Upgrade will help Chicago navigate a thornier bond market

Last week’s Fitch Ratings upgrade of Chicago offers dual benefits for Mayor Lori Lightfoot’s administration as it pursues passage of a proposed 2023 budget and preps a general obligation issue.

Fitch’s Friday upgradeto BBB from BBB-minus, the city’s first from Fitch in 12 years, and the potential for more good rating news could help sell the City Council on supplemental pension contributions and other pieces of the budget plan viewed favorably by analysts.

The Fitch action and an overall rosier view of the city’s fiscal condition should also broaden the investor appeal of an upcoming $757 million general obligation issue in a more fickle and tumultuous market than prevailed in the city’s last GO offering in late 2021.

“Chicago’s credit quality has steadily improved over the last few years,” John Miller, head of municipals at Chicago-based Nuveen, said in an email. “The city’s commitment to improving pension contributions and funding has been impressive and did not waiver during the pandemic. The improved credit story should be good for credit spreads when they bring their new deal.”

Secondary market spreads for Chicago GO paper have held up during a challenging 2022 market environment.

“It appears to us that Chicago GO in the secondary market trades more in line with investment-grade rated bonds than it does with below investment grade. This should also help the deal come at BBB-type levels,” Miller said.

Fitch, in upgrading the city,also signaled the prospect for more upward momentum by assigning a positive outlook.

Fitch also lifted the rating on the city’s senior lien Sales Tax Securitization Corp.’s rating to AA from AA-minus and assigned a positive outlook while the junior lien was affirmed at AA-minus with a stable outlook.

Chicago’s Fitch rating had sat at BBB-minus, the lowest investment grade, since Fitch cut it two notches and assigned a negative outlook after the state Supreme Court struck down the city’s pension overhaul in 2016.

The city’s improved pension funding status and structural budgetary balance drove the upgrade that comes as the City Council is weighing Lightfoot’s proposed $16.4 billion all-funds spending package. With a healthy fund balance, the plan directs surplus tax revenues to make a $242 million supplemental pension payment in addition to the $2.37 billion statutory payment.

The new money GO issue selling in multiple series later this month or early in December will follow budget passage.

Chicago hopes for further positive rating news. S&P Global Ratings, which rates Chicago’s GOs BBB-plus with a stable outlook, offered positive words in a special commentary bulletin Friday. Kroll Bond Rating Agency rates Chicago A and stable.

A bigger coup for the city would come with a Moody’s Investors Service upgrade out of junk territory. Moody’s cut the rating to Ba1 in 2015 after the Illinois Supreme Court overturned state pension reforms, a ruling that correctly signaled city pension changes would meet the same fate due to state constitutional protections against diminishing promised benefits.

Lightfoot’s predecessor, Rahm Emanuel, halted communications with Moody’s and asked the rating agency to remove its ratings but the rating agency maintains them on existing debt. Moody’s declined to comment on the proposed budget.

Since taking office in 2019, Lightfoot has not asked Moody’s for ratings but it did restore communications.

“We have provided Moody’s with regular financial updates since the start of the administration,” Chicago’s Chief Financial Officer Jennie Huang Bennett said in an email Monday.  

Moody’s revised its outlook for Chicago to stable from negative in July 2021.

“The upgrade is overdue,” Matt Fabian, partner at Municipal Market Analytics, said of Fitch. “Chicago is too well supported by the state and has too much at stake to be considered that close to junk. Will it help prices? Maybe a little. Moody’s may be inclined to move soon, especially if the near-term economic challenges wind up not testing the city’s finances too severely.”

Fabian credited the city with meeting its hike in pension contributions to reach a payment based on actuarial factors without turning to one-time budgetary maneuvers, which he called welcome development but cautioned that the benefits of any one upgrade may be limited given market jitters over a deteriorating national economic picture.

“Current market volatility/illiquidity remains problematic for an inconstantly-bought name like Chicago, and sustained spread improvement is thus unlikely based on this news alone,” Fabian said.

