BRADENTON, Fla. — Moody's Investors Service said Monday that "novel" refinancing plans proposed by bankrupt Jefferson County, Ala., and Detroit are being threatened by rising interest rates.
Federal Judge Thomas Bennett approved circulating Jefferson County's Chapter 9 exit plan and seeking creditors' votes on it Aug. 6 in Birmingham, the county seat. Creditors holding lease, school and general obligation warrants will be made whole, though some of the debt will be restructured.
The county's exit plan hinges on refinancing $3.1 billion of outstanding variable- and auction-rate sewer refunding securities. If creditors approve the plan, the county will refinance $1.9 billion of sewer warrants in December, which will reduce the outstanding principal by about $1.3 billion.
Creditors holding sewer warrants stand to recover 60% to 80% of their investment under the propose plan with JPMorgan taking most of the loss. In response to rising interest rates, county commissioners have twice proposed increasing sewer rates to support the financing.
Just weeks before Detroit filed its July 18 petition for bankruptcy, the city's emergency manager proposed selling $2 billion of limited recourse participation notes with a 1.5% interest rate, and distributing the proceeds to creditors of $11 billion of so-called unsecured obligations, including general obligation bonds, GO limited tax bonds, and pension certificates of participation, as well as unfunded pension and retiree health care liabilities.
"Tethering bondholder recovery to market appetite for new debt from issuers in bankruptcy exposes the recovery to market risks, such as the spike in interest rates since May," said Moody's analyst Silvio Zanardini. "Higher tax-exempt bond yields over the past few months threaten not only Jefferson County's recovery plan for its sewer warrants, but also Detroit's plans.
"Both issuers have proposed satisfying existing creditors with proceeds from the sale of new bonds, a novel tactic in public finance."
Zanardini said historically high recoveries following local government defaults in the past have been driven by the issuers' operations or assets, not by new bond issuance. Such was the case in Orange County, Calif., in the 1990s and Wenatchee, Wash., last year, Moody's said.
"In Jefferson County's modified plan, projected yields on the new sewer warrants range between 4.5% and 7.0%, depending on the maturity," Zanardini said. "It is unclear whether the county could execute this transaction and pay creditors under the currently proposed agreements. The recent rate rise leaves limited room for investors to demand a higher risk premium or for benchmark yields to rise further."
Increasing tax-exempt yields could result in increased leverage on the new sewer warrants, which would increase the probability of a second default, according to Moody's. Rising rates also could require the county to revise the plan further and seek agreement from investors and from the judge.
"Either scenario could delay sewer warrant holders' ultimate recovery by several months," said Zanardini. "Detroit bondholders may face similar recovery risks dependent on refinancing."
Meanwhile, Jefferson County's two recent proposals to increase sewer rates — the latter due to rising interest rates — have come under criticism. The second plan to raise sewer rates increased customers' base rates to $15 from $10 does not increase the amount the county will pay existing sewer creditors, County Commission President David Carrington said Sunday in an editorial published in the Birmingham News.
The Birmingham Water Works' current base rate charge is $19.80, according to Carrington. The Water Works board attempted to oppose the county's exit plan last week, but the judge ruled that the board is not a creditor eligible to vote on the plan.
Carrington said the base rate increase is designed to "stabilize revenues" when water use declines. He also rejected allegations that the county's plan does not provide for sewer system capital expenditures going forward, and that it fully funds the system's capital needs for the next 10 years, including more than $160 million required under a consent order with the Environmental Protection Agency.
Carrington also rejected criticism about the county's refinancing plan, which includes the use of capital appreciation bonds, and said a majority of commissioners are committed to resolving the county's complex financial and operational issues.
"The county's goal is to exit bankruptcy by the end of this year, but many challenges remain, including the instability of interest rates," he said.