CHICAGO – Chicago Public Schools is readying its inaugural sale under a new dedicated capital improvement tax crafted to provide a borrowing outlet it can present as insulated from both the district's operating struggles and the threat of Chapter 9 bankruptcy.
The district, which issues through the Chicago Board of Education, outlined the structure in the offering statement distributed this week for a $500 million pricing, the first to tap $840 million of board-approved authority.
The new structure offers a new ad valorem tax pledge distinct from the district's traditional double-barreled offering of a general obligation pledge and alternate revenue source pledge.
It's a "unique credit and security," Ronald DeNard, senior vice president of finance, said in a recorded investor presentation. "The credit is secured by a new unencumbered limited purpose dedicated property tax levy within the school district that will be statutorily limited to capital improvement -- cannot be used for operating expenses. The CIT revenues are neither a general revenue nor are they available for debt service on any of the board's existing debt."
The isolation of the revenues earned the bonds an A rating from Fitch. That's eight notches above the junk level rating of B-plus Fitch assigns to the district's GOs.
"The distinction between the 'A' rating on the series 2016 bonds and the 'B+' IDR [issuer default rating] reflects Fitch's assessment that the pledged revenues meet the definition of "special revenues" under the U.S. Bankruptcy Code and therefore, bondholders are legally insulated from any operating risk of the board," Fitch wrote in its review distributed Thursday.
Kroll Bond Rating Agency was the other rating agency asked to rate the new, non-GO structure. It assigned a BBB. Fitch, Moody's Investors Service and S&P Global Ratings all rate the district's $6.8 billion of GOs at junk level. Kroll assigns a BBB-minus rating to most of the outstanding GOs and a BBB to a sale earlier this year. All assign a negative outlook to the GOs.
The new structure offers multiple protections aimed at quelling bondholder unease about the distressed district's precarious finances. It includes a direct intercept that sends the tax levy revenues directly from county collectors to the bond trustee.
Excess revenues are freed up after debt service payments in the current calendar year and through the following April are set aside and the district must identify and certify what projects are to be funded with the cash. The tax revenues are statutorily limited to pay for capital or for debt service on the capital levy backed bonds.
The bonds are further secured by a trustee-held debt service reserve, funded with bond proceeds in an amount equal to 0.14 times of maximum annual debt service, which combined with CIT revenues, provides 1.35 times coverage through 2032 and then 1.24 times. Future issuance under the structure would require that a 1.1 times additional bonds coverage test be met.
"The 2016 bonds are not secured by the board's general obligation full faith and credit pledge or any other revenues and the CIT revenues flow directly from a third party intercept structure isolating the CIT credit from the board's general credit," investor documents say.
Upon issuance of the 2016 bonds the board will file a dedicated CIT levy equal to annual debt service through final maturity. No further governmental actions are needed for debt service to be paid.
The structure is built to withstand a bankruptcy test and offers to special revenue opinions to support its argument.
"CIT revenues would be classified as special revenue under the U.S. bankruptcy code if the board able to file bankruptcy," investor documents say.
To support its position, the offering statement provides two legal opinions on special revenues, one from bond counsel Katten Muchin Rosenman LLP and the other from underwriters' counsel McDermott Will & Emery LLP, saying they believe the dedicated revenue stream would qualify as "special revenues" under the U.S. Bankruptcy code.
While current state law does not allow the school district to enter Chapter 9, Gov. Bruce Rauner has said such an option should be on state books and that CPS is an ideal candidate for such a filing.
Rauner's comments on the subject earlier this year rattled investors ahead of a deal that drove up the district's borrowing cost to a high of 8.5%, 500 basis points over the Municipal Market Data's top-rated benchmark at the time and near the state's 9% cap.
In the event the state added a municipal bankruptcy provision to state law and CPS landed in Chapter 9, the law firms say the special revenues designation would shield the pledged revenues from the code's automatic stay on payments on pre-petition debt and should protect the bonds from a haircut in any confirmation plan.
