“It’s the most interesting high-yield bond in the marketplace,” John Miller, co-head of fixed income at Nuveen Asset Management, said of Chicago Public Schools.

CHICAGO – From a threatened teacher strike to an escalating state-level attack on its governance and borrowing powers, the barrage of bad news has not let up since junk-rated Chicago Public Schools sold $725 million of debt at a punishing 8.5% rate.

Market participants disagree on whether to define the district insolvent or barely solvent, but they agree any lasting fix remains caught in the state political divide, and that the clock is ticking.

"We believe risk levels are accelerating for the district on a nearly daily basis at this point. They are taking hits from seemingly all directions, and would honestly face an uphill battle to put their fiscal house in order even if everyone was rowing in the same direction," said Tom Schuette, co-head of credit research and co-heard of portfolio management for Gurtin Fixed Income Management LLC. "Without the state stepping in with tangible financial help, it is extremely difficult to see how things get resolved."

On Jan. 27, when it originally planned to price the bond deal, the district's finance team struggled to secure orders after the district took a headline beating over fresh downgrades, labor troubles, and Gov. Bruce Rauner's backing of legislation that would allow for a state takeover and Chapter 9 filing.

John Miller, co-head of fixed income at Nuveen Asset Management, said the takeover talk "had a chilling effect."

The district retrenched, launched a hard press for investors with the city's help, and returned a week later with orders lined up on a scaled-back issue. Since then, the district's labor troubles have come to the forefront in response to cost cutting measures and a new state threat to its short- and long-term borrowing abilities has emerged.


The state school code exempts CPS from many oversight rules, but the state Board of Education does have the power to investigate its finances and it recently launched such a probe. Rauner believes the state Board of Education can block future CPS borrowings if declares the district to be in "financial difficulty" as soon as next month.

CPS' chief executive officer, Forrest Claypool, says the district is exempt under Article 34A of the code, which deals solely with CPS. Rauner's administration argues the provision no longer applies to the district because it was tied to the existence of the Chicago School Finance Authority, which provided financial oversight of the district after its financial collapse in 1979 and was dissolved in 2010.

CPS argues that Article 34A and other provisions of the school code limit the state board solely to reviewing its finances and then notifying the governor and Chicago mayor of its findings.

Market participants say the open question and potential for litigation alone could chill future attempts to access the market. With no near-term public offerings planned, the district's more urgent needs lay in setting up short-term credit lines for fiscal 2017.

If state officials' arguments are correct, the district's current private placement structure with a tax revenue pledge would appear to violate the code. Several market participants who work with the district said it could get around the limits by pledging revenue not cited in the state statutes or using some other short-term structure.

Concerns over ongoing access, absent state approval, could drive short-term rates up even higher from the 3.25% paid on several recent transactions, a steep penalty for lines of short duration.

Richard Ciccarone, president of Merritt Research Services LLC, said in times of distress governance discussions can be worthwhile. A new sheriff in town, like the Illinois State Board of Education, could help bring the Chicago Teachers Union to the table, but then "Gov. Rauner and the state takes ownership of the situation." Rauner has said a bailout is not on the table, so forcing more drastic cuts or driving teachers to strike could cast a negative spotlight on the state.

A long-term solution is especially challenging because it involves more revenue, Ciccarone said, at a time the city and state governments are also struggling.

A state takeover or a shift to an elected school board, which was approved by the state House last week with an unclear fate in the Senate, wouldn't solve the district's financial problems. Installing new leadership or oversight only works as part of "comprehensive solution that not only provides for accountability but also a mechanism to provide adequate funding," Ciccarone said.

The oversight authority put in place to manage the Chicago school district's finances following its 1979 collapse had the power to levy a special property tax support with strong security features to repay a deficit financing.

The most pressing issue for investors is how the state budget standoff will play out and where CPS and its push for aid will land, Miller said. The district's woes haven't scared Nuveen off from purchasing and holding Chicago Board of Education bonds and Miller maintains the value in CPS as an investment lies with its statutory liens and potential for some of the revenue pledges to survive bankruptcy if state law changes to make Chapter 9 an option.

