By Andrew Teras
It was only nine months ago that Gov. Jerry Brown prohibited Californians from hosing off their sidewalks and required them to use shut-off nozzles when washing their cars.
On May 12th, Moody’s downgraded Chicago’s GO credit rating to Ba1/negative, below investment grade. The action prompted liquidity-related downgrades from Fitch and S&P, and triggered additional downgrades from Moody’s for Chicago’s sales tax bonds, water and sewer systems, and the Chicago Park District. By May 15th, the market was left with unhelpfully broad split ratings for several Chicago-area issuers (see table below).
The paroxysm of downgrades that afflicted Chicago during the second week of May seems likely to beset other local governments in the future. Rating agencies today hold unusually unsettled judgments about four ascendant risks affecting fiscally stressed local governments: (a) pension risk, (b) market access risk, (c) legal covenant risk, and (d) governance risk. Until the agencies form a better consensus of how these risks impact credit quality, investors should expect the incidence of ratings dispersion to grow. They should also expect an uptick in yields and volatility for bonds that could be impacted by this dispersion.
In this White Paper, we briefly remind readers why broadly divergent ratings are detrimental to capital formation in the municipal market. We then explore how pension, market access, legal covenant, and governance risks have helped drive the divergent ratings on several Chicago-area credits, including the City’s GO, sales tax, and water and sewer bonds, as well as those of the Chicago Park District. Lastly, we argue that some of the ratings assigned to Chicago’s sales tax, water and sewer, and Park District bonds seem very off-base.
Participants in the fixed income markets have come to rely on credit ratings to intermediate trillions of dollars in capital on a daily basis. Though technically a rating is merely an opinion of the creditworthiness of a borrower, in practice it is much more.
When the same bond carries widely divergent ratings, it tends to disintermediate the market. A wide dispersion in the ratings for the same bond suggests that that at least one of the major rating agencies has a flawed approach to assessing credit risk. This tends to sow confusion among investors and increase credit spreads. The problem is exacerbated in the municipal market, which is prone to bouts of illiquidity and where retail investors comprise roughly 70% of demand.
The ratings gaps for several Chicago-area issuers are particularly concerning. Chicago is a large, transparent issuer with known credit problems. That the agencies have unsettled conclusions about its creditworthiness and its related issuers suggests there are latent uncertainties in the municipal market for which investors should demand additional compensation.
In our view, these uncertainties boil down to four key risks: pension risk, market access risk, legal covenant risk, and governance risk. Rating agencies have not yet reconciled how to analyze these risks, especially when they matter most: in the case of a struggling local government. The dearth of municipal bond defaults and bankruptcies since the early 1970s provides little detail on how pension obligations, swap termination fees, acceleration provisions, special revenue bonds, and the debt of associated governments might be treated in a municipal restructuring. The Chicago downgrades suggest that the rating agencies are unlikely to reach agreement on how these risks should be weighed, anytime soon.
An uptick in divergent ratings for weak local governments and their related issuers, therefore, seems likely.
Each of the above-mentioned risks was a key factor in the downgrades of several Chicago-area issuers and the ratings dispersion that resulted. This includes the ratings for Chicago’s GOs, sales tax bonds, and water and sewer revenue bonds, as well as the debt of the Chicago Park District.
(a) Pension Risks: Different approaches to assessing pension risk explain most of the four-notch difference between Moody’s and S&P’s GO ratings for Chicago.
Prior to the downgrade, Moody’s rated Chicago Baa2/negative and S&P rated it A+/negative. That ratings gap mostly reflected each agency’s view of Chicago’s ability to service its pension debt. In Moody’s opinion, Chicago’s growing pension costs were increasingly insurmountable without substantial reforms. In S&P’s, pension risks seemed more manageable in the context of other credit factors.
Moody’s gloomier assessment of Chicago’s ability-to-pay is partly grounded in its more conservative approach to measuring pension liability. That methodology includes discounting Chicago’s pension debt at a high-grade, taxable bond equivalent rate and amortizing the payment schedule over 20 years. When Chicago’s pension problems were exacerbated by a detrimental May 8th Illinois Supreme Court ruling, Moody’s, downgraded the City, again.
(b) Market Access Risks: Different sensitivities to market access risks have also led to ratings dispersion in Chicago’s case.
S&P downgraded Chicago’s GOs two notches, from A+/negative to A-/negative on access concerns. The Moody’s downgrade to “junk” triggered swap termination fees and acceleration provisions that lowered S&P’s assessment of Chicago’s liquidity profile, specifically its ability to access the market for funds, if needed.
