With other debt stories grabbing headlines lately, some U.S. municipal investors may have missed an event a little closer to home: Chicago placed an approximate $743 million in taxable and $347 million in tax-exempt bonds. The transaction was needed to refinance short-term debt and related payments triggered by Moody’s downgrade of the city’s general obligation bonds to below investment grade on May 8.
Elevated funding costs in the wake of the downgrade signal the realities of the city’s fiscal challenges. Nevertheless, we believe investors are now being more than adequately compensated for the risks associated with Chicago’s bonds. We see long-term value in both taxable and tax-exempt debt at current levels.
What are the challenges?
- There is no quick fix for pensions. The fiscal problems stemming from the city’s poorly funded pension systems are well documented. The Illinois State Supreme Court’s May 8 ruling makes it clear that deleveraging through pension reform is not likely.
- High leverage is here to stay. Legislation pending in Springfield is designed to alleviate near-term budgetary stress from increased pension funding requirements. This would result in continued growth in unfunded pension liabilities. Regardless of the outcome, the city’s leverage will continue to grow and will likely remain elevated for years.
- Difficult decisions are ahead. Policy decisions are paramount for Chicago’s future. While the city’s administration has been reluctant to meaningfully raise revenue to date, we anticipate a revenue raise announcement this fall. The administration will likely also need to implement spending cuts to help meet increased pension funding.
Why do we still see value?
- The city maintains revenue flexibility. While its tax burden is elevated, Chicago has additional revenue capacity based on current economic fundamentals, in our view. The city’s home-rule status gives it the ability to raise revenue without the state’s approval, but it must now show its willingness to do so.
- Chicago is not Detroit. Comparisons to Detroit are not supported by economic fundamentals. Chicago has a far more diverse economy, the city’s labor force and employment base are at the highest levels in over a decade, and its population has stabilized and grown modestly over the last five years.
All that said, a delicate balance will be required. Chicago must sequence tax increases carefully over the coming years so as to not spur population flight. It must also be mindful of the needs of its overlapping tax entities, which face structural deficits of their own.
Despite its pension overhang, Chicago remains a dynamic city with sufficient revenue capacity to meet its steep fiscal challenges in the coming years. With the hope of pension reform all but snuffed out by a recent State Supreme Court ruling, the city must now begin to address its challenges head on. Current market valuations reflect the realities of the city’s fiscal situation and now offer potential long-term value for investors.