NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the following Chicago, IL ratings:
--Long-Term Issuer Default Rating (IDR) at 'BBB-';
--$9.2 billion outstanding unlimited tax general obligation bonds (ULTGOs) at 'BBB-';
--$536.7 million (accreted value) outstanding sales tax bonds at 'BBB-'.
The Rating Outlook has been revised to Stable from Negative.
Fitch also maintains the Negative Watch on the city's 'BBB' rated $181.3 million motor fuel tax revenue bonds, which is linked to the Rating Watch on the state of Illinois' IDR.
SECURITY
The ULTGO bonds are payable from the city's full faith and credit and its ad valorem tax, without limitation as to rate or amount.
The sales tax bonds have a first lien on the city's 1.25% home rule sales and use tax and the city's local share of state-distributed 6.25% sales and use tax. Additionally, there is a springing debt service reserve funded over a 12-month period that would be triggered if coverage fell below 2.5x.
The motor fuel tax bonds have a first lien on all motor fuel taxes distributed to the city by the state, subject to annual appropriation by the state legislature. Additionally, various project-related revenues are pledged.
KEY RATING DRIVERS
The Outlook revision to Stable from Negative reflects the recently enacted material increase in funding to the city's pensions. The chronic underfunding of pensions over many years has resulted in a high and growing long-term liability burden and constrained expenditure cutting flexibility. Aside from its pension funding issues, Chicago's financial profile has markedly improved in recent years, although full structural balance remains a challenge, and the city's financial cushion provides solid capacity to address cyclical downturns. The 'BBB-' rating recognizes the city's role as an economic hub for the Midwestern region of the United States, supporting solid revenue growth prospects, as well as the city's unlimited independent legal authority to raise revenues, a key credit strength.
Economic Resource Base
Chicago serves as the economic and cultural center for the Midwestern region of the United States. The city's population totaled 2.7 million in 2014, down 6% from the 2000 census, but still accounts for 21% of the state's population. Socioeconomic indicators are mixed with elevated individual poverty rates, average per capita income levels, but strong educational attainment levels.
Revenue Framework: 'aa' factor assessment
Fitch expects slow, steady economic recovery to lead to continued solid revenue growth, excluding the effect of new or raised taxes and fees. The city's home rule status affords it access to a wide variety of revenue-raising options, many of which are legally unlimited.
Expenditure Framework: 'bb' factor assessment
Carrying costs for debt service and retiree benefits claim a substantial portion of operating resources. Public safety, which is fairly inflexible as a practical matter, comprises a majority of general fund spending, further constraining expenditure flexibility. Rising pension costs will continue to drive expenditures to grow at a much faster natural pace than revenues, likely necessitating ongoing revenue-raising measures and careful expenditure control.
Long-Term Liability Burden: 'bbb' factor assessment
The long-term liability burden is high relative to the resource base at 42% of personal income.
Operating Performance: 'a' factor assessment
The city's ability to close recessionary revenue gaps is strong. This is a function of the city's strong revenue raising flexibility and long-term reserves available to offset the expected level of revenue volatility in a downturn.
RATING SENSITIVITIES
Improved Pension Prospects: A demonstrated improvement in pension plan prospects as evidenced by a trend of rising asset-to-liability ratios as well as a reduction in the overall long-term liability burden could result in an upgrade. Failure to achieve such improvement in the medium-term could put negative pressure on the rating.
Structural Balance: The Stable Outlook incorporates Fitch's expectation that the city will continue to make progress toward structural balance according to its announced plan and maintain reserves commensurate with the rating throughout the economic cycle. Achievement of recurring structural balance, including actuarially based pension funding, would improve prospects for the rating.
Sales Tax Rating Cap: The city's IDR serves as a ceiling to the sales tax rating. A change in the IDR would result in a change to the sales tax rating.
Motor Fuel Tax Rating Cap: The rating on the fuel tax bonds is limited by the state of Illinois' credit quality. The rating is capped at the state's appropriation rating, currently 'BBB'/Rating Watch Negative.
CREDIT PROFILE
Chicago acts as the economic engine for the Midwestern region of the United States. The city's residents are afforded abundant employment opportunities within this deep and diverse regional economy. The city also benefits from an extensive infrastructure network, including a vast rail system, which supports continued growth. The employment base is represented by all major sectors with concentrations in the wholesale trade, professional and business services and financial sectors. Socioeconomic indicators are mixed as is typical for an urbanized area, with above-average per capita income and educational levels but also elevated individual poverty rates.
Revenue Framework
Operating revenues are diverse, with the largest source, state and local sales tax, comprising 19% of general fund revenues. Other large sources include the utility tax, transaction tax, fines, and income tax which account for 13%, 11%, 11% and 10% respectively. Notably, property taxes do not fund general fund operations, but are directed to other funds in support of debt service, pensions and a small amount of library contributions.
Growth prospects for revenue are solid. Fitch believes that natural revenue growth, without taking into account planned rate increases, will continue to perform in a manner that exceeds the rate of inflation, but falls short of national GDP. After a long period without major revenue-raising policy action, the city has raised or announced plans to raise a variety of taxes and fees to provide funding for dramatically increased pension funding.
