NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned an 'AA' rating to the following Chicago, IL (the city) revenue bonds:
--$108 million second-lien water revenue bonds, series 2016A-1 (tax-exempt) and 2016A-2 (taxable).
The bonds are expected to sell via negotiation the week of May 9. At the same time as the sale of the 2016A bonds, the city will reoffer the series 2000 and series 2004 bonds at fixed interest rates with proceeds to pay the purchase price of the bonds mandatorily tendered.
Proceeds of the 2016A taxable bonds will be used to refund certain lines of credit issued to fund swap termination payments related to the conversion of the city's outstanding series 2000 and series 2004 bonds, and pay issuance costs.
In addition, Fitch affirms the following ratings:
--$27 million senior-lien water revenue bonds at 'AA+';
--$2.2 billion second-lien water revenue bonds at 'AA'.
The Rating Outlook is Negative.
SECURITY
The 2016A bonds are secured by net water system revenues after the payment of operation and maintenance (O&M) expenses, transfers to the rate stabilization fund and senior lien debt service payments.
KEY RATING DRIVERS
STRONG FINANCIAL PERFORMANCE: The water system's strong financial performance over the past few years has resulted from a significant rise in rates since 2012 to meet increased capital funding goals. Debt service coverage (DSC) of all debt is strong at 2.6x (projected) for fiscal 2015.
FUTURE COST UNCERTAINTY: The Rating Outlook remains Negative, as higher pension contributions and anticipated new debt service combined with limited expected revenue growth may materially weaken financial metrics over the next few years. The city is formulating a plan to address rising pension costs; Fitch expects that the plan, when available, will provide greater clarity on the potential impact on the utility's operating performance.
INDEPENDENT RATE-SETTING, AFFORDABLE RATES: The city has full authority to raise rates, which remain affordable despite sizable recent increases.
STABLE OPERATIONS, AMPLE CAPACITY: The water system is a large regional provider serving roughly 5.3 million area residents either directly or through wholesale contract. High-quality water from Lake Michigan is sufficient to meet long-term customer demand and treatment capacity is ample.
LARGE CAPITAL PLAN: The capital improvement plan (CIP) anticipates funding roughly 40% of the $2.1 billion in proposed spending from internal sources.
IMPROVING DEBT PROFILE: The debt burden is expected to rise but remain manageable with metrics somewhat elevated but still well below the levels demonstrated by most comparably-rated urban systems. After issuance, the system's debt profile will no longer include any variable rate debt or associated counterparty and other risks.
STRONG, SIZABLE SERVICE AREA: The city serves as the economic engine for the region with a broad and diverse employment base and solid underlying economic fundamentals.
RATING SENSITIVITIES
FURTHER OPERATING PRESSURES: The ratings on Chicago's water revenue bonds will remain pressured by the city's long-term liability burden and its potential impact on the utility's financial margins. If that impact is significantly greater than currently anticipated, causing erosion in system key metrics, a rating downgrade would likely result.
CREDIT PROFILE
The city of Chicago's water system is a large retail and wholesale potable water supplier serving roughly 494,000 accounts within the city and 125 suburban communities for a total population of approximately 5.3 million. The customer base is diverse and stable.
With roughly 1,500 employees, the system is managed by the department of water management, which also oversees the day-to-day operations of the sewer system. However, the water and sewer systems are operated as separate enterprise funds of the city. Raw water is supplied by Lake Michigan through four water intakes and treated by two large water purification plants. Water supply and plant capacity are ample.
FINANCIAL METRICS CURRENTLY STRONG
In fiscal 2014, DSC on the senior-lien bonds totaled a robust 18.2x, while coverage of all debt service including second-lien revenue bonds and state loans was a healthy 2.6x. Prior to the rate plan, DSC for the senior-lien bonds in fiscal 2011 was robust at 12.5x while coverage of all debt service totaled just 1.5x.
In fiscal 2014, free cash flow from existing rates was a very healthy $238 million and over 4x annual depreciation. Similar financial results are projected for fiscal 2015. System liquidity has also improved to 261 days cash on hand in fiscal 2014 from 159 days in fiscal 2011.
NEGATIVE OUTLOOK TIED TO RISING COST PRESSURES
The system's financial profile, while currently strong following full implementation of a multi-year rate plan through fiscal 2015, is expected to come under additional pressure following the recent Illinois Supreme Court's ruling that struck down pension reform legislation for two of the city's four pension funds (municipal and labor). The legislation contained proposed benefit changes and a multi-year ramp-up of contributions that would have helped reduce the long-term liability and provide the city with a framework to meet the higher contributions over time.
