Triple-A ratings boost Chicago's new bond program

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CHICAGO – Chicago’s new sales tax securitization financing structure received AAA ratings from Kroll Bond Rating Agency and Fitch Ratings.

They released their ratings reports Thursday. S&P Global Ratings later on Thursday assigned its AA rating to the bonds. All three assign a stable outlook.

The City Council last month signed off on the creation of the Sales Tax Securitization Corp. with the goal of bypassing the city’s weak bond ratings and its steep yield penalties to lower costs on up to $3 billion of existing sales tax backed and GO bonds.

“KBRA believes the bonds have strong legal and structural protections that insulate its pledged sales tax revenues from day-to-day operating and financial risk of the city,” Kroll analysts wrote.

State legislation sought by the city paved the way for any home unit government to establish such a special purpose entity to leverage a local government’s share of revenue that flows through the state. The city will assign its roughly $660 million in annual state collected sales taxes to the corporation to leverage for the refundings.

The first borrowing under the new credit will refund the city’s existing sales tax bonds in two series, one for $400 million of tax-exempt bonds and the second for $175 million of taxable bonds with pricing expected the week of Dec. 4. Bond maturities will go out 30 years.

Jefferies is senior manager on the first deal. The Sales Tax Securitization Corp. will then issue bonds to refund $905 million of GOs in January with Goldman Sachs in the senior manager role. The corporation expects to issue additional refunding bonds throughout 2018, with plans to refund about $2.3 billion of mostly callable, high coupon GOs in the coming years.

“The STSC is a responsible financing tool that allows the city to reduce its debt service costs, and the high credit investment grade ratings are a direct reflection on the strength of this tool,” said Chicago’s chief financial officer, Carole Brown, said in a statement after release of the ratings.

The sales tax securitization bonds hold a first lien on the state-collected portion of the city's home rule sales and use taxes and local share of the statewide sales and use taxes, net of a 2% administrative fee imposed by the state.

“The bankruptcy-remote, statutorily defined nature of the issuer and a bond structure involving a perfected first lien security interest in the sales tax revenues, are key credit strengths that lead Fitch to consider the corporation's credit quality as distinct from the city of Chicago,” Fitch wrote. It rates Chicago's GO bonds BBB-minus.

Kroll rates Chicago GOs BBB-plus.

Kroll said the corporation “has effectively and irrevocably acquired the pledged revenues through a true sale” and the “pledged revenues are insulated from ongoing operating and financial risk of the city.”

Kroll analysts assessed whether the sales tax asset is allowed to be sold, whether the structure and legal documentation represent a true sale, whether the special corporation is bankruptcy remote, and whether the legal provisions are in place that insulate it from a city bankruptcy.

“These features are really important distinctions of this transaction” as opposed to sales tax revenue bond issue “and we believe these are important hallmarks of a securitization transaction,” Kroll municipal analyst William Cox said of the final factor.

The structure passed on all fronts, Cox and Lenny Giltman, Kroll’s internal counsel, said in an interview. The two said Kroll’s conclusions were based on their examination of legal covenants that establish the separateness of the corporation from the city, the entity’s bylaws, the city ordinance, the sale agreement, the state legislation, transactional and other documents, as well as the legal opinions provided by the city and a review by Kroll’s own legal counsel and outside counsel.

"KBRA believes these protections apply even in the unlikely event of an insolvency or bankruptcy of the city,” its rating report said.

S&P cited strong coverage of maximum annual debt service of 16.5 times, and our anticipation that the corporation will bond down to its additional bonds test of 4 times and the city and the state's broad and diverse tax bases.

While statutory language reduces the likelihood that a bankruptcy court could rule that the pledged revenues are property of the city, the ability to levy and collect sales and use taxes depends directly on the underlying economic activity in Chicago and Illinois, which can be affected by the governments' financial conditions.

“We believe that dependence and linkage cannot be entirely overcome through the overlay of a legal structure supporting the bonds,” S&P said. It rates Chicago GOs BBB-plus with a stable outlook.

The city carries GO ratings that range from speculative grade to a high of BBB-plus and its existing sales tax bonds range from junk to the double-A category depending on whether the rating agency links it to the GO rating.

The legislation to create the new security and other documents also make clear the state’s “intent” to allow and the City’s intent in separating and selling off the pledged sales taxes.

“In our opinion they have overcome each of the hurdles necessary to truly securitize the pledged revenues,” Cox added.

Some market participants – burned by the efforts to impair structures they once thought air tight in Detroit and Puerto Rico’s bankruptcies -- have warned that no legal opinion can guarantee the sturdiness of a structure until it’s tested in a distressed situation.

While considered a bankruptcy-remote entity, the corporation’s bylaws include the appointment of an independent director to act on behalf of bondholder interests if it were to be pulled into such a proceeding.

“KBRA does note that the requirements related to an independent director…are generally less robust than would appear in a standard asset backed securitization transaction that featured a special purpose entity,” the report said.

After passing the structural and legal assessment, Kroll analysts said they applied six adverse economic scenarios to test debt service coverage.

“Even under severe economic downturns and other stressful scenarios, the pledged sales tax revenues will remain more than sufficient to meet timely principal and interest requirements on the bonds,” the rating agency said.

Under various scenarios, Cox said coverage could be met even if the city’s population declined by 1% annually resulting in a 2% drop in pledged sales taxes. They also applied a scenario envisioning two recessions occurring in one decade on par with the Great Recession’s impact.

Sales taxes must provide maximum debt service coverage of four times for additional senior debt to be issued. The city could turn to a subordinate pledge to meet a lower threshold.

Chicago CFO Carole Brown, budget director Samantha Fields, comptroller Erin Keane, and a representative of the council’s finance and budget committees will govern the special purpose corporation.

Bankers have told the city the bonds could sell at a spread under 100 basis points to the Municipal Market Data’s top-rated benchmark. City GOs have been trading at just under a 200bp while it paid a record spread of more than 300bp on its last GO sale.

Brown has said the refundings will be completed for net present value savings but that doesn't mean the savings will be level throughout maturities and the 2018 budget relies on roughly $90 million in upfront savings.

S&P said the majority of the savings will be taken upfront, and the final maturity will be extended two years beyond the prior structure. The issue was structured in consideration of the corporation's future sales tax securitization bond issuances, and as a result, the series 2017 bonds will help the city level its annual debt service costs, the rating agency said.

Several council critics of the plan who wanted more time to vet the program have likened it to the city’s scoop and toss GO debt restructurings that pushed off debt repayment even though there will be overall debt service savings.

Cox said the rating agency’s report doesn’t address those issues because it’s focused solely on assessing whether the structure meets a true securitization.

The report does address the impact on existing bondholders and whether they might have a claim should the city seek to restructure debt.

Kroll said it consulted with outside counsel and concluded that while the Illinois constitution grants the city authority to incur debt there’s no provision that grants additional rights to the holders of GOs.

“While the city regularly levies a dedicated debt service tax for each issue of its general obligation bonds and may pledge its full faith and credit and make other contract covenants with its bondholders, no priority for general obligation bondholders exists under the Illinois Constitution,” Kroll wrote.

Some buyside representatives have warned that the diversion of sales taxes could damage the value of existing bonds because the pool of revenues that flow directly to the city’s corporate fund will shrink. Others have said easing pressures on the GO credit – as long as the city doesn’t turnaround and add to that load – could improve existing values.

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Ratings Primary bond market Securitization City of Chicago, IL Kroll Bond Rating Agency Fitch Illinois