“Chicago is in such a deep fiscal trench that we don’t expect the 2016 budget to contain all the solutions needed to get back on solid ground,” said Nuveen analyst Kristen DeJong.

CHICAGO - Chicago's fiscal reckoning is at hand.

With his political legacy as a fiscal manager at stake, Mayor Rahm Emanuel will unveil his 2016 budget Tuesday giving the muni buyside a few days to digest his proposals to solve the city's grim fiscal problems before Chicago's annual investor conference Friday.

Skeptical investors are looking to the mayor to take big steps toward stabilizing the city's fiscal foundation with a substantial tax package to tamp down growing pension strains.

Moody's Investors Service pushed the city's general obligation rating down to junk in May over its $20 billion unfunded tab, further driving up the city's already steep borrowing penalties.

Emanuel faces the daunting task of persuading investors, analysts, the public, and the City Council that what's expected to be a record property tax hike in the range of $500 million, along with other new taxes and fees, will put the city on a sound fiscal path. At the same time, Emanuel must consider what the city's populace is willing to pay, market participants warn.

"On Tuesday, Mayor Rahm Emanuel will present the most important budget this generation of Chicago taxpayers will ever see," Laurence Msall, president of the Chicago Civic Federation, wrote in an op-ed piece last week. "This budget will either drive away residents and businesses or give them the confidence that Chicago is capable of long-term, sustainable change."

Steep yield penalties on Chicago bonds have tightened slightly since word began circulating late last month that Emanuel would seek such a big property tax hike, although chief financial officer Carole Brown said recently the final package remains a work in progress.

Investors and analysts have offered limited praise as they wait for the city to actually take action; they say are worried the city may rely on the state government for help when the mired in a budget impasse amid political gridlock.

"I think the buyside is optimistic that it [what will be proposed] will help but we have a wait and see outlook," said Lyle Fitterer, head of tax-exempt fixed income at Wells Capital Management. "Is he able to actually execute the plan? The plan may be good, but it still hasn't passed."

The state is also a factor.

"Everyone is still waiting to see what the state comes forward with in balancing its budget," Fitterer said. "There are still hurdles to pass."

Bolstering pension payments with a recurring revenue source like the property tax is a "positive" but on its own only goes so far, said Nuveen Asset Management fixed research analyst Kristen DeJong.

"Chicago is in such a deep fiscal trench that we don't expect the 2016 budget to contain all the solutions needed to get back on solid ground," she said.

"In our view a fully structurally balanced budget would include full funding for pension payments and we don't see that happening in the 2016 budget," DeJong said. If the state acts to reamortize the police and fire contributions by pushing back the date it commits to fully fund them, it only adds to the long-term funding burden.

"The city has more pain to see before everything gets better," DeJong said.

The potential impact of cuts and higher taxes on residential and business decisions to remain in the city is a concern, but one that will play over a longer time frame, DeJong said.

 

FISCAL ILLS AND CURES

 

The city heads into the next budget facing a $754 million gap. That includes a budget shortfall of $426 million, made up of a $233 million operating deficit combined with the need for an additional $93 million to cover city contributions to the city's laborers and municipal pension funds and $100 million to cover debt service the city previously planned to push off.

Emanuel announced earlier this year his intention to phase out by 2019 the city's use of scoop-and-toss debt restructuring for budget relief and to reduce the use of debt to cover operating costs. Both are practices he inherited from former Mayor Richard Daley's administration but has continued.

The city's gap grows to $754 million when the $328 million hike in contributions for the police and firefighters' pension funds is added. The additional dollars must be levied this year and are due in 2016 under a 2010 state mandate to stabilize local government public safety pension funds by requiring them to be funded on an actuarial basis. The actual amount would grow to $550 million if the city does not win state approval to reamortize the funding schedule.

While making strides during his first term on whittling down the structural budget gap, the city's credit rating has plummeted over its pension obligations. Reforms Chicago adopted for its municipal and laborers' funds face a legal challenge that the Illinois Supreme Court will decide this fall. Chicago carries a junk Ba1 rating from Moody's, with a negative outlook; BBB-plus ratings from both Fitch Ratings and Standard & Poor's with both assigning negative outlooks; and is rated A-minus rating with a stable outlook by Kroll Bond Rating Agency.

"We expect that during the next five months…the city will demonstrate how serious it is about implementing both immediate and far-reaching plans to address the structural cracks in its budget," Standard & Poor's said recently.

Emanuel expected $500 million property tax hike is expected to include about $50 million that would go to the Chicago Public Schools for capital spending. Emanuel wants to increase an exemption for homes valued at under $250,000 to ease the hit but it's unclear whether that can win state approval. A legislative hearing is set for later this week.

A new garbage collection fee, a surcharge for rides in taxis and Uber-style ride share services will also be proposed with the expectation of producing about $140 million in new revenue. The package is also expected to levy a new tax on e-cigarettes.

 

YIELD IMPACT


Chicago paid a high yield of just under 8% on its July sale of taxable securities, a spread of 485 basis points to the 30-year Treasury, and it paid a high yield of 5.69% on its long tax-exempt bond, 252 basis points over the Municipal Market Data's top-rated benchmark of 3.17%.

After word spread of the looming property tax hike, spreads on taxables shrunk 30 to 40 basis points and spreads on tax-exempt narrowed 10-20 basis points, according to several market participants.

The city's tightening on its taxables is "partially due to movements in Treasuries but also from perceived improving credit quality," said Michael Coomes, portfolio manager at Cumberland Advisors.

The Barclays municipal credit research group says the city could see further improvement but it faces headwinds.

"We think there could be room for further tightening if a property tax increase is accepted," Barclays wrote in a commentary last week.

"However, headlines about the Chicago Board of Education and weakness in BBBs and high yield munis continue to pressure yields on Chicago-related entities. Additionally, market anticipation of a significant amount of issuance from Chicago entities and other Illinois issuers could weigh on performance," Barclays analysts wrote.

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