Reestablishing its presence in the traditional market is important because it indicates whether bondholders have confidence in the city as a going concern, he said.

The city has made strides. It has an economic plan to address a balloon payment that looms to cover its pension obligations, and can boast of a series of economic development investments that are driving downtown and midtown revitalization, including the recently opened Little Caesars Arena.

Fabian says that the city’s recovery plan and future revenue growth is complicated by the need to set aside from surpluses an additional $335 million between fiscal 2016 and fiscal 2023 to deal with the bigger-than-anticipated unfunded pension liability. “This, of course, is fiscally responsible but comes at the expense of using these funds for reinvestment and service improvement,” said Fabian.

The city has presented deficit-free budgets for two consecutive years and is on the path that would allow it to exit Financial Review Commission oversight. Although the city ended fiscal 2016 with a $63 million surplus its general fund revenues came in lower than anticipated owing to lower than expected intergovernmental aid. The city’s four-year forecast shows an annual growth rate of only about 1%.

The plan to address pension obligations is aimed at shoring up the city’s long-term fiscal health and Naglick says it shows the city has recognized the need to tackle it. Detroit developed a long-term funding model with the help of actuarial consultant Cheiron, obtained City Council approval for changes to the pension funding ordinance that established the Retiree Protection Trust Fund, and deposited $105 million into this IRS Section 115 Trust. This fund, said Naglick, will grow to over $335 million by 2024 and will provide a buffer to increased contributions beginning then.

“More importantly, the growing contributions each year from the general fund to the trust will build budget capacity to make the increased contributions in future years,” he said.

Mayor Mike Duggan claimed during his 2016 State of the City speech that consultants who advised the city through bankruptcy had miscalculated the pension deficit by $490 million.

Pension woes aren’t the only challenge the city faces. Fabian said that economic development has been limited to the city’s downtown and midtown areas. The rest of Detroit’s neighborhoods haven’t fared so well.

Duggan is seeking a second term and will face state Sen. Coleman Young II in the Nov. 7 general election.

Duggan has built his platform for re-election on the promise to build on the economic progress since the city exited bankruptcy. The incumbent has acknowledged there's much more to be done and he's announced several plans aimed at investing in neighborhoods.

In March the city issued an RFP for investment bankers for Michigan Transportation Fund bonds that will be used to accelerate projects that will upgrade road infrastructure in various neighborhoods across the city. The debt would be issued through the Michigan Finance Authority to enhance the security and marketability of the bonds. The bonds would be secured by revenues collected through highway user taxes; state motor fuels taxes, vehicle registration fees, and other miscellaneous automobile related taxes are deposited in MTF.

The city, Naglick said, ultimately couldn’t get past the negative arbitrage that it would have if it were to do a public offering and has opted to privately place it with one bank instead. It will be a delayed draw type product where Detroit will be committed to borrowing $125 million and there is no negative arbitrage because the city pays interest as it draws the funds.

A public bond offering would have been rated an single-A or double-A, similar to a bond refinancing the city executed last year, because it is secured by access to state revenue and would have likely sold below the 3% interest range, according to Naglick.

“That confirmed what we think and that is as long as we tie a high quality revenue stream to it and have an intercept to make the bondholders feel more comfortable I think we do have capital access but that is all of the capital access we have,” said Naglick.

The funds will finance infrastructure and road improvements in 10 neighborhoods, the so-called 20-minute neighborhoods that the Duggan administration is looking to reactivate as commercial corridors.

“The beauty of it is that if we increase jobs for Detroiters we could also see the income tax collections go up, and the hope is that you can raise the income tax line,” said Naglick. “The bottom line for us is that state revenue sharing isn’t likely to go up, wagering tax is solid but is not expected to go up, property taxes look like they have hit bottom; so the only real revenue stream that can grow is income tax. If all these neighborhoods get built out you re-energize small business development and jobs for people.”

Fabian said that the city’s limited access to the capital markets is not really surprising. “In Detroit the cliff related with its pensions is still a real thing and with not much evidence of economic growth beyond the downtown it’s a bit of a push to assume they could have traditional market access,” he said.

Since exiting bankruptcy Detroit has tapped the public bond market twice: in August 2015 with $245 million of local government loan program revenue bonds and in August 2016 with a $615 million general obligation/distributable state aid backed bond sale. Both deals were issued through the Michigan Finance Authority. The 2015 debt was enhanced with a statutory lien and intercept feature on the city's income taxes, which landed an A rating from S&P Global Ratings.

“That is what we can to market with,” said Naglick. “It has to be the high-quality secured bonds. The good news is that is really where our needs lie.”

Naglick said that the city may have an opportunity to test its access to the capital markets as it looks to begin paying some $630 million of unsecured B notes and $73 million of outstanding unsecured C notes the city sold near the end of bankruptcy. “The B notes are interest-only for10 years and that stuff is amortizing in principal in year 11,” said Naglick. “That is what we are looking at next -- what can we do with our other general fund debt that is out there.”

Also coming up is the refinancing of $250 million in bonds that were originally issued through Bank of America Merrill Lynch in 2014 to finance the $650 million Little Caesars hockey arena. They are supported by tax increment financing revenues collected by the DDA. Also up for refinancing will be the $35 million of bonds the city privately placed in August to fund the NBA Pistons' move into the downtown arena. Naglick said that those bonds will have to be refinanced in 2018 in order to avoid what he called a big increase in the interest rate.

Detroit is rated B with a stable outlook by S&P and B2 with a stable outlook by Moody’s Investors Service. Naglick said the city is up for a ratings update by the rating agencies next month.

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