STUMP » Articles » Chicago Bonds: Junk or Not Junk? That is the Question » 20 May 2015, 06:44

Well, there are more questions than those, but there are some interesting things being published on the matter, so let’s do a round-up.

As I noted with regards to credit spreads, it could seem like the market is pricing the bonds as junk. But the bond market is not the most liquid out there, so “price discovery” can be a mysterious thing.

Let’s see what various entities have to say.

EXPECT[ED] LOSS

(That’s the name of the blog, not an analysis of expected loss)

Is Chicago Really a Junk Issuer?

Chicago’s pension funds are seriously underfunded, but that is nothing new. At the end of 2011, Chicago’s four pension funds had a composite funded ratio of 37.9% – based on market value of assets. At the end of 2013 (the latest date for which complete statistics), the funded ratio was little changed at 37.0%.

That said, Chicago’s pension costs are quite large relative to city revenues. In 2013, actuarially required pension contributions totaled $1.74 billion, or 22.3% of the city’s total revenues of $7.82 billion. This proportion is very high by national standards – higher, for example, than every single city in California.

I am skeptical of Actuarially Required Contributions (ARC) as a solvency measure, because a city can, in theory, meet its pension obligations on a pay-as-you-go basis. In other words, the city’s pension funds can all have a zero percent funded ratio, and all pension benefits and administrative expenses can be paid out of revenues.

OMG

REALLY

Guys, you really need to think through why pensions are pre-funded as opposed to pay-as-you-go. Pay-as-you-go used to be the standard on public pensions. Then the Depression occurred. You may have heard about that one.

Mind you, asset prices were depressed during the period, but still having some savings of some sort could pay pensions, as opposed to having no cash flow with which to support pensions. It’s bad enough to issue bonds to pre-fund the pensions, it’s really really bad to issue bonds when you’re having to support current cashflows to retirees.

But let me be fair, here is what comes next:

But a review of Chicago’s benefit costs does not offer solace. In 2013, expenditures by the city’s four pension funds, totaled $1.84 billion, or 23.5% of total revenue. (Under current Illinois law, the city will have to pay much more than this in future years because it will be mandated to both meet existing pension obligations and raise its funded ratio to 90% by 2040).

……
Even worse, the trend is not in the city’s favor. Each plan’s actuarial valuation contains projected benefit payments through at least 2041. If we add up these future expenses, we find that they are projected to grow by about 4% annually through 2023. After that, benefit cost growth decelerates, as “Tier 2” beneficiaries – who are entitled to reduced pension benefits – begin to retire. The benefit growth rate from 2013-2023 is faster than the rate of revenue growth the city experienced in the previous decade. Between 2003 and 2013, revenue grew from $5.75 billion to $7.82 billion – an annual rate of 3.1%, significantly slower than projected

That’s projected benefit payments, not contributions to the pension fund. No, Chicago can’t afford to do pensions on a pay-as-you-go basis. Luckily, there are some assets in the pension funds, but those are not sufficient to support those flows, either. Remember the “less than 40% funded” bit? If the valuation is on-the-level, that means that less than 40% of future cash flows already earned would be supported by current assets.

The unfunded liability and ARC do have some meaning, you know.

MOODY’S

Part of what kicked off all this brou-ha-ha was Moody’s downgrading Chicago to below-investment-grade status. They must have gotten pushback, because they’ve put out a FAQ.

The FAQ is not easily linkable, so I’m linking to this piece at Crain’s which is more accessible

1. Does the downgrade mean Moody’s expects Chicago will file for bankruptcy or default on its debt?

“No,” Moody’s says. Historically, about 5 percent bonds rated in the Ba range, like Chicago, have defaulted over a three-year period.

“We do believe, however, that the city’s pension-related challenges are significant and introduce speculative elements into the credit profile.”

Insolvency of the city’s retirement funds is at least 10 years away. In that happens, it is unclear under Illinois law whether the city will be forced to pay beneficiaries, Moody’s says.

In the event of insolvency, Moody’s sees three options: “massive” tax hikes and spending cuts; bankruptcy, which is currently not allowed under Illinois law: or restructuring of bond payments.

I do not want to get into a bond primer here (mainly because I am not a credit analyst nor bond trader, but I am familiar with the market and do related analyses), but I want you to understand “junk” does not mean “sure to default”.

Far from it.

And Ba is the highest “junk” rating in Moody’s scale. [UPDATE: typo fixed]

The thing is, many bond investors are investing in bonds because they give kickass returns but because they are risk-averse and have particular cashflow needs.

