Detroit Water and Sewer Bows Out with Deal, Upgrade

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CHICAGO – With a fresh upgrade in hand and the prospects of more to come, Detroit's water and sewer department heads into the market next week with its final deal before handing its more than $5 billion of debt over to the Great Lakes Water Authority.

The Michigan Finance Authority is issuer for the Detroit Water and Sewerage Department's $280 million current refunding.

The debt carries mostly investment-grade ratings although one rating agency still has second-lien paper at junk.

As part of their purchase, investors consent to the GLWA's impending assumption of the department's obligations, which is expected by Jan 1. The shift is viewed positively by rating agencies and market participants because of its benefits to investors, including legal insulation from Detroit, which exited Chapter 9 bankruptcy in late 2014.

"GLWA would not be consolidated into a hypothetical future Detroit bankruptcy proceeding," reads an investor presentation on the bond sale.

While the DWSD has enjoyed mostly independent operations from the city, its debt was still dragged into the bankruptcy at a cost of about $28 million in professional and insurance fees during fiscal 2015 alone, according to Fitch Ratings, which views the transfer as a credit positive for investors.

The sale offers three series: $90 million of senior-lien water revenue bonds tentatively structured with serial maturities through 2034, $39 million of second-lien water revenue bonds structured as a 2034 term, and $155 million of second-lien sewage disposal revenue bonds with serial maturities through 2035, according to the offering statements. The bonds are secured from pledged revenues generated by the enterprise systems.

Citi is the senior manager with another six firms in the syndicate. First Southwest is financial advisor. Dickinson Wright PLLC is bond counsel to the authority. Dykema Gossett PLLC is bond counsel to the department and Kutak Rock LLP is underwriters counsel.

"Interest rates are favorable and so there was the opportunity for some net present value savings on a refunding" ahead of the transfer of assets and obligations under a lease agreement, said GLWA chairman Robert Daddow. "Bondholders understand that the debt will move over."

Detroit Emergency Manager Kevyn Orr's plan of adjustment set in motion the establishment of the regional water authority – long in the works -- to take control of the city's Water and Sewerage Department in exchange for lease payments.

Under the 40-year lease agreements struck with the city in June, GLWA will assume responsibility for regional water and sewer infrastructure while the city will maintain responsibility for local water and sewer infrastructure serving city residents.

"The separation is just huge and bondholders will benefit," Daddow said.

The legal separation between the new authority and Detroit is clearly a positive for bondholders, said Matt Fabian, partner at Municipal Market Analytics. “Bondholders should want to be as far from the Detroit name as possible because the city still has meaningful risks” of a future Chapter 9, Fabian said. But while the debt will be legally separate, some credit risks remain as the authority is exposed to the city as a customer.

The lease calls for the GLWA to make an annual $50 million revenue-financed capital contribution to finance capital improvements and debt service and to fund assistance programs.

GLWA will be governed by six board members: two from the city; one each from Wayne, Oakland and Macomb counties, which are served by the department; and one representing the state government.

The board last month named interim chief executive officer and director of the city department Sue McCormick as its CEO.

The authority must finalize some legal and technical documents, permits and contracts but it remains on course to launch Jan. 1, Daddow said. A critical piece of the deal is to obtain consent of existing bondholders.

"I don't see any barriers to completion," Daddow said.

A series of credit upgrades recognizing departmental improvements and the impending water authority's assumption of the debt, with new structural benefits, offer persuasive benefits for bondholders, Daddow said.

In addition to the central benefit that a direct link to the troubled city's credit is removed, the distance also gives the new authority more flexibility on contracts allowing it to be "more nimble" without the need for City Council review.

Under the terms, bondholders will hold a statutory lien on pledged assets and rates must be set at a level to meet various coverage ratios. GLWA will have "step-in" rights to enforce rate increases set by the department.

"This dual rate-making power and direct step-in rights enforcement authority is not available under the pre-GLWA structure," according to an investor presentation.

Lease payments are restricted to debt repayment and capital projects and a debt stabilization fund must be established over the next three year to offset bad debts.

Ahead of the sale, Standard & Poor's raised its rating one level on senior bonds and affirmed its ratings on the second lien bonds. That puts the second lien water and sewer bonds at BBB-plus with a stable outlook and the senior lien bonds at A-minus and stable.

"The upgrade on the senior-lien bonds reflects the DWSD's stabilizing financial profile," said Standard & Poor's analyst Scott Garrigan, "supported by revised rate methodologies and various cost-control efforts."

The ratings also recognize GLWA's pending assumption of the DWSD debt.

"We believe that a significant amount of uncertainty regarding management and governance of both the Detroit retail and regional systems has been resolved," S&P added.

The credit reflects adequate-to-good financial performance and projections that indicate improving conditions, affordable rates, and strong management policies and procedures.

The city's $3.3 billion of sewer debt includes 61% under the senior lien, 25% under the second lien, and 14% in an unrated junior lien.

The city's $2.3 billion of water debt includes 73% in the senior lien, and 27% in the second lien, with a small piece of unrated junior-lien debt.

Fitch Ratings, which gave the debt a one-notch upgrade over the summer, affirmed its BBB-minus rating for the second lien water and sewer bonds and the BBB rating for the senior lien.

Outlooks are stable.

"The planned lease of the systems by GLWA provides further assurance that system operations will remain independent of the city," Fitch said.

The credit reflects a system that is highly leveraged and expected to remain so. The water system serves nearly 40% of the state's population with 75% of revenue coming from wealthier suburbs and the sewer system serves 30% of Michigan's population with more than 50% of operating revenues coming from suburban customers.

The water system revenues provided total debt service coverage of just under 1.1 times in fiscal 2015 while sewer coverage was at 1.2 times.

"Improvement in financial results is attributable to DWSD's efforts both to enhance revenues and cut operating costs," Fitch wrote. The department has implemented new revenue forecasting procedures and worked to reduce late payments more proactively on payment plans with scheduled shut-offs declining from 26,000 to 6,000.

The department came under scrutiny and national criticism for its aggressive shut-offs for customers in the arrears.

The systems' 2016-2020 estimated capital improvement plan calls for $796 million in water spending and $594 million for sewers, with about $520 million in water borrowing planned and $161 million for sewers.

Moody's Investors Service affirmed its Baa3 rating for senior-lien bonds and the speculative grade Ba1 rating on second-lien debt.

Moody's upgraded the debt in August, bringing the senior-lien debt to investment grade for the first time since before Detroit's August 2013 bankruptcy filing.

It assigns a positive outlook, citing continued improvements to operating performance and the impending transfer.

Once the transfer is completed, its ratings "could be several notches higher," Moody's said.

"The separation will significantly limit the possibility that the water and sewer revenue debt would be at risk for impairment if the city were to again file for bankruptcy," Moody's wrote.

Fitch and Standard & Poor's lifted the senior-lien bonds out of junk territory in 2014 ahead of a tender financing.

Detroit's water and sewer revenue bonds were for years among the city's highest-rated debt, but the ratings agencies began knocking the debt down in 2013 after Orr declared he would restructure the department's bonds amid the financial crisis that sent the city into bankruptcy.

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