"There's nothing like this in the marketplace. It's the most interesting high-yield bond in the marketplace," Miller said.

The credit benefits from the district's significance to a major city with strong security features that make it attractive, he said.

"It's really going to take numerous initiatives and political developments and compromises to really improve the credit overall," but investors are well compensated for the risk, Miller said.


Claypool's announcement last week that the district would phase out its longstanding coverage of 7% of the teachers' 9% pension payment drew a fiery response from the Chicago Teachers Union, which took the position that such a move violates its contract.

It warned of a strike as soon as April 1. The district countered that the current contract's expiration permitted the move.

The district further fanned the flames with the announcement later in the week of three furlough days. The two sides have since retreated somewhat but if they can't agree, a strike could occur by mid-May.

The district has announced a total of $335 million in annual cuts or savings, part of its plan to tackle a $1.1 billion budget deficit. It also relies on city and state legislative support for a special pension property tax levy and more state help. Chicago Mayor Rahm Emanuel supports the tax hike but state approval is needed and the fate of both at the state level is clouded.

District officials now say they have the cash needed from the budget cuts and bond issue to open schools in September.

While the CPS cuts added to its labor tensions, the market welcomed them.

"We have seen them try to implement measures to rein in their budget and they are addressing the expenditure" side, said Molly Shellhorn, a senior research analyst in Nuveen's municipal fixed-income team.


Plans for a $1 billion in late 2015 were delayed, but the district was ready to go in late January with its $875 million issue needed for liquidity. The district ended up trimming the sale down to $725 million when it finally priced in early February.

The 8.50% yield on the 2044 maturity was 580 basis points over the Municipal Market Data benchmark and just 50 basis points away from a state-imposed 9% interest rate limit. The bond came with a 7% coupon and a deeply discounted price of $83.939, underscoring its distress. The discount puts less investor money on the line and offers a greater profit should the bonds' value rise.

Miller said trading on the February bonds has tightened by about 40 basis points while other CPS bonds with 5% coupons are trading at about 76 cents on the dollar.

Markit said it’s seen spreads generally tighten between 15 and 20 basis points since the February sale.

The discount meant the district raised only $615 million in proceeds with about $340 million going to reimburse the district for capital spending and $209 million to roll over debt service coming due last month. Another $46 million represented capitalized interest and the remainder covered issuance costs.

The district put off a roughly $113 million conversion of floating-rate debt and was forced to forgo raising about $86 million to repay a short-term line tapped to make swap termination payments.

The week's delay saw Chicago's chief financial officer, Carole Brown, a former public finance banker, step more prominently into the fray and Emanuel was enlisted for personal meetings and calls with investors that included a trip to New York City. The administration sought to portray it as a routine visit with rating agencies on the city's credit.

Pressed by key institutional investors, the district posted an offering statement supplement stressing a legal opinion that its ad valorem tax pledge under an alternate revenue pledge could qualify as "special revenues" in a potential Chapter 9.

Future market access was clouded even before Rauner launched his latest attack.

In addition to the state's 9% rate cap, which limits the district's ability to lure investors with even higher yields, market participants said bankers face a tough task in clearing a deal through an underwriter's credit committee. The leads on the February sale, JPMorgan and Barclays, are the current providers of short-term credit lines, providing incentive to get the deal done, sources said.

The board also discloses in the OS that it tapped in February $130 million of a fiscal 2016 short-term line structured as a tax anticipation note. The district also pays extraordinarily high rates on some of its $1.1 billion of floating-rate debt. A $47 million series that had a remarketing set for late last month carries an interest rate of 9%. The rate on a $106 million series with a remarketing coming up in June is expected to rise to 9% from 7.5%.

The district will pay $1.9 billion to repay the principal and interest on the issue through its final maturity in 2044. After completing the deal, the district’s debt schedule now stands at $13.2 billion.

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