If you put $50 into a stock, you don’t know if you’ll get any cash via dividends not if you can even get your original $50 back when you sell it. It doesn’t “mature”.

If you put money into a bond, you are promised certain interest payments for a certain period of time and then a return of the face value of the bond. If the bond is sold “at par”, that means the original price equals the face value, so the extra value during the investment are those interest payments (called coupons). There are fancy-pants elaborations on that bond structure (zero coupon bonds, sinking fund bonds, callable bonds, etc.), but that’s the general idea.

Credit ratings are supposed to be related to probability of default – how likely are you to get that face value at maturity? (or if there’s a default in between, you’d also lose those coupon payments).

Investment grade bonds are supposed to have really low probability of defaulting before maturity.

Below investment grade bonds are supposed to have differing levels of probabilities of defaulting.

And, of course, this does not necessarily have a large correlation with what you recover upon a default.
But we’ve seen that recovery in a municipal bankruptcy could be extremely low, while the pensions are untouched. Recovery in a municipal bankruptcy obviously operates differently than corporate bankruptcies, and Moody’s mentions that in the FAQ as well.

FIXED INCOME DATABASE

Why Chicago’s Bonds are Junk, in 7 Charts

….all of these charts suck. They’re just a few numbers lumped onto a graph. Edward Tufte would have your hide for making these. And many of the numbers don’t really dig into the reasons Chicago is financially distressed.

I will throw in this chart:

Just because I find it amusing and totally irrelevant.

Yes, NYC and Chicago have very high waste disposal costs. Have a cookie. I promise you that cutting down city service costs would not produce a huge amount of savings. Not saying it shouldn’t be done, but that most of Chicago’s problems are past accrued debt, not just high spending into the future.

So way to go by undermining the argument by making a weak one.

The other graphs are not much better. Expect[ed] Loss had the better analysis.

IT’S DETROIT’S FAULT

Expert: Chicago in better shape than Motor City but is now ‘paying Detroit’s bills’

Matt Fabian, a partner at Municipal Market Analytics, told a tale of two cities during a lively panel discussion on city finances before a packed house at a City Club of Chicago luncheon.

“Detroit is Iraq. Detroit is a disaster zone. They have no economy. Their economy is in the rubble. They have raised revenues repeatedly, and it’s been unsuccessful,” Fabian said.

“Chicago is the third-largest city in America. It’s nothing like Detroit. Chicago is a real city. There are people. There are jobs. There are solutions. There’s growth. If anything, the Loop is too crowded. It’s a completely different ballgame.”

But Fabian said Chicago is “paying Detroit’s bills” when it comes to the hundreds of millions of dollars in penalties and higher interest rates it will pay, now that its bond rating is no longer investment-grade.

“Chicago may not have been downgraded below investment grade if Detroit hadn’t happened . . . Detroit fractured trust between borrowers and lenders in the municipal bond market. That has created an extra cost for Chicago. Now, trying to assure those same investors that it is not going the same way” will cost more, Fabian said.

You know what? Detroit used to be full of jobs and people, too. It emptied out. Chicago’s population has also decreased:

Maybe it has turned around recently, but that can easily change.

Of course, Fabian argues that the problem is Chicago has not taxed everybody enough.

I don’t think Chicago can get away with NYC levels of taxation. They’re not NYC nor LA. They do not have enough of a draw. They’re not even the second city anymore.

TIMING OF NEXT BOND ISSUE

Someone privately remarked to me that of course Chicago was not going to stall on its bond issues.

Someone may have been wrong.

Chicago’s Downgrade to Junk Makes Timing for Bond Deal Uncertain

Less than a week after Chicago’s credit rating was cut to junk by Moody’s Investors Service, the timing on the biggest piece of a $383 million bond deal has been cast into doubt.

A $201 million offering managed by Ramirez & Co. and initially planned for Tuesday has been shifted to day-to-day status, according to data compiled by Bloomberg. The sale is part of an effort to refinance floating-rate debt that exposed the city to penalties after Moody’s cut Chicago to junk on May 12. Standard & Poor’s and Fitch Ratings also lowered the city last week, while giving it an investment grade.

To be fair, the market overreacts to information even in the stock market, and the bond market is more illiquid. Just because the market is skittish does not mean Chicago bonds are junk.

But then, the market could have been underreacting all these years to the mounting pension debt.

Under-responsiveness is often followed by hyper-sensitivity.

Compilation of Chicago posts.