“We signed with Hammond, but specifically made it non-exclusive so we could look for an alternate water source,” said Chicago Heights, Ill. Mayor David Gonzalez

CHICAGO - The city of Hammond, Ind. is selling $36.2 million of junk-rated, moral obligation bonds this week backed by payments from a water supply contract with a Chicago suburb that is looking to exit the agreement.

The northwest Indiana city, riddled by years of chronic deficits, plans to use the proceeds to boost its general fund into positive territory.

The bonds are also backed by casino revenue, one of Hammond's most reliable revenue streams, which the city has relied on in the past to cover shortfalls.

Issued through the Hammond Local Public Improvement Bond Bank, the deal is expected to price Wednesday or Thursday.

Fifth Third Securities Inc. is the underwriter. Cender & Company LLC is the city's financial advisor and Faegre Baker Daniels LLP is the bond counsel.

The debt is taxable and matures from 2015 through 2033. Standard & Poor's has rated the deal BB-plus based on the city's moral obligation pledge, saying the speculative-grade rating reflects the city's credit characteristics and the risk of non-appropriation.

With the relatively weak security and fundamental credit challenges, the Hammond deal could be a tough sell in a post-Detroit credit landscape, said Richard Ciccarone, president of Merritt Research Services LLC.

"This is not a high-profile credit and doesn't get a lot of scrutiny, but the problem is, it needs a lot of scrutiny," Ciccarone said. "With these kinds of credits, analysts and investors have to be very careful. Given the ingredients you have - the security is inferior and the credit has been coping with a stagnant economic base - that makes it a challenge for the long-term."

Located about 20 miles outside Chicago, Hammond, with about 80,000 residents, is part of the Chicago metropolitan area and is the fifth largest city in Indiana. It has long struggled with a weak regional economy and general fund deficits that it has papered over with casino gambling revenue.

Hammond expects to pay debt service on the $36.2 million borrowing using payments from a water contract it has with the Chicago suburb of Chicago Heights, Ill. That suburb has gotten its water from Hammond for more than 20 years and itself supplies water to three additional south Chicago suburbs. Under the contract, rates may not exceed 88% of the city of Chicago's water rates.

But a new contract, inked in 2012, allows Chicago Heights to leave at any time, and its mayor said he could be ready to exit as soon as six months from now.

"I took office in 2011 and realized that we had one year left on the contract, and it takes three to four years to plan for some alternate source," Mayor David Gonzalez said. "So we signed with Hammond, but specifically made it non-exclusive so we could look for an alternate water source." Chicago Heights is in the midst of negotiating with private company Aqua, which currently manages its water department, for an alternate water source, Gonzalez said. "We're going to see some hard numbers in three to six months," the mayor said.

Despite the rate cap at 88% of Chicago rates, Chicago Heights still thinks it's paying too much for Hammond's water, Gonzalez said.

"Every time Chicago raises its rates, they raise ours," he said.

Chicago Heights is one of several suburbs that complain about the rates of the Chicago water system. In Harvey, Ill., payment delinquencies to Chicago for water purchases prompted Chicago to file a lawsuit against the city and last month a Cook County judge said Harvey - which operates on a $38 million budget -- must pay Chicago $26 million. The court is expected to rule next month whether to strip Harvey of its management of water fees.

Hammond officials are confident Chicago Heights will continue to buy Hammond's water.

The suburb "doesn't have any viable alternative water sources besides the city of Chicago, and Chicago's water rates are higher than Hammond's," Hammond's financial advisor, Karl Cender, said in an email. "In the event that Chicago Heights would find an alternative water source, Hammond has a secondary pledge of gaming revenues that will more than satisfy the debt service on the bonds and the city's other obligations."

In 2013, the net revenue from the Chicago Heights contract totaled $4.6 million, according to Hammond's preliminary bond documents. Maximum annual debt service on the 2014 bonds is projected to be $3.1 million, translating into just under 1.5 times coverage.

Cender also noted that the 1.5 times coverage is projected to increase to 2.0 times next year with a planned water rate increase in early 2015.

Beyond the water payments and the gambling revenue, there is no source of funds available to make up deficiencies in the event of a default, Hammond said in preliminary bond documents. Under a risk factors discussion, the bond documents note, in all capital letters, that Chicago Heights is under no obligation to buy any water from Hammond.

Risks related to the city's gambling revenue, which declined in 2013 from 2012, include the possibility that Chicago will get its own casino, the bond documents said.

The city's casino revenue in 2013 totaled $23.3 million. Of that, $7.5 million goes to 2010 and 2012 bonds, and $3.1 million is expected to go to the 2014 bonds, translating into 2.20 times coverage of the 2014 bonds.

Standard & Poor's earlier this year downgraded Hammond's general obligation rating to BBB-plus and its moral obligation bonds to BB-plus.

For the upcoming deal, the rating is based on the city's moral obligation pledge, not the revenue streams expected to pay the debt, analyst Kathryn Clayton said.

"We are aware of the Chicago Heights mayor looking into other feasible sources so we did not pay much credence to the water revenue stream," Clayton said. "But with the moral obligation analysis we do want to see if any risk is involved with the pledged revenue streams, and we could notch it further [below the GO rating] if we thought it was likely they would not have the revenue to pay those bonds."

The casino revenue provides relatively strong support for the bond repayment, Clayton said.

"It's a pretty stable revenue source, though we do recognize that the city has been using that excess revenue as a plug for its general fund," she said. "That could move the rating: if they start using the gaming revenue to replenish the debt service and don't have as much to transfer to the general fund, that could impact their GO rating and in turn the moral obligation rating."

Despite the challenged credit and the junk ratings, the bonds may find eager buyers among investors hungry for yield in the current market, Ciccarone said.

"There's so much demand for high-yield paper, they might be received in the market," he said. "But the conservative investor won't find this level of security sufficient, especially in light of the fact that the city has a challenged financial condition and challenged economy," he said, adding that the casino sector may also face pressures over the 18-life of the debt.

Some of the city's tax-exempt, BBB-plus rated GO bonds with a 3% coupon and 2019 maturity were yielding 2.27% in trading last week, according to Electronic Municipal Rulemaking Board web site. Bonds with a 4% coupon and 2023 maturity yielded 3.17%, according to EMMA.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.