S&P also dropped Chicago’s water and sewer revenue bonds by three notches on market access concerns after the Moody’s downgrades. The water and sewer systems face swap termination payments and acceleration risks just like the City’s general fund.
By contrast, Moody’s ratings actions against Chicago’s GO and water/sewer ratings reflected no new concerns regarding the City’s market access risks.
(c) Legal Security Risks: Different assessments of legal covenants have led to a 10-notch ratings differential for Chicago’s sales tax bonds. S&P affirmed the AAA/stable rating on these bonds in March 2015 while Moody’s now rates the same bonds Ba1/negative.
S&P’s gilt-edged rating stems from the sales tax bonds “strong legal provisions,” including a springing debt service reserve fund and 5.0x additional bonds test. According to S&P, coverage of maximum annual debt service is expected to be 16.1x in FY 15.
Moody’s junk rating reflects an entirely different judgment. Moody’s rates dedicated tax securities no higher than the GO-level whenever the pledged tax revenue can be diverted for purposes other than repaying the bonds (that is, whenever the pledge is an “open lien”). This is true in Chicago’s case.
(d) Governance Risks: Different assessments of governance risks underpin broad ratings differentials on Chicago’s water and sewer system bonds and the Park District’s bonds.
The ratings differentials between Fitch and Moody’s on the water and sewer bonds are six and seven notches, respectively. Fitch continues to rate Chicago’s senior lien water bonds AA+ while Moody’s rates them Baa1. Fitch rates Chicago’s junior lien sewer bonds AA and Moody’s rates them Baa3.
Most of the difference in these ratings is explained by Fitch’s and Moody’s different sensitivities to the governance linkages between the City and the water and sewer systems. While both agencies cite concerns that the utilities are exposed to Chicago’s general fund stress and the risk that the City Council will balk at approving future rate hikes, only Moody’s has tethered the water/sewer ratings to Chicago’s GO credit rating. Moody’s methodology for rating utility revenue bonds specifies that “in most cases, the ratings of GO and associated utility revenue debt… will remain relatively close.”
The ratings differential between S&P and Moody’s on Chicago Park District bonds is nine notches. S&P rates the Park District AA+/stable while Moody’s rates it Ba1/negative.
The ratings disparity on the Park District reflects vastly different views of the governance linkages between the District and Chicago.
In its last review of the Park District, S&P made no mention of the governance connection between the District and the City. By contrast, Moody’s has specifically cited the District’s close ties to the City as the prime reason for its downgrade to Ba1/negative. Its board is appointed by the Mayor, subject to City Council approval, and the City influences certain budget and taxing decisions.
In our view, some of the ratings assigned to the Chicago-area credits discussed here are aberrant. This seems particularly true of the non-GO credits: (a) the sales tax bonds, (b) the water and sewer revenue bonds, and (c) the Park District bonds.
(a) Sales Tax Bonds: S&P’s AAA/stable rating on Chicago’s sales tax bonds is a bold rating, in our view. S&P’s rating hinges on sound coverage and a couple of nice contractual commitments, including a 5.0x additional bonds test. Also, the plain language of the bankruptcy code would appear to protect open lien dedicated tax bonds from the automatic stay in Chapter 9.
However, as an issuer becomes financially strapped, relying on an open lien pledge may prove foolish. In an extreme situation, an issuer might renege on certain dedicated tax covenants to gain access to pledged funds that they routinely use for purposes other than paying debt. Moreover, while closed lien pledges have been honored in prior bankruptcy cases, we are unaware of an instance in which an open lien pledge has been tested.
As the table above illustrates, Moody’s has downgraded Chicago’s sales tax bonds in tandem with the City’s GO rating since July 2012, even though pledged sales taxes have grown relative to maximum annual debt service (MADS) requirements.
Ratings divergence in the dedicated tax space seems likely to grow as local government credit quality deteriorates in some quarters. Until the agencies receive more clarity from the courts, we think investors should expect a greater incidence of ratings dispersion for these kinds of bonds. They should also demand better yields for these bonds insofar as stress at the GO level can lead to downgrades.
(b) Water and Sewer Revenue Bonds: Moody’s low-investment grade ratings for Chicago’s water and sewer revenue bonds are a bit low, in our view. As described above, Moody’s generally tethers the rating for a water or sewer utility revenue bond to that of a city’s GO rating. Among other things, Moody’s approach reflects governance concerns that a utility may make transfers to the local government’s general fund, that the utility may have a responsibility to fund its portion of the government’s pension costs, or that the city council may refuse to pass rate hikes for the system.
