Market's demand for new paper a plus for Chicago GO deal
The municipal bond market's thirst for new paper means it's unlikely Chicago will pay a price for scheduling a $700 million general obligation bond deal a day after an Illinois state deal and only six days before its mayoral runoff election.
“Typically if two fiscally distressed issuers came to market at the same time it wouldn’t be good for either, especially if they are from the state, but in this era where there is insatiable demand and insatiable demand especially for higher yielding bonds, both will do fine,” said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners.
“They will pay the normal penalty” imposed on most Illinois-based borrowers, “but not for coming at the same time,” Battle said.
Chicago will price the new-money GO paper to pay for 2018 and 2019 projects, pay off interim financings, and to cover capitalized interest. Barclays has the books.
Chicago had initially sought to come ahead of its election but the week after the state government. The state initially planned to sell the week of March 18, but pushed its $452 million competitive deal that’s a mix of taxable and tax-exempts off a few days to March 26.
Both issuers will face competition as nearly $9 billion of new money is on the calendar up from $2.5 billion this week, but market participants say there’s plenty of cash to go around especially for higher yielding credits like the city and state.
Investors in the secondary market have sliced by more than half the spread penalties seen in Chicago’s last GO sale in January 2017. That’s in recognition of the city’s increased pension funding, downsized budget gap, its school district’s improved fiscal picture, and a new administration at the state capital that’s viewed as more city-friendly.
The city still faces plenty of headwinds. It has a $250 million deficit and faces a $270 million spike in pension payments – with another $310 million spike coming in 2022 -- and must negotiate big labor contracts.
The rating agencies and Chicago Civic Federation offered fresh warnings over the landmines ahead and actions they say the city should avoid, such as tinkering with pension contribution schedules or the material use of reserves.
While all may provide informative reading material for the victor in the April 2 runoff between Lori Lightfoot and Toni Preckwinkle, Battle had another suggestion. “Resumes,” he said. “The first thing the new mayor should be reading the day after the election is the resumes of people with budget and public finance experience so she can put together an expert financial team.”
Lightfoot is an unknown and political novice. Preckwinkle’s track record as president of the Cook County Board of Commissioners offers some insight on taxes and debt and the types of financial managers she’s hired, but managing a city is more expansive, market participants say.
"We have an imminent management change in the city and one of the candidates is an unknown” that could translate into a premium demanded by investors on the city deal," Battle said.
Throughout the campaign and in two televised debates this week, both have endorsed and rejected various tax ideas, said they would look at spending reforms first and said they support Gov. J.B. Pritzker’s proposal for graduated income tax rates in Illinois that could provide the city with some additional funding, and they oppose Mayor Rahm Emanuel’s proposed $10 billion pension obligation issue.
Neither has offered any fixes that come close to addressing the funding needs that loom next year.
Asked Thursday during a WTTW Chicago Tonight debate how she would come up with the money for pensions next year, Preckwinkle highlighted her county management experience in cutting expenses and jobs and the county’s debt load. She raised the sales tax to better fund pensions.
Asked about the POB proposal, Lightfoot offered a critical assessment over the lack of “transparency” on the planning and structure -- although Emanuel in December did lay out a security structure -- and said she was “very concerned about it” because municipal bankruptcies in California and Detroit of issuers who had issues POBs offered a “cautionary tale.”
The Civic Federation issued a report March 12 sounding fiscal alarms on the pensions, rising debt and deficit. The city’s debt service rises to $643 million next year from $513 million this year and then to $681 million in 2021, according to offering documents.
It also presented a look at the pros and cons of various revenue measures and recommendations on a path forward and warns against one-shot sources.
“It is important to have a good ‘Plan A,’ but sound financial planning requires a strong backup strategy for when ‘Plan A’ doesn’t materialize as hoped or expected,” says federation president Laurence Msall.
Fitch Ratings affirmed the city’s BBB-minus rating that is one notch above junk, Kroll Bond Rating Agency affirmed the city’s A rating, and S&P Global Ratings affirmed its BBB-plus. All assign a stable outlook.
Moody’s Investors Service rates the city at the junk level of Ba1 and stable but is no longer asked to rate new city deals. The city has $7.4 billion of GO principal.
The deal marks what may be the last or one of the last under Emanuel, who announced in September he would not seek a third term.
“We expect that 2019 will be a period of near-term stability for Chicago, but we think that the following three years will test the city's willingness and ability to manage its budget in a sustainable manner,” wrote S&P analyst Carol Spain. “The city's fiscal 2020 budget will be significantly more challenging.”
The city is operating on a $10.7 billion budget this year.
“We view the current rating level as incorporating the city's lingering structural misalignment and high fixed costs…that said, significant downside risk to the rating remains and if action to address the city's projected fiscal 2020 budget gap is not timely or the city backslides on its progress toward structural alignment on full actuarial pension funding, we could take a negative rating action,” S&P added.
“Rising pension costs will continue to drive expenditures to grow at a much faster natural pace than revenues, likely necessitating ongoing revenue-raising measures and careful expenditure control,” Fitch said.
Even after the $270 million spike in 2020 funding for police and firefighter contributions and $310 million for the municipal and laborers’ funds, contributions will continue to grow annually to meet actuarial based requirements needed to reach a 90% funded ratio between 2055 and 2057.
Any effort to restructure the payment scheme in state statute would trigger red flags. “Failure to show progress according to the city's plan could put negative pressure on the rating,” Fitch warned.
"The stable outlook incorporates Fitch's expectation that the city will continue to make progress toward structural budgetary balance, including progress toward actuarially-sustainable pension contributions, and maintain reserves commensurate with the rating throughout the economic cycle,” Fitch said. “A reversal of this trend could lead to negative rating action.”
The city has little wiggle room to alter the pension schedule because even as reaches its targeted contributions for all four plans come 2022 they will still fall short of true actuarially based contributions because they are tied to the 40-year funding formula.
“The stable outlook reflects the city’s identification and dedication of permanent revenue sources to address its severely underfunded pensions. In KBRA’s opinion, this is not a panacea, as additional revenue sources will be required once the ramp-up period is concluded and the pension funding is on an actuarial schedule,” Kroll wrote. “This financial risk will have to be addressed by a new administration, and require critical decision-making."
Like its counterparts, Kroll gives the city credit for fiscal gains and halting one-shot practices like the use of reserves and scoop-and-toss restructuring. Kroll analysts believe the city’s tax base has the ability has the ability to absorb future tax shocks to address pensions, a position outlined in a special 2017 report.
While Emanuel’s ended in the 2017 deal the city’s long time practice of restructuring some GO principal as it matures, Kroll noted that the city extended GO maturities in its Sales Tax Securitization Corporation structure refundings.
Reserves are solid at about $670 million, or 19% of the city’s general fund expenses, in addition to an unassigned balance last year of about $155 million. While they provide a cushion, Kroll warned against their use saying it “would view significant use of long-term reserves for operations as an unfavorable action with potential negative rating implications.”
— Chip Barnett contributed to this story