The city is a home-rule unit of government, and as such, enjoys the ability to raise or impose a wide variety of taxes and fees, many of which are legally unlimited.
Expenditure Framework
The city devotes 60% of the general fund budget to public safety and 31% for general government.
Fitch expects the natural pace of spending growth to be well above that of revenues, requiring careful budget management. The fastest growing expenditure item is pension contributions as the city ramps up from statutory to actuarially-based contributions over the next several years. The city has identified revenue sources for much of these in the near-term, and intends to continue raising revenues to offset these rising costs in the out years.
Expenditure flexibility is constrained, given the large proportion of the budget devoted to public safety, which may be difficult to cut as a practical matter, and very high fixed carrying costs. The carrying costs for debt service, actuarially-required pension contributions and other post-employment benefit (OPEB) actual payments, account for a full 45% of governmental spending. That percentage may decline somewhat in the near term, as overall spending rises due to ramped up pension payments that are closer to the actuarially determined contribution, but will still comprise an outsized proportion of the budget.
Long-Term Liability Burden
The long-term liability burden for net pension liability and overall debt is high, at 42% of personal income. Sixty percent of the liability relates to net pension liability, which Fitch anticipates will rise in the near term before ramped up payments reverse the negative trend and the net pension liability stabilizes or declines. Under GASB 68 reporting, the fiscal 2015 combined net pension liability for all four plans was $33.8 billion with assets covering a scant 23% of liabilities, raising the real risk of plan depletion.
The city maintains four single-employer defined benefit pension plans, all of which have weak asset-to-liability ratios, due to an historical statutory funding formula that fell well short of actuarial requirements. In fiscal 2014 the combined actual pension contribution amounted to just a quarter of the actuarially required amount. That percentage improved in fiscal 2015, to 52%; while this is still well short of the mark, it represents the beginning of a multi-year step up to higher, more actuarially sustainable pension contributions.
A new state law, effective fiscal 2016, requires increased funding for two of the city's plans: police and fire. The law requires a contribution that would be sufficient to bring both systems to a 90% funding level by 2055. It allows a five-year ramp up period to the 90% actuarially based funding level which will be reached by 2020. The city council passed a multi-year property tax increase to accommodate the steep increase in payments ($330 million in fiscal 2016) for the public safety plans.
Following an adverse state supreme court decision which overturned the city's pension reform legislation for its Municipal and Laborers' plans, management negotiated in principal new pension solvency plans with labor that are designed to be compliant with Illinois' strict constitutional pension protections. The new plans identify sources for increased funding without diminishing existing benefits. The Laborers' plan will rely on a 911 cell phone fee for its increased payments in the near term, while the Municipal Employees' plan calls for a tax on water and sewer charges to fund its payment increases. The 911 fee is already in place, while the new tax on water and sewer charges is subject to city council approval.
Operating Performance
Reserve levels -- including those stemming from prior asset sales/leases -- have stabilized over the last several years, standing at 23.7% of spending in fiscal 2015. The city relies on a variety of revenue sources to fund operations, some of which are economically sensitive. During a normal economic downturn, Fitch's FAST model estimates the city's revenues are at risk of a slightly elevated rate of decline, leaving the city with a fairly substantial shortfall to address. Fitch believes this would present a challenge to the city's financial operations in a downturn, but expects that financial flexibility would be recovered as conditions improve. Recent extensive revenue-raising measures that have been enacted or announced make it unlikely the city would rely solely on its revenue-raising authority to close such a recessionary revenue gap. Similarly, the constrained expenditure flexibility makes it unlikely that the city could make meaningful spending cuts to address the gap. As such, Fitch believes that while the city may take some revenue- or expenditure-side policy action to address a recessionary revenue decline, reserve levels would bear the brunt of the shortfall, but would remain at levels consistent with the 'a' operating performance assessment throughout the economic cycle.
Chicago's budget management at times of economic recovery has improved markedly in recent years; although, full structural balance remains a challenge even well into the economic recovery. Management has made significant progress toward matching ongoing revenues with annual expenditures. Fitch considers sustainable, affordable, actuarially-based pension funding, like those that have been recently enacted or announced, a critical component of structural balance. Successful execution of the city's plan toward financially sustainable practices would be considered a positive rating factor. Remaining plan elements include the elimination of scoop-and-toss refundings by 2019, elimination of the use of current funds to pay routine legal settlements or judgments, and growth of the 'rainy day fund.'
The city ended the practice of appropriating reserves beginning with fiscal 2015. The fiscal 2015 general fund budget was balanced with a reduced but still significant amount of one-time measures, including scoop-and-toss refunding. The year ended with a $74.6 million net general fund operating surplus (2.2%), largely attributable to underspending of budgeted expenditures.
The $3.6 billion fiscal 2016 general fund budget closed the previously identified budget gap of $232.6 million through a variety of recurring and one-time measures and no appropriation of general fund balance. Fitch believes the budget target is achievable given the city's recent history of budgetary adherence.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
Applicable Criteria
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
https://www.fitchratings.com/site/re/879478
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