Fear mongering and headline risk in the municipal market are a very real issue; there are certain municipal issuer names that frequent the headlines and create fear amongst retail and institutional investors on the