The city’s next deal will come amid steady and significant municipal fund outflows and continuing Federal Reserve rate tightening to fight inflation.

If fund flows don’t reverse course, the city could be tested by a tough technical environment, said one market participant. 

“Should the market stabilize in November or we have even the hint of a turnaround in the general market, then the deal could go smoothly. If the market overall continues to trade down, and fund flows continue on what has already been the largest outflow cycle of all time by far, the deal could have a tough time getting through a 5.75% for max yield term,” the market participant said.

“I think every upgrade gives them a vote of confidence” at least in the short term, said Richard Ciccarone, president of Merritt Research Services.

Lightfoot has faced questions and pushback from some council members over her plan to make a supplemental pension contribution.

“The city has gotten to this place of structural balance by making tough decisions, building structural solutions, and using federal funds wisely,” Bennett said in defense of the proposal during the first budget committee hearing earlier this month.

With revenues revised upward by $260 million the city “has the wherewithal to begin paying down our pension debt,” Bennett said, adding that upgrades could translate into $100 million in savings per $1 billion borrowed.  

“I think the proof of the policy effectiveness is in the upgrade. They should see it as an additional good reason to vote in favor of it,” said Alderperson Scott Waguespack, chairman of the Finance Committee. “Some are not swayed by financial expertise that created the upgrade.”

Supplemental contributions being labeled “advance” payments have the benefit of keeping growth of unfunded pension liabilities in check and staving off the need to sell off assets to meet annual retirement benefits when investment returns fall short of assumed returns.

Bennett said the 2023 proposed advance payment launches a new policy and that future annual payments would also be tied to a level needed to curtail unfunded growth.  

The city advanced a portion of its 2022 payment early in September “to prevent an asset loss,” Bennett said during the hearing.

The 2023 supplemental contribution will stave off a potential $130 million annual increase in future contributions needed if assets were sold off in 2023 to meet benefits and should result in $2 billion in future savings over the course of the city’s funding plan.

The statutory goal for the city is to reach a 90% funded ratio in 2055 for the police and firefighters funds and 2057 for the municipal and laborers’ funds.  The city this year completed a ramp up in payments to one based on an actuarial basis.

The city will codify the supplemental funding plan through a formal debt and pension management policy. While Ciccarone called the supplemental pension contribution “a step in the right direction” he’d like to see a more formal mechanism be put in place that future administrations have to abide by.

Bennett also told council members that the city must keep its reserves at a level of more than 20%, above the city’s 16% policy, because it’s a metric expected by the rating agencies due to the city’s outlier status on pension debts that total $33.7 billion.  

Proceeds of the sale will finance capital projects in the city’s $3.7 billion, five-year Chicago Works capital program and the $1.2 billion Chicago Recovery Plan that also relies on COVID-19 American Rescue Plan Act relief grants to fund a broad range of social programs. The deal will also include the city’s first environmental, social, and governance-labeled bond series and will be structured to prioritize local orders.

In its preliminary review of the proposed budget, S&P notes the phase out of one-time fixes that had long kept the city’s spending plan structurally imbalanced.

“After a one-year delay due to the pandemic, the 2023 budget is balanced without one-time revenue sources,” S&P said. “During this time Chicago made several notable changes to its budget, including ramping up to full actuarial pension funding, which contained an increase of $1.8 billion over eight years.”

S&P also praises the administration’s targeting of new revenue sources through its pursuit of its first casino license and adoption of a policy raising property taxes modestly through an inflationary trigger. The city will forgo the up to 5% hike allowed this year.

“While S&P Global Ratings views structural changes such as annual CPI increases as critical to maintaining structural balance, forgoing them under these circumstances does not indicate a weakening of the city’s credit quality,” analysts wrote.

Fitch praised the city’s actions to date but the rating level remains “well below the sector median” and said any future upgrade hinges in part on budgetary balance. “A sustained focus on recurring fiscal solutions to maintain budgetary balance through economic cycles will be a key factor in future rating outcomes,” analysts said.