What happened to Chicago’s bonds?
Last week, on August 23rd, an unlimited tax general obligation bond for Chicago had a disastrous performance.
The bond (Cusip 167486PS), was issued in 2012 and matures in 2032. The original offering was for $594 million. The piece in discussion was $1.65 million (big bond offerings are usually chopped up into smaller pieces with different characteristics and maturities). The yield on the bond (rated A+ by Standard & Poor’s and AA- by Fitch) was 5.94 percent on August 23, or over 10 percent on a fully taxable equivalent basis. Is Chicago really this risky? What is going on?
I pulled the average yield for comparable New York City bonds. The bonds, which are rated Aa2 by Moody’s and AA by Standard & Poor’s (approximately two notches higher than Chicago’s bonds), were yielding 4.66 percent for 2032 maturities on the same day. This is a 1.28 percent difference (128 basis points in bondtalk). Chicago bonds are selling pretty cheap.
Some observers point to deep structural problems and the mayor’s vow not to raise taxes in comparing Chicago to Detroit. A lot of attention has been paid to Chicago’s substantial pension problems, problems in the school district and pockets of extreme violence.
One of the biggest fiscal issues is that Chicago’s teacher pensions are funded at 54 percent. This is considered unhealthy. The under-funding problem has been brewing for decades since the state legislature granted the Chicago school district a break from contributing to its pension contributions in 1995. Since then, the city has never contributed the required amount.
Is this what spooks investors? The need for Chicago to somehow radically shore up its pension funds from a budget that is already extremely tight? Or are the broader fiscal problems of Illinois impacting investors’ perceptions of Chicago bonds? The state of Illinois is the worst-rated state in America with seemingly intractable fiscal and political problems.
I compared the yields of Illinois’ general obligation bonds (GO) with the yields for California GOs, which have a one-notch credit rating difference (almost identical credit risk). You can see that Illinois bonds are trading cheaply, where California trades close to the AAA benchmark.
A Chicago municipal bond trader, Adam Buchanan of B.C. Ziegler and Company, told me that muniland overall has under-performed the Treasury market and Chicago GOs have been affected. Buchanan believes that future borrowing costs for Chicago are going to be a concern. Robert Millikan, Executive Director at Sterling Capital who manages state-specific municipal bond fund portfolios, believes that there will be continuing temporary weakness for Chicago paper. And one unnamed dealer firm told me that they are buying as much Chicago paper as they can at these prices.
Are Chicago bonds priced appropriately for their risk? It’s really hard to say. Chicago will have to return to the market to borrow at some point and we will likely have an answer then.