CHICAGO — Detroit faces a skeptical market for its first post-bankruptcy borrowing next week, as investors weigh unprecedented state-crafted protections and an investment-grade rating against concern over the underlying credit and the weakness of the city's economic recovery.
The Michigan Finance Authority is expected to price $245 million of local government loan program revenue bonds on behalf of the city on Aug. 19. The debt is enhanced with a statutory lien and intercept feature on the city's income tax, which will pay off the bonds.
The protections, combined with debt-service coverage levels of 6.5 times, helped the deal win an A rating from Standard & Poor's.
Investors warn of two chief risks: the income tax revenue is highly concentrated, hinging on the city's fragile recovery; and it's unknown how a statutory lien and trust would play out in a federal courtroom if Detroit ends up in Chapter 9 again.
"The statutory lien and enhancements the underlying structure appear strong, but we're of the opinion that the same economic and employment forces that drove the city downward in the past can still have an effect on this deal," said Michael Johnson, head of research for Gurtin Fixed Income Management. "The economic forces around this gives us pause."
It's the Motor City's first public bond sale since it exited the largest municipal bankruptcy in the country last December. Proceeds from the deal will largely be used to repay Barclays for a $275 million loan that financed the bankruptcy exit. The city saved $30 million from attorneys and consultants who agreed to lower their fees, and will redeem $30 million of the bonds on the conversion date on Sept. 1, leaving a final borrowing amount of $245 million.
Barclays Capital Inc. is also the underwriter on the upcoming sale. Miller Canfield is Detroit's bond counsel. The finance team and city officials are promoting the deal with investors this week, with presentation set for Detroit and New York City.
The borrowing is divided into two series: $134.7 million of tax-exempt bonds with a 2029 final maturity and $110.3 million of federally taxable bonds with a 2022 maturity.
The coverage is projected at 6.5 times or higher based on 2014 collections and monthly coverage of maximum annual debt service has not been less than 2.85 times in the past three years, according to S&P.
The new pledge giving bondholders a superior, statutory lien on income tax revenue -- which Gov. Rick Snyder signed into law in April -- marks a first for Detroit or any Michigan borrower. The law also exempts the revenue held in trust from being levied upon, sequestered or applied toward any other debts.
A legislative fiscal analysis of the pledges estimated the enhancements would save the city roughly $2 million to $3 million a year in interest.
Detroit continues to operate under a financial recovery board. Mayor Mike Duggan, Snyder and others have trumpeted gains made over the past year, including economic development projects tied to the city's downtown.
Moody's Investors Service two weeks ago boosted its issuer rating on the city to B2 from B3, revising the outlook to positive from stable. The rating doesn't apply to the income tax bonds. The upgrade reflects the city's improved financial position since the bankruptcy and management's continued improvement of financial operations, analysts said.
The city's bond deal next week will be the first market test of the city's recovery. Appetizing yields and high debt service coverage levels will attract investors, said buy side experts, though they still have reservations.
"We're not dismissing it immediately, but we're also not ready to jump in," said Josh Gonze, co-portfolio manager at Thornburg Investment Management, which has $10 million in municipal assets. "We are impressed with the statutory lien and the 6.5 times debt service coverage and the trustee intercept. However, we're not positive that's enough to get it to be creditworthy because we're not sure it will hold up in bankruptcy if the city enters another bankruptcy."
The city reached settlements with its bondholders during its Chapter 9 case, so bond protections weren't litigated, leaving open questions surrounding various securities, including unlimited-tax general obligation bonds, which Detroit treated as unsecured.
"Michigan did its best to provide some structural protections that insulate the debt from a future Chapter 9 for Detroit, but you just don't know going into another bankruptcy if the structure would hold up," said Lisa Washburn, managing director at Municipal Market Analytics. "If there is another bankruptcy, it's likely that the income tax revenues are suffering anyway."
Gurtin's Johnson noted that some states, like New York, provide additional bondholder protections by pledging that a local credit cannot go into Chapter 9 during the life of the bonds. No such protection exists in the Detroit case.
In fact, preliminary bond documents are clear on investor risks in the event of another Chapter 9.
"Should the city file for bankruptcy protection, the bankruptcy court's decision regarding these matters would be based on its own analysis of the law and interpretation of the factual evidence before it," said documents, referring to the statutory lien. "The bankruptcy court would not be bound by legal opinions other than binding precedent, and there currently is no binding precedent regarding these matters."
The city's income tax revenue, which is its largest revenue source, is also highly concentrated, with 90% of collections coming from just 40 employers, according to Standard & Poor's. That's a risk, according to the ratings agency and market participants.
"We're not entirely comfortable with a lien on income tax revenue in a city that has very few income tax payers," Gonze said.
The city currently levies income taxes at the maximum rate allowed under state law, which is 2.4% for residents, 1.2% for non-residents and 2% for corporations. Detroit needs an act of the Legislature to raise the rates.
The city sets aside roughly 8% of the revenue to fund police operations, a pledge that is superior to bondholders' lien.
"You're talking about a city that has had decades of employment flowing out," said Johnson. "If you have that continue, it could have an outsized effect on income tax." Collections would take a double hit if an employer leaves, taking the corporate income tax as well as the individual income tax from the employees, he added.
Detroit expects income tax revenue to peak at $264.5 million in 2018 - the first year it begins to pay debt service - from $256.5 million in fiscal 2015.
Income tax collections totaled $228.3 million in fiscal 2011 and $248 million in 2013.
If the revenue is insufficient to pay debt, the city said it will tap property taxes and other funds to pay the bonds.
Debt service on the Series F-1 bonds begins in 2020, rising from $2 million in 2020, 2021, and 2022 before spiking to $15.4 million in 2023, and climbing steadily to $21.7 million in 2029.
Debt service on the F-2 bonds begins at $13.4 million 2018 before rising to $25.9 million in 2022.
The city also has taxpayer concentration with regard to its property taxes, with the top 10 2014 property tax payers comprising 28.5% of assessed valuation, according to Moody's.
Seeking to assuage bondholder concerns by pledging its largest revenue source to bond payments, the city is taking some risks, according to Washburn.
"It's arguably the strongest revenue stream they have and they've pledged that specifically to repay this debt," she said. "This is exactly what they were trying to get away from in bankruptcy -- they were trying to prioritize services and their citizens ahead of investors and here it seems once again they've prioritized creditors," she said. "[Debt payments] could be taking a bigger chunk of the revenue in the coming years, meaning less money go to the city, so there's a lot at stake for the city to experience stability and growth in the next several years."