In Chicago’s case, Moody’s tethering strategy seems a bridge too far. As the tables below demonstrate, coverage and liquidity at both the water and sewer utilities has increased over the past five years. In addition, the City Council has seen fit to pass substantial rate hikes despite Chicago’s other credit challenges. Current rates remain affordable.
Moody’s somewhat pro forma approach also seems to ignore other key credit factors. In particular, it may place too little emphasis on economic and financial credit factors. It also seems to ignore that water and sewer revenue bondholders benefit from strong legal protections under state law and in Chapter 9.
Nonetheless, if a greater number of local governments become fiscally distressed in the years to come, more water and sewer revenue bonds are likely to carry divergent ratings from Moody’s and the other rating agencies.
(c) Chicago Park District: Moody’s Ba1/negative rating on the Chicago Park District is among the most confounding to emerge from the Chicago downgrades.
Moody’s Park District rating is grounded in the District’s close affiliation with the City. In its opinion on the Park District, Moody’s notes that Chicago’s Mayor appoints the Board of Directors, that City officials “hold sway” over certain fiscal decisions of the District, and that the District recently sold 20 acres of land to the City for a mere $1. It describes the District as tantamount to a “department” of the City.
In our view, the governance connections that worry Moody’s are significantly overblown, and even if not, other credit metrics likely outweigh Moody’s governance concerns.
The Chicago Park District is governed by the Chicago Park District Act and the Park District Code. Under those statutes, the District is a legally distinct entity with independent taxing authority. A Chicago Chapter 9 filing would have no direct impact on the Park District. (Note that, presently, Illinois does not authorize Chapter 9 filings, anyway.) The Park District’s Commissioners serve for staggered five-year terms, which provide some insulation from the political and fiscal needs of City politicians.
Under generally accepted accounting principles, the District is also understood to be distinct from the City of Chicago. Notably, the District is not a component unit of the City. Component unit governments are legally separate entities over which another government has administrative control and some financial connections.
Conceivably, the Park District could loan or transfer funds to Chicago to offset its operating deficits. But this seems unlikely. Aside from the political impediments to doing so, the Park District cannot transfer assets to the City without a change to state law, and its property tax authorization extends to funding only the “necessary expenses” of the District. Also, the Park District cannot sell, lease, or exchange any of its real estate unless it continues to be used for park or recreational purposes. In this context, the recent sale of land to the City for $1 dollar seems innocuous. That land will be used for a Park District purpose: the Barack Obama Presidential Library.
Finally, transferring the District’s assets via dissolving the District seems very unlikely. Under current law, dissolution requires a referendum and two-thirds approval from the District’s voters. If the legislature rewrote the law, the property tax levy that supports the bonds would almost certainly remain in place.
However, even if Moody’s governance concerns were warranted, the agencies’ Ba1/negative rating seems low. As the table below shows, over the past five years, the Park District has managed to grow its reserves, keep its cash position in-line, and pass a consensual pension reform with its unions. These metrics suggests that the Park District’s Commissioners are not shills for City politicians.
We are under no illusions that the Park District is a sterling credit. It shares Chicago’s overburdened tax base. It may be challenged to raise property taxes as other units of government in Chicago are compelled to raise theirs (e.g., the City and the School District), and it is not entirely clear that its pension reform is insulated from the Illinois Supreme Court’s recent decision. Still, it is among the sturdiest junk-rated credits we have ever seen.
Moody’s downgrade of the Park District suggests that the agency will take a similarly broad view of other related special district governments in Illinois – and elsewhere – where the special district shares governance ties with a struggling issuer. This is consistent with Moody’s latest thoughts on municipal default risk, including its view that when “credit risk rises in a given region… severe stress and default are likely to occur in clusters.” We expect Moody’s approach to drive more ratings dispersion for weak local governments.
The recent downgrades of Chicago’s GO, sales tax, water and sewer ratings, as well as the ratings of the Chicago Park District reflect broad differences in rating agencies assessments of four risks that seem likely to grow in the coming years: pension risk, market access risk, legal covenant risk, and governance risks. The low default rate for full service local governments over the past 40 years provides limited information to the agencies about how issuers will manage these risks when finances become strained. Current ratings frameworks reflect this lack of data.
The variety of ratings now assigned to Chicago-area issuers – and the future ratings dispersion they portend – present investors with new opportunities and risks. Those willing to conduct independent credit research may be able to identify weaknesses in rating agency approaches, from time to time. This kind of independence is likely to become increasingly valuable, as bonds with dissonant split ratings generally exhibit higher yields and more volatility. Investors may be forced to decide whether (and when) they wish to make strategic purchases or whether they wish to avoid ratings risk, altogether.
