Fitch Affirms Chicago, Illinois 2nd Lien Sewer Revs at 'AA'; Outlook Remains Positive

AUSTIN, Texas--()--Fitch Ratings affirms the following city of Chicago, Illinois (the city) ratings:

--$1.3 billion in outstanding second lien bonds at 'AA'.

The Rating Outlook is Positive.

SECURITY

The second lien bonds are secured by net revenues of the city's sewer system (the system) after the payment of operations and maintenance expenses and senior lien bonds.

KEY RATING DRIVERS

POSITIVE OUTLOOK MAINTAINED ON RATE PACKAGE: The scope of the 2012-2015 rate package, with cumulative increases of 120% from 2011 levels, remains a significant credit positive. Audited financial results have improved and are expected to post additional gains over subsequent audit cycles.

CITY PENSION STRUGGLES: Current system cost expectations related to a legislatively-approved pension funding plan for two of the four city pension plans appears manageable. However, further clarification of possible system credit impacts related to the city's pension issues are necessary to resolve the Positive Outlook.

MATERIAL EQUITY FUNDING FOR CAPITAL: The adopted rate package should provide significant surplus revenues for planned capital improvements, although recent acceleration of projects has led to increased borrowing expectations.

RATES REMAIN AFFORDABLE: Even with the magnitude of the approved rate package, user charges should remain competitive relative to other large utilities and below Fitch's affordability threshold.

LIMITED OPERATING RISK: The system's limited role in collecting and conveying wastewater flows to the regional treatment provider minimizes operating risk to a large degree.

SIZABLE SERVICE AREA: The system serves a broad and diverse service territory with sound economic underpinnings.

RATING SENSITIVITIES

IMPROVED FINANCIAL RESULTS: A demonstrated improvement in financial performance commensurate with forecasted expectations could lead to a rating upgrade.

CITY SPILLOVER EFFECTS: Direct or indirect weakening of the system's credit fundamentals arising from city's pension and/or related budgetary pressures could have negative ramifications on the system's credit.

CONTINUED DEBT ESCALATION: Continued growth in planned system borrowings could offset positive considerations relating to the financial profile.

CREDIT PROFILE

APPROVED RATE PACKAGE A CREDIT POSITIVE

In an effort to enhance the system's operating performance and provide additional financial capacity to address aging infrastructure, the mayor and city council passed a multi-year rate package for 2012-2015, with cumulative rate hikes of 120% from 2011 levels. The 2012-2014 rate hikes have been implemented to date, with the final 20% adjustment scheduled to take effect Jan. 1, 2015. In addition, annual inflationary adjustments beginning in 2016 have been approved that require no additional action by the city council before being implemented. Despite the magnitude of the rate package, user charges are expected to remain moderately below Fitch's affordability benchmark.

SIGNIFICANT IMPROVEMENT IN FINANCIALS EXPECTED

As a result of the adopted rates, total debt service coverage (DSC) for 2012 rose to 1.6x net of transfers to the rate stabilization account from just 1.1x the year prior. Financial forecasts provided by the city point to total DSC at or above 1.9x through at least 2018 excluding proposed pension costs discussed below.

Key liquidity and cash flow metrics also have experienced significant positive performance which is expected to continue or improve further over the several years. For audited 2012, days cash rose to a solid 207 days with the first year of rate hikes from just 150 days in 2011. Cash flows improved even more, with free cash relative to depreciation accelerating to a very high 186% in the 2012 from a poor 40% in 2011. Continued demonstration of strong results that enhance the system's financial profile further could lead to a rating upgrade.

CITY PENSION ISSUES

Over the course of the last year the city's unlimited tax general obligation (GO) rating has dropped markedly to 'A-' Negative Outlook as a result of significant underfunding of pensions that has the potential to put tremendous fiscal strain on the city's general fund in the near future. Legislation recently passed at the state level, which is awaiting the governor's signature, would begin to address the underfunding of two of the four city pension funds (municipal and laborers). The vast majority of system's employees and retirees are covered by these two funds.

The plan approved by the state would, among other things, lead to a significant increase in the amount of pension contributions from the system beginning in 2015 in order for the city to reach the annual required contribution rate on these funds by 2021. The increased system contribution would be solely for pension costs allocable to the system's employees and retirees and would not be used for non-system pension obligations.

Currently, it is estimated that system pension costs would increase around 140%-150% to roughly $12 million. While the increased expense is material (system pension costs are estimated to rise from 4% of operating expenses to approximately 10%) the jump appears manageable given the system's recently improved financial results. Illustrating the system's capacity, total DSC would have been a little over 1.5x or less than 0.1x difference from actual results had the additional costs been incorporated into the 2012 financials. Despite the apparent ability of the system to absorb proportional costs identified under the proposed plan, Fitch believes greater clarity surrounding the resolution of the city's pension underfunding and related budget pressures are necessary in order to resolve the system's Positive Outlook as credit issues could arise over the near term that offset the system's favorable financial expectation.

LARGE CAPITAL NEEDS BUT SOLID PAY-GO

The system's 2014-2018 capital improvement program (CIP) is sizeable at $1.6 billion and has risen nearly 30% from last year as the city has accelerated system renewal and replacement plans. Debt levels currently are average and will rise to above average for the rating level as a result of the CIP, but the scope of the adopted rate package is anticipated to yield surplus revenues sufficient to allow a solid portion of pay-go funding (over 30% of all sources) over the CIP period.

The balanced mix in capital funding is a marked departure from recent CIPs which relied virtually entirely on borrowable resources. With the planned use of pay-go funding, debt levels are expected to improve over time as the system is able to address deferred maintenance and then scale back on capital spending closer to depreciation levels; capital spending relative to depreciation was an exceptionally high 539% in 2012 and this will rise based on planned CIP spending. While not an immediate concern, continued sizeable borrowing plans could erode financial gains expected from the 2012-2015 rate package and become a credit issue in the future.

BROAD SERVICE AREA AND LIMITED OPERATING RISK

The system provides collection and conveyance of sewer and stormwater flows to a population of 2.9 million city residents. All wastewater treatment is provided by the Metropolitan Water Reclamation District of Greater Chicago (Metropolitan, GO bonds rated 'AAA' by Fitch) thereby limited operating risk of the system. The region was hard hit by the recession and recovery has been sluggish.

Additional information is available at 'www.fitchratings.com'

In addition to the sources of information identified in Fitch's Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria', June 2013;

--'U.S. Water and Sewer Revenue Bond Rating Criteria', July 2013;

--'2014 Water and Sewer Medians', dated December 2013;

--'2014 Outlook: Water and Sewer Sector', dated December 2013.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=709499

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715275

2014 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724358

2014 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=827347

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Contacts

Fitch Ratings
Primary Analyst
Doug Scott, +1 512-215-3725
Managing Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Adrienne Booker, +1 312-368-5471
Senior Director
or
Committee Chairperson
Amy Laskey, +1 212-908-0568
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Sharing

Contacts

Fitch Ratings
Primary Analyst
Doug Scott, +1 512-215-3725
Managing Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Adrienne Booker, +1 312-368-5471
Senior Director
or
Committee Chairperson
Amy Laskey, +1 212-908-0568
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com