Financial projections already indicated a decline in margins and DSC, primarily from rising pension-related costs and increases in debt service from new debt. Projections indicate total DSC will decline over the forecast period from 2.2x in fiscal 2016 to 1.9x and 1.8x in fiscals 2017 and 2018, respectively. While coverage at this lower level is still solid, Fitch anticipates further declines in DSC as operating costs escalate at a pace beyond the inflation-adjusted automatic rate hikes in those years.
Fitch believes the state Supreme Court's decision further burdens the city's municipal and laborers' pension systems, which may, in turn, result in increased pension contributions and/or general fund cost reimbursements over the intermediate and long-term. Should increasing cost pressures result in significant declines in projected financial margins and DSC beyond current expectations and/or cause a significant pullback in capital spending, which would run counter to the department's capital replacement goals, negative rating action could result.
On the other hand, a strategy that includes rate adjustments beyond the currently expected inflation-adjusted increases would be viewed as a credit positive and could lead to the stabilization of the ratings at their current levels and a return of the Outlook to Stable. The city expects to present a strategy to address the increased burden resulting from the ruling in the next several weeks.
TANGENTIAL RISK FROM CITY FINANCIAL PRESSURE REMAINS
The city's unlimited tax general obligation (ULTGO) rating of 'BBB-'/Negative Outlook reflects concerns over significantly underfunded pensions and rising long-term liabilities. Additionally, the rating recognizes the city's role as an economic hub for the Midwestern region of the United States with a highly educated workforce and improving employment trends. Aside from its pension funding issues, Chicago's general government financial profile has markedly improved in recent years, although full structural balance remains a challenge. The city's independent legal authority to raise revenues remains a key credit strength.
Fitch expects the potential spillover of general government financial pressures to the city's utility funds to be limited to the aforementioned increasing pension payments and rising indirect costs. Should additional material spillover occur, it could result in negative rating action. Fitch believes severe liquidity stress within the non-enterprise funds (including the general fund) would likely pose the greatest threat to the utility. Consequently, diversion of utility monies for non-utility purposes (e.g. transfers out, borrowable resources); a shifting of non-utility costs to the system (e.g. increased headcount); and/or other potential indicators of possible stress that might lead the city to divert system resources would be considered a significant departure from prudent system management and counter to Fitch's current expectations and rating approach.
LARGE CAPITAL PLAN
The system is in year five of a comprehensive 10-year capital improvement plan. Over the next five years, the city anticipates spending a sizable $2.2 billion on various water capital renewal projects including replacing 450 miles of water mains and adding/updating 100,000 water meters. The multi-year rate plan approved in 2012 was designed to provide adequate funding for the capital spending program, which will consist of additional debt but also increases the amount of pay-as-you-go resources.
The city expects to issue approximately $1.6 billion in additional debt (through a combination of revenue bonds and state loans) through 2020. This more balanced approach to capital funding is considered to be a positive credit factor, as previous CIP's were almost exclusively debt-financed.
IMPROVED DEBT PROFILE, BURDEN MANAGEABLE DESPITE NEW DEBT
The city has been more aggressive in funding system capital needs. Since fiscal 2010, the city has spent roughly $250 million annually on infrastructure improvements leading to greater system reliability, but has also increased system leverage. As of fiscal 2015, the system had $2.2 billion in total debt outstanding consisting mainly of second-lien bonds.
The system's debt profile will improve after this issuance. The 2016A bonds will fund swap termination payments while the re-offering of the 2000 and 2004 bonds will eliminate the system's exposure to counterparty and other risks associated with variable rate debt, which Fitch views as positive for the rating.
Debt metrics are somewhat mixed. In fiscal 2014, debt totaled an affordable $497 per capita and carrying costs comprised just 22% of gross revenues. However, debt-to-net-plant was an elevated 75% in fiscal 2014 and principal amortization is somewhat slow with 33% retired over the next 10 years. The debt burden is expected to rise as the city continues to fund its CIP. Fitch does not anticipate the additional debt will greatly change the system's overall debt profile, but may pressure financial performance. Debt is projected to rise to a still affordable $681 per capita.
BROAD AND DIVERSE SERVICE AREA ECONOMY
The city's economy is exceptionally broad and diverse, with significant business and financial service sectors and a well-educated work force. The unemployment rate for the entire Chicago metropolitan area was 6.7% in January 2016 compared to 8.7% two years prior.
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
Revenue-Supported Rating Criteria (pub. 16 Jun 2014)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012
U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 03 Sep 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869223
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1003350
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1003350
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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