 See: Federal Reserve Flow of Funds data, Table L. 211, March 12, 2015.
 See: “Chicago’s Pension forecast –Tough Choices Now or Tougher Choices Later,” Moody’s Investors Service, May 1, 2015.
 See: S&P’s February 2015 rating opinion on Chicago.
 See: “Adjustments to U.S. State and Local Government Reported Pension Data,” Moody’s Investors Service, April 17, 2013.
 See: In re Pension Reform Litigation, May 8, 2015. Available at: http://www.illinoiscourts.gov/Opinions/recent_supreme.asp. The court wrote that the Illinois constitution’s provisions not only vest employees with a contractual right to pension benefits which can be impaired only if reasonable and necessary, but that the constitution also prohibits any “diminishing” of those benefits even in the absence of contractual protection. See paragraphs 70-72 of the opinion.
 See Moody’s July 17, 2013 Chicago rating opinion, which downgraded the City from Aa3/stable to A3/negative based on Moody’s new approach for measuring unfunded pension liabilities relative to peers.
 Based on Moody’s response to a listener question in a call for Moody’s clients on May 17th, 2015.
 See: S&P’s rating affirmation of Chicago’s sales tax bonds, March 5, 2015.
 See Moody’s U.S. Public Finance Special Tax Methodology, January 31, 2014.
 See “Frequently Asked Questions: The City of Chicago and Related Credits,” Moody’s Investors Service, May 18, 2015. See also: Fitch’s August 2014 opinion regarding Chicago’s second lien water revenue bonds.
 See: Rating Methodology for U.S. Muniicpal Utility Revenue Debt, Moody’s Investors Service, December 2014.
 See: 11 USC 902(2)(B). This part of the bankruptcy code qualifies as “special revenues” any “special excise taxes imposed on particular activities or transactions.” We see no reason to exclude open lien sales tax bonds from this definition.
 For example, the closed lien sales tax bonds at issue in Heffernan Memorial Hospital District and Jefferson County escaped those bankruptcies unimpaired.
 See: Fitch Ratings August 29, 2014 opinion on Chicago’s Second Lien Water Revenue bonds.
 As we have outlined in previous commentaries, utility revenue bonds were paid on time, and in full, in the bankruptcies of Vallejo, Stockton, and Harrisburg. In Detroit, the city embarked on a novel strategy to impair water-sewer revenue bondholders that resulted in the vast majority of bondholders receiving their principal back. And in Jefferson County, the bankruptcy court established that cities may not divert pledged net revenues to the general fund, alter the calculation of net revenues, or ignore commitments under rate covenants. (See Breckinridge’s 2014 Credit Outlook, available at: http://www.breckinridge.com/insights/whitepapers/2014-credit-outlook/.) Impairing special revenue debt in municipal bankruptcy may be possible through the use of priming liens and the cram down provisions, but as we have outlined previously, these risks seem remote. (See: “Detroit Makes Advances in Bankruptcy Filing, April 28, 2014, available at: http://www.breckinridge.com/insights/whitepapers/detroit-makes-advances-in-bankruptcy-filing/.)
 See “Frequently Asked Questions: The City of Chicago and Related Credits,” Moody’s Investors Service, May 18, 2015.
 See: 70 ILCS 1505 and ILCS 1205.
 This is our own brief definition. For a precise definition, see GASB Statement #14 or better, page 153 of Governmental Accounting Made Easy, Warren Ruppel, Wiley, Copyright 2010.
 See Moody’s opinion on the Park District, March 2014.
 See 70 ILCS 1505/19.
 See: 70 ILCS 1205/10-7.
 See: Dahleen Glanton, “Chicago Park District approves transfer of parkland for Obama library,” Chicago Tribune, February 12, 2015.
 See: 70 ILCS 1205/Art. 13.
 See: 70 ILCS 1505/18.
 See: “U.S Municipal Bond Defaults and Recoveries, 1970-2013,” p. 7, Moody’s Investors Service, May 7, 2014.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, including but not limited to, Federal and various state & local government documents, official financial reports, academic articles, and other public materials. However, none of the information should be relied on without independent verification.
By Andrew Teras
It was only nine months ago that Gov. Jerry Brown prohibited Californians from hosing off their sidewalks and required them to use shut-off nozzles when washing their cars.
Away from the federal government, states are increasingly exploring legislation to price carbon emissions.
Podcast recorded September 14, 2018
In this month’s From the Desk market podcasts, our investment team discusses CA spreads, cross over trading, Ford’s downgrade, M&A activity, UMBS and more.