Detroit's standalone deal will test appetite for credit
Detroit is planning to end the year with two deals that will offer up to $243 million of bonds and test the market's perception of its recovery from its Chapter 9 bankruptcy.
The city plans to price $112 million of new money unlimited tax general obligation bonds the week of Dec. 3 in its first standalone borrowing since the 2013 bankruptcy.
City officials have said achieving bond market access without the support of state aid or some other backup mechanism is the next big step for the junk-rated city to signal it has come full circle.
Detroit has also launched a redemption offer for bonds it issued in 2014 as part of its bankruptcy exit package. The city is targeting $131 million of nearly $632 million of series 2014B financial recovery bonds that mature in 2044 with a tender offer that expires Dec. 3.
Goldman Sachs is the lead manager on both the UTGOs and tender. Citi and Siebert Cisneros Shank & Co are the co-managers.
The tender offer’s selling range is between $85 and $89 per $100 of the bonds’ par amount, according to city documents. The city will pay for the bonds it decides to purchase from proceeds of a financial recovery bond refunding issued via the Michigan Finance Authority and backed by a fifth lien on the city’s distributable state aid revenue. The city redeemed $70 million of series 2014C bonds earlier this year with surplus cash from the city’s coffers.
The UTGOs will be sold solely on the back of the city’s junk-level credit. In May, Moody’s Investors Service upgraded the city’s issuer rating to Ba3 from B1. It assigns a stable outlook. In December, S&P Global Ratings upgraded the city’s issuer credit rating to B-plus. The outlook is stable.
It's less than four years since Detroit exited Chapter 9 after shedding a significant portion of its liabilities, in part by cramming down its bondholders. Today's investors are likely to have a short memory, said Lisa Washburn, a Municipal Market Analytics managing director.
“There is such a demand for anything that has any sort of yield that those that are interested in the bonds are going to be looking at the positives and may not be placing as much weight on the historic nature of their city’s bankruptcy and default,” she said.
Howard Cure, director of municipal bond research at Evercore Wealth Management, said that investors are looking for some extra yield, and appetite for the bonds will depend on their investment time horizon.
“Keep in mind that not all investors hold onto bonds for the whole maturity,” Cure said. “They may say well right now things are going well I will hold on and if things improve I could sell, make a profit that way as opposed to the longer-term view on how well-established is the city to maintain this trajectory. This is where you have differing opinions from investors.
"[Investors] are still looking for yield, rates aren’t that high — so [Detroit] may think their story is convincing enough to give people hope they will ultimately get upgraded to above investment grade.”
Much of Detroit's improved budget performance was made possible by shedding fixed costs during bankruptcy, including debt service and retiree costs for pensions and other post-employment benefits. The city’s plan of adjustment required it to initially make only modest contributions from its general fund to the pension system, but the city must resume making actuarially determined contributions in fiscal 2024.
The city’s most recent estimate pegs its fiscal 2024 contribution requirement at $140 million, equal to 14% of fiscal 2017 operating revenue. The city has put aside roughly $105 million in a Retiree Protection Fund in preparation for the increase in pension payments.
“The city has to deal with escalating pension and debt payments in the coming decade,” said Washburn. “That really focuses on Detroit being able to grow its population, its revenues and achieve stability.”
Moody’s warned in a Nov. 8 report that this combination of rising fixed costs and volatile revenues leaves Detroit vulnerable to an economic downturn.
The rating agency credits Detroit’s surge in employment and tax revenue growth to an influx of affluent resident and large-scale developments that have transformed the city’s downtown. Growth in the core downtown, which accounts for just 6% of the city’s population, has seen a 28% increase. Since 2010, the core downtown has added almost 1,000 residents and the greater downtown area has added about 9,000 residents, according to Moody’s. Also contributing to income tax growth is improved administration and enforcement of collections.
But that downtown growth has not spread throughout the city, Moody's said. It estimates Detroit has lost about 35,000 residents since 2010.
A number of large projects in the pipeline are likely to continue fueling growth downtown.
