CHICAGO — Detroit comes to market Wednesday with nearly $500 million of senior-lien water revenue bonds in a deal that could face headwinds from the city’s well-known fiscal woes along with the uncertainties being raised over the treatment of water and sewer debt in Jefferson County, Ala.’s bankruptcy.
Roughly half of the sale proceeds will finance the unwinding of 15 interest rate swaps tied to the water bonds.
Detroit has $4.6 billion of water and sewer bonds, which have long been considered relatively isolated from the city’s financial problems.
The senior-lien bonds have high single-A ratings, in contrast to Detroit’s own junk-level general obligation rating.
Bondholder payments come from a lien on revenues in the Detroit Water and Sewerage Department, which is one of the largest in the country. More than 80% of the system’s revenues come from outside the city.
But as Detroit edges closer to a state takeover and the spectre of bankruptcy looms, its problems could taint the water bonds, according to some market participants. Detroit owns the system, exposing its revenue to the uncertainties and risks surrounding the Motor City’s own fiscal future.
Wary investors also cite Jefferson County, where the largest U.S. municipal bankruptcy is raising questions about the treatment of revenue bonds during Chapter 9 proceedings.
The city’s finance team attempted to address investor concerns in preliminary bond documents, outlining the city’s financial problems, describing how the bonds would be treated in case of bankruptcy, and arguing that the Detroit water bonds offer more bondholder protections than are afforded to Jefferson County sewer debt.
This week’s borrowing comes less than two weeks after Michigan launched a preliminary investigation into Detroit’s finances, an act that is often the first step toward the appointment of an emergency manager and a state takeover. The review could take 30 days. but state treasury officials expect to complete their report as soon as this week or next.
City and state officials continue to downplay the possibility of bankruptcy, and many observers view the likelihood as remote. But just the threat is a negative for some investors who may demand an interest rate premium for the risk.
Howard Cure, director of municipal credit research for New York-based Evercore Wealth Management LLC, said he is cautious about an otherwise historically strong credit.
“It’s one of the biggest water systems in the country, but it’s still owned by the city,” Cure said. “Also, you can’t help but think of the implications of what’s going on in Jefferson County. It’s a little disconcerting.”
Jefferson County is arguing that the automatic stay that went into place when it filed for bankruptcy should give it the authority to determine if it should continue paying its $3.14 billion of sewer debt.
“We’ve operated under the assumption for a pretty long time now that [water bonds] will be a secure revenue stream and not clawed back,” Cure said. “I don’t think the odds are that the revenues would be clawed back or even that the city would declare bankruptcy, but there’s a shifting of a paradigm of what you assume are secure revenues.”
Jefferson County is “in the back of people’s minds,” said Thomas Spalding, chief investment officer at Nuveen Investments. “If the city does go bankrupt, you can think everything is going to be fine, but if you get a politically minded judge, that’s the risk.”
Despite the problems, Spalding said he expects the deal to price relatively well.
“I think it would do better if it wasn’t the city of Detroit issuing, if there was a water authority issuing,” he said. “But I still think it will do fairly well.”
Preliminary bond documents include a section on investor concerns related to bankruptcy in language that has become common when the city or Detroit Public Schools comes to market with their own GO bonds. But it is the first time it has appeared in water or sewer revenue bond documents.
The documents note that the city has faced financial challenges and that it is the city’s intent to “eliminate its current deficit and provide for future balanced financial operations.” But if those efforts fail, Detroit’s “financial status could deteriorate further and its options to improve its fiscal health may be limited,” the documents say.
The discussion notes that the state has launched a preliminary review but has not yet taken any additional steps. If the state did take over the city and appoint an emergency manager, that would not affect the security for the water bonds or the use of pledged assets for the payments of the bonds.
The fate of the water bonds is less clear, however, if the city were to file for bankruptcy protection, because no Michigan municipality has done so.
Echoing similar language in Detroit and Detroit Public Schools’ bond documents, the disclosures say that special counsel has advised that it is likely, but not certain, that a bankruptcy court would rule that the debt would constitute a special revenue and as such would not be subject to an automatic stay.
The bond documents assert that Detroit water bondholders will enjoy greater protections than the holders of the Jefferson County water and sewer debt, mainly because the city currently has the power to voluntarily distribute the pledged assets to bondholders, in contrast to Jefferson County, where a state court-appointed receiver was appointed before the county’s bankruptcy filing to act on behalf of the bondholders and control the system.
The judge in the Jefferson County case has yet to determine whether the receiver will stay in place.
Nearly half of the proceeds from Detroit’s $493.4 million deal will finance the unwinding of all interest-rate swaps hedging the water bonds, which are already in a fixed-rate mode.
Siebert Brandford Shank & Co. is lead underwriter on the transaction. JPMorgan is co-senior. Bank of America Merrill Lynch, BMO Capital Markets, Loop Capital Markets, and Morgan Stanley round out the team. Lewis & Munday PC is bond counsel. Robert W. Baird & Co. is financial advisor.
The system’s extensive swap program features a total of 15 swaps, including four that have been reversed with so-called mirror swaps, three fixed-to-floating-rate swaps, two floating-to-fixed-rate forward starting swaps, and two swaps that are indexed to the consumer price index, according to Standard & Poor’s.
The cost of terminating the swaps is estimated at $210 million, according to preliminary bond documents. Like some of Detroit’s other swaps, the water bond swaps would be subject to termination if the state appoints an emergency manager.
In 2009, the city refinanced a chunk of water bonds, shedding the liquidity providers and avoiding expensive termination payments on existing swaps by leaving the swaps in place and bidding out the reverse swaps.
The swap terminations will end up having little impact on the credit, said Standard & Poor’s analyst Scott Garrigan.
“By terminating the swaps, obviously they are amortizing the costs of that over time, which adds to the fixed costs the system has to handle,” Garrigan said. “But on the positive side, they are also eliminating some of the counterparty and interest rate risk. So on balance, we view it as neutral.”
Standard & Poor’s rates the senior-lien water bonds A-plus with a stable outlook.
Garrigan said it was too early to speculate on how the appointment of an emergency manager might affect the water debt.
Moody’s Investors Service rates the debt A2. Last week, it put the water bonds, as well as the rest of Detroit’s debt, on review for possible downgrade in light of the possibility of a state takeover, bankruptcy, and large swap termination fees.
“The credit outlook is currently under review for possible downgrade, given that the system is city-owned and may not be completely immune to the risks associated with a city bankruptcy filing,” Moody’s analyst Genevieve Nolan wrote in a recent release on the upcoming deal.
Both rating agencies note that the water and sewerage department is large and diverse, serving nearly 40% of the state’s population across eight counties.
After a few years of wobbly debt-service coverage, levels are expected to return to 1.6 times for senior-lien bonds and 1.12 times for total debt service coverage in 2012 after a planned rate increase, according to Garrigan.
In addition to Detroit’s problems, challenges include a large debt burden as well as a $556 million capital plan that could pressure the system’s balance sheet, analysts said.
