The Chicago penalty

The Chicago penalty

Chicago paid a premium on its recent bond offerings. Why? Default risk.

The Chicago Board of Education paid the price to get the deal done on its April 21 bond offerings. The Bond Buyer reports:

“The top yield of 5.63% on a 25-year maturity landed 285 basis points over the Municipal Market Data’s triple-A benchmark.

“While the board’s rating remains in investment grade territory, its yields aren’t.

“Tuesday’s MMD scale Tuesday put a mid-level, triple-B rated credit at a 3.78% yield on a 2039 maturity, underscoing just how severe a penalty the district paid. The Chicago Board of Education is rated between the BBB-minus level and A-minus.

“Secondary trades on the board’s $6 billion of debt jumped 140 basis points in recent weeks with 10-year paper trading around 250 basis points over MMD and 15 year paper trading at 300 basis points over.

“The two tranches offered a C series for $275 million and an E series of $20 million in green bonds. Both carried a general obligation pledge plus an alternate revenue pledge of state aid.”

The penalty

Not only did Chicago have to pay a 285 basis point penalty over top-rated bonds, it paid 185 basis points over similarly rated bonds even though the bonds contained an alternate pledge of state aid, and even though Illinois law does not yet allow bankruptcy.

Why? Default risk.

Gov. Bruce Rauner has pledged not to bail out Chicago on the backs of Illinois taxpayers. Illinoisans should commend Rauner for that stance.

Few institutional buyers

Here’s a pair of telling comments from the article about who may be taking the risk:

“‘The 2035 is a discount structure, that typically signifies to me that you got some alternative buyers looking for some pop on the run, so they will try to trade on the headline news,’ said a Midwestern trader. ‘The structuring had a fairly deep discount. Only $10 million in the 2035, a little telling on the premium structure, which tells me you only have a few institutional buyers.’”

“‘The question that is on everyone’s mind is did the Kroll rating do anything? Overall, it has wide spreads but you can really tell by the dollar amount who the buyers are,’ the Midwestern trader said.”

Is this similar to the institutional shun-and-dump of General Motors Co. bonds ahead of its bankruptcy?

Recall that high-yield GM bonds were dumped on unsophisticated mom-and-pop investors ahead of that debacle.

No miracles coming

How is a state that is billions of dollars in the hole going to bail out a single school district – Chicago Public Schools – that is $1.1 billion in the hole?

The obvious answer is that it won’t and can’t. There are no miracles to be had. The Chicago Public Schools system is bankrupt. All it will take to trigger bankruptcy is for the Illinois General Assembly to allow just that.

That said, the law does mandate that parties in a chapter 9 bankruptcy dispute attempt to negotiate a settlement.

Realistically speaking, however, history shows unions will not concede benefits, even though court decisions prove otherwise.

Detroit made a huge mistake attempting to forestall the inevitable. Rauner needs to give an out-of-court settlement a chance, but for the sake of Chicago and Illinois, that chance should be of limited duration.

Bankruptcy the only sensible option

Since downstate voters will not want to bail out Chicago, we may easily be approaching the point the Illinois legislature realizes it has no choice other than to allow municipalities the option of declaring bankruptcy.

This won’t come easily for the legislature, but it’s the right thing to do. Upstate vs. downstate politics may be enough to tip the tide.

Image credit: Giant Ginkgo

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