“The trends, coupled with savings achieved through bankruptcy, have led to marked improvement in the Motor City's financial position and credit quality,” Moody’s said.
“A material strengthening of the demographic profile and property tax base would better position the city to afford the cost of servicing the city's still high debt and pension burden,” said Moody’s. “But such improvement is unlikely unless there is an acceleration of growth or expansion beyond downtown.”
In his State of the City address earlier this year, Mayor Mike Duggan announced plans to expand his strategic neighborhood fund from three initial investment areas of the city to ten. The model for this effort is built around the strategy used in the city’s downtown revitalization, which was to secure philanthropic and corporate donations to close the gap between the upfront cost of key projects and what developers could expect to realize in terms of rents.
"The comments in the Moody's report about expanding the footprint of the city's revitalization is in alignment with stated priorities and activities of the administration," Arthur Jemison, Detroit's chief of services and infrastructure, said in an emailed statement.
Washburn said the state’s fiscal condition and/or a lower population across the city’s large footprint could also impact the state aid that city receives in the future. "Detroit had a lot of problems before bankruptcy and one of them that got less attention was the dramatic cut in the revenue sharing payments coming from state,” said Washburn. “If that revenue source declines again it could be a hardship for the city.”
Moody’s has also warned that the capital needs of Detroit’s public school system pose a threat to the city’s “post-bankruptcy economic revitalization” unless the state or the philanthropic community step in with funding. The school system was rescued by the state government and now has very little funding on hand to make badly-needed improvements to its buildings and infrastructure. For fiscal 2019, the district has budgeted just $9 million in capital expenses out of a budget of roughly $760 million.
A facility assessment commissioned by the district and conducted by third-party consulting firm OHM Advisors in July reported that the school’s district’s 100-plus school buildings in operation have approximately $530 million in capital needs and deferred maintenance. The report projected that the figure could top $1.5 billion by 2023 if not addressed.
“DPSCD's escalating capital needs pose a potential credit risk to the city's economic recovery because a successful public school system is crucial to its revitalization efforts,” Moody’s said. Population loss could accelerate if the school system weakens, hurting tax revenues and further weakening the city's out-migration.”
Cure said turning around public schools is critical for the city as it looks to expand its tax base beyond downtown.
“While on the revenue side the benefits have been showing up on the income tax, it hasn’t so much on property taxes, which is much broader-based,” Cure said. “When you have a reliance on income tax, it is prone to fluctuation particularly in the next recession, while property taxes are much steadier.”
Property taxes currently bring in $135 million per year, less than 20% of the city's revenue base. Income taxes are the city’s major revenue source, bringing in approximately $290 million per year. The city’s second major revenue driver is the 6% state income tax that is passed back to cities, which brings Detroit about $200 million per year.
The city’s third largest revenue source is a wagering tax of just a little less than 12% of net gambling revenues paid by the three casinos in Detroit. The city collects on average about $180 million per year from the tax.
"Those three sources of potentially volatile revenue comprised nearly 60% of the city's operating revenues in fiscal year 2017," Moody's said.
Detroit’s Downtown Development Authority is separately working on a transaction to issue up to $294 million of Series 2018A tax increment revenue refunding bonds to refinance all of the senior debt on Little Caesars Arena that were issued through the Michigan Strategic Fund. The bonds are secured by a senior lien on pledged tax increment revenues in the area around the sports arena.
DDA also plans to sell $24.1 million of 2018B subordinate tax increment revenue refunding bonds to refund outstanding tax increment bonds issued in 1998. The bonds are secured by a subordinate lien on net general tax increment revenues.
The bonds are expected to price Thursday.
Kroll Bond Ratings Agency assigned an underlying BBB-minus rating and stable outlook to the Series 2018A bonds.
Both Series 2018A and Series 2018B will be insured by Assured Guaranty, and carry insured ratings of AA-plus from Kroll and AA from S&P.
Jefferies LLC is senior manager. Hilltop Securities Inc. is the municipal advisor and Dykema Gossett PLLC is bond counsel.