CHICAGO - Municipal market observers aren't too impressed by the Chicago Public Schools' move to drop Moody's Investors Service in favor of an agency that assigned a higher rating.
Several investors and analysts labeled the move "rating shopping," although they said they understand why a fiscally distressed credit like CPS would want to forgo a Moody's rating as it heads into the market after suffering a fresh round of multi-notch blows from three rating agencies.
Moody's March 6 dropped the school district two notches to Baa3, the lowest investment grade rung, citing its rising pension payments, budget gap and governance ties to Chicago. The outlook is negative.
CPS instead sought an initial rating from Kroll Bond Rating Agency, which assigned the district its BBB-plus rating with a stable outlook.
District officials wanted to offer investors a "fresh set of eyes" with the aim in part of highlighting a security that benefits from a pledge of state aid layered over the general obligation, said one market source familiar with the deal.
"It is not unprecedented, but it is rare for a large municipal bond issuer to not use the prominent rating services and it is uncommon for them to drop a rating from one of the major rating agencies from a new issue offering," said Tom Kozlik, a managing director and municipal credit analyst at Janney Capital Markets.
Janney published a report last year that examined the issue of rating shopping.
The report warns investors against solely depending upon ratings for their investment decisions due in part to the differentials.
"Most large institutional investors are familiar with the credit strengths and weaknesses of individual issuers because they usually have a team of credit analysts performing internal credit analysis not related to rating agencies' opinions," Kozlik said.
The ratings maneuvers didn't stop the district from paying a steep penalty last week.
It didn't help that the district got two other downgrades ahead of the deal.
Although officials expected some downgrade from Fitch Ratings, sources said the district was jolted by its March 20 three-notch downgrade to BBB-minus, at the same level as Moody's.
Standard & Poor's also cut its CPS rating two notches to A-minus with a negative outlook.
The district, which borrows through the Chicago Board of Education, sold $180 million of floating rate notes, paying an initial rate of 4% plus the SIFMA index, for a total 4.02%. The paper, which doesn’t require bank support, carries a soft put in 2017, and a final maturity in 2032.
The board was initially planning to return to the market as soon as this week with about $370 million.
Market sources said the banking team and CPS finance officials decided to give the market time to digest the recent downgrades - which triggered swap termination events -- and the results of the April 7 mayoral runoff. They won't likely return to market until mid-April.
Market participants say they understand the district's ratings moves, but they are skeptical of their benefits.
"Clearly it's a little bit of rating shopping which should be discouraged," said Howard Cure, director of municipal bond research at Evercore Wealth Management LLC. "Clearly, Moody's is more critical of Chicago up and down."
Cure said it's understandable why issuers seek out the best rating in hopes of lowering interest costs, but said given the headlines over the Chicago school system's fiscal stress a "savvy" market isn't likely to reward the district for forgoing a rating from a well-established agency in favor of a newer one like Kroll.
"It's cherry-picking," but could be driven by bankers' advice that it could make some difference on valuation for some in the universe of buyers, said Jim Colby, senior municipal strategist at Van Eck Global.
The district faces rising pension payments that are straining its books to the tune of $700 million next year. Like the Chicago city government, the school district is banking on state help to obtain reforms.
The administration of chief executive officer Barbara Byrd-Bennett - who was handpicked by Chicago Mayor Rahm Emanuel -- must tackle a $1.1 billion deficit in its fiscal year 2016 budget. The district closed past gaps through debt restructuring and the use of reserves and has limited revenue raising ability as it bumps up against state imposed property tax caps.
The Fitch and Moody's downgrades below the BBB level triggered swap termination events that could, under terms of the swap contracts, force payments of nearly $230 million to swap counterparties. The district has 10 interest rate swaps on a notional amount of $1.1 billion.
CPS is negotiating with the banks -- Loop Financial Products LLC, Merrill Lynch Capital Services LLC, Royal Bank of Canada LLC, Bank of America NA, Goldman Sachs Bank, Goldman Sachs Capital Markets LP - to stave off payments.
On its line of credit debt, the district has little breathing room. One more downgrade by Fitch or Moody's, to below investment grade, would trigger a default event that could result in the district's tax-exempt interest rate rising to 9% and its taxable rate growing to 13.5%. The district doesn't face any threat of acceleration under its credit terms.
Fitch warned it "will downgrade the rating further if there is not clear and meaningful progress in reducing the large structural imbalance . a notable increase to debt or unfunded post-employment liabilities would also likely result in a rating downgrade."
After the swap termination events were triggered, Standard & Poor's issued a special report saying it was monitoring the impact but its rating would hold for now.
"While we view the possible trigger payments as pressuring the district's budget, we do not view these payments as likely to cause a liquidity crisis at present," S&P analysts wrote.
If forced to cover the negative valuations, the district could tap a debt service stabilization fund that holds $174 million, its unrestricted cash balance of $71 million, or draw on a $500 million bank line of credit. Standard & Poor's specifically warned the district that its current rating is conditioned on the maintenance of adequate unrestricted reserves.
In its rating, Kroll called the security structure a key credit strength as state aid is deposited directly with the bond trustee to cover debt service. The credit also benefits from a substantial tax base and management strides in cutting costs.
The budget deficit tops the list of Kroll's credit concerns followed by pension obligations and weakened liquidity down which dropped to $255 million in fiscal 2014 from $1.3 billion a year earlier.
Richard Ciccarone, president of Merritt Research Services, said it's understandable that the district wants to cast itself in the best possible light.
"You can't fault them from trying to put their best foot forward" and look for avenues where it will get credit for the strong alternate revenue pledge, which is all the more attractive to buyers in a post-Detroit bankruptcy universe where a GO pledge alone has lost some of its luster, Ciccarone said.
Ciccarone said a downside to dropping Moody's is the possible elimination of some buyers who might require a rating from the agency.
"The lower the rating and weaker the perception of the credit, the more importance that should be placed on the security provisions," he said.
A market source familiar with the CPS deal acknowledged that the SIFMA-plus-4% rate on the notes is a steep penalty but said the district got the deal done, benefitting from it by shedding its bank credit exposure, which is all the more important given the threats of further ratings deterioration.
The finance team was under the gun to get the note sale completed as current bank support was on the verge of expiring. The team was able to place all the paper with institutional buyers but could not lower the rate.
There's no such rush on the remaining bonds so the finance team will wait until headline risk subsides from the April 7th mayoral runoff between incumbent Emanuel and rival Jesus "Chuy" Garcia, a Cook County board commissioner.
The remaining deal on the CPS calendar features a mix of new money and refunding bonds including a $175.6 million fixed-rate tranche, $100 million of new money put bonds, $20 million of fixed-rate paper designated at green bonds, and $75.5 million of fixed-rate bonds to refund 2004 bonds for economic savings.
The school board is also privately placing $4.3 million of qualified zone academy bonds.
PNC Capital Markets and BMO Capital Markets are co-senior managers on the financings. Acacia Financial Group Inc. and Public Financial Management Inc. are advising the district.