The bankruptcy code lays out five categories of special revenues including three involving tax revenue. Attorneys believe the tax backing the new bonds qualifies as a special revenue because it's being levied for a specific use or purpose that is isolated from general operations.
The opinions make clear that the position is "not free from doubt" because there is no existing case law and there's no guarantee that the court would not allow access to the special revenues for necessary operating expenses.
"I think what they tried to do is structure something where the lawyers could give opinions that it is special revenues and I think it's wrapped pretty tightly," said a bankruptcy lawyer who has read the documents.
The attorney said some of the language about the special revenue classification or potential that the revenues could be diverted in bankruptcy is overly cautious.
"If the revenue is collected, dedicated, and pledged to pay bondholders," bondholders would continue to receive it, the attorney said. "The structure is pretty sound."
The district took the same position with language included in its most recent public offering in February that its ad valorem tax pledge under the state's GO/alternate revenue bond structure would meet the special revenue designation.
Analysts, lawyers, and investors disagreed over whether the district's position would hold in court. The district did not include the opinion from Katten Muchin in the February offering statement although it provided the opinion to Kroll which, after consultation with its own external counsel, rated the bonds one notch higher than the district's previous issuance.
"Special revenue investors have been better protected during a bankruptcy, as payments are likely to continue," Moody's Investors Service said in a February report. "Except for Jefferson County, all recent Chapter 9 cases where investors had debt secured by a water and sewer revenue pledge did not experience a default."
CPS' new structure could lure some additional buyers and help trim the district's punishing yield penalties, but the district faces plenty of other headwinds.
Gov. Bruce Rauner last week vetoed $215 million in state funds to help the district cover its teacher pension payments and the funding may not be restored absent a break in the prolonged state budget impasse.
"CPS' problem is its legacy liabilities so this pledge does remove bondholders from that main risk to an extent," said Matt Fabian, partner at Municipal Market Analytics. "But if there is broader drama this security will still be impacted and the worry is headline risks and questions over what the state will do.
"I think this security structure is more about securing market access than significantly lower yields," Fabian added.
Barclays and JPMorgan are lead managers with Barclays running the books. Public Financial Management Inc. and Acacia Financial Group Inc. are advising the district. The district is hosting investor calls and has put the sale on the calendar for the week of Dec. 12 although the exact timing is dependent on market conditions, according to CPS spokeswoman Emily Bittner. The investor roadshow expires Dec. 26.
Interest only will be paid until 2033 with the annual tab at $30 million. Principal is amortized between 2033 and 2046 when debt service rises to $55 million.
The General Assembly gave the city the ability to levy the tax in 2003 but it was not approved by the City Council until October 2015 and collections began in July.
The levy can be raised based on the consumer price index but a floor is set so that it can't be reduced in the event of deflation. The levy is expected to grow to between $200 million and $300 million through 2042 depending on the Consumer Price Index.
Proceeds of the deal will fund capital projects, capitalized interest, and the reserve. Schools chief Forrest Claypool announced last week $600 million in supplemental capital spending for fiscal 2017 bringing to $938 million total planned spending.
The bond documents outline a long list of investor risks. The district has not reached a final agreement with the teachers' pension fund on a $250 million credit it is seeking toward its teachers' payment due in July. The credit would recognize anticipated collections of the pension tax levy approved in June by state lawmakers.
The bond documents note the board's resolution of teachers' contract negotiations. The board approved a supplemental budget Wednesday adding in the $55 million costs of a new teachers' contract and the revenue from a city tax increment financing surplus to cover it.
The amended budget does not address the $215 million vetoed by Rauner last week. The funds were part of a state package that helped the district trim a $1 billion deficit. The district's cash flow remains negative and it relies on expensive short term credit lines to stay afloat; the district faces more red ink in the coming year as it looks for greater state help.
