How a bond market return would seal Detroit's comeback
With Detroit's budget solidly in the black, its exit from state oversight complete, and a funding plan in place to tackle a looming hike in pension contributions, Detroit is beginning to eye a return to the bond market on its own.
Achieving bond market access without the support of state aid or some other mechanism is the next big step for the junk-rated city to signal it has come full circle from its historic 2013 Chapter 9 bankruptcy filing, said the city's chief deputy chief financial officer and finance director, John Naglick Jr.
When the city exited bankruptcy in late 2014 it had the cash needed for capital projects from its exit financing, grant dollars, and other secured sources to show the rating agencies it could fund capital needs, "but the day has to come in the not-to-distant future where we bond for capital like any other normal government," Naglick said in an interview after a panel discussion at The Bond Buyer's Midwest Municipal Market Conference last week.
“I don’t have any timing," Naglick said, declining to say whether that return happens in 2018, 2019, or beyond, "but it could be soon" as the city is reviewing banker responses on debt financing options and has been told by market participants that demand remains strong for high-yield paper.
The goal in the meantime is to keep taking credit-positive actions to better position the city to get into the market on its own, Naglick said.
Market access on its own is eventually needed to relieve pressure on the general fund which will be relied on to cover higher pension contributions which begin in 2024 and a $25 million spike in debt service in 2025.
“If we can’t bond for capital it’s going to be a drag on the general fund because obviously in the future the general fund is going to have to cover existing debt and pension contributions,” Naglick said. “We need to get back to bonding for capital.”
The city's ratings and market perception -- from residual anger over haircuts taken in the bankruptcy to concerns about the city's ability to stay in the black -- pose hurdles but some indicators are moving in the city's direction.
In May, Moody’s Investors Service upgraded the city’s issuer rating to Ba3 from B1. The outlook, previously positive, is stable at the new, higher rating. Moody’s had upgraded Detroit to B1 in October. In December, S&P Global Ratings upgraded the city’s issuer credit rating to B-plus. The outlook is stable.
Naglick said that the city may be willing to come to market with a junk rating as long as investor appetite exists. Naglick said the city needs more investor outreach to get into the market on its own.
“We don’t want to go to market and get a poor reception,“ he said.
Earlier this month, the city participated in a state-organized Michigan Investor Summit.
"As Chicago Public Schools’ recent sale showed, there is an appetite out there for yield even if it means buying debt that you are well aware is speculative in nature and carries public ratings well outside of investment grade territory," said Tom Schuette, a partner at Gurtin Municipal Bond Management. "I think investors who jump in on any future Detroit bonds that don’t carry some sort of state intercept mechanism need to do so with eyes wide open about the risks that those bonds carry absent a broad economic and demographic recovery for the city."
CPS carries three junk ratings but saw strong demand in a $560 million May deal.
“As a recovering credit exiting bankruptcy clearly without being able to assure payment you really have to think about how you are going to sell bonds and assure people they are going to get paid back,” Naglick said.
"Clearly the city has made great strides in improving their credit situation in terms of providing services and expanding its tax base," said Howard Cure, director of municipal bond research at Evercore Wealth Management. "Also, the city is giving confidence to investors that its financial disclosure is both timely and accurate. I think any investor still needs to grapple with the city’s upcoming pension burdens despite the restructuring that took place during bankruptcy as well as asking how prepared is the city for the next recession.
"Also, no city can be viable, in the long term, without an adequate public education system. This is necessary in order to repopulate the city with stable families. The capital needs and quality of the schools must be addressed," he added.
Naglick stressed that Detroit still has about $100 million of capacity in a third lien securing its distributive state aid and could open another lien with even more capacity if needed.
“What we are weighing is, when we come to market is it best to do another secured deal using our remaining DSA capacity or does it make sense to use general obligation debt?” he said.
The city is also currently dealing with more pressing “pinch points,” according to Naglick, the first of which is ensuring its ten-year financial plan works.
In May, the Detroit Financial Review Commission unanimously voted to waive active oversight of the city. The city now has the power to enter into contracts and enact city budgets without seeking state approval. Naglick said that the waiver is only an annual waiver. “They have to meet and vote every year,” he said.
The FRC's decision to scale back oversight was triggered by three consecutive years of balanced budgets along with three years of projected balanced operations. The city is projecting a $36 million surplus this year, thanks in part to higher property tax revenues. Naglick said that income taxes are the city’s major revenue source this year, bringing in approximately $290 million.
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. Naglick said the city collects on average about $180 million per year from the tax. Property taxes currently bring in $135 million per year.
Much of Detroit's improved budgetary performance was made possible by shedding some fixed costs during bankruptcy, including debt service and retiree costs for pensions and other post-employment benefits.
The city has put aside money in a Retiree Protection Fund to meet an increase in pension payments of nearly $100 million more than initial post-bankruptcy estimates beginning in fiscal 2024. Naglick said the FRC will continue to monitor whether the city continues to put away the right amount set aside by the 2024 deadline to restart payments.
Detroit is also working on a strategy to deal with a scheduled escalation of debt service payments in 2025 from $1.28 billion of borrowing the city closed on in December 2014 to fund creditor settlements and raise funds for revitalization efforts. The deal paved the way for its exit from Chapter 9, during which it shed $7 billion of its $18 billion of debt and obligations.
General obligation debt service costs are scheduled to rise to $161 million in fiscal 2021 from $132 million in fiscal 2017.
The city is reviewing ideas and proposals submitted by bankers who responded to a request for proposals to assist with possible restructurings of the city’s $632 million of LTGO debt obligations. The unsecured bonds were used to pay off various creditors. Issued as term bonds, the debt has a 30-year maturity, and bears interest at 4% for the first 20 years and 6% for the last 10 years. Payments are interest-only for the first 10 years and start amortizing principal in year 11.
“We specifically are looking to smooth out debt service in fiscal 2025 to 2030 where there is a confluence of debt service that will have to be funded by the city's general fund,” Naglick said.
In March, the city fully defeased the C series of bonds that were part of the city’s exit financing. The bonds carry a final 2026 maturity. The C series of unrated, taxable bonds totaled $88.4 million and paid 5% interest. They are secured by the city’s limited tax general obligation pledge and payable from city parking revenues.
Detroit’s Downtown Development Authority will issue an RFP soon to refinance the senior debt on Little Caesars Arena, a pro hockey arena that opened in 2017. The original Series 2014A bonds in the amount of $250 million were issued through the Michigan Strategic Fund and the bonds have a mandatory call at January 1, 2019. Naglick is treasurer and chair of the finance committee at the Detroit DDA.
The city also has the Series 2017 bonds in the amount of $36 million that was issued to finance the modifications to the arena to accommodate pro basketball, which have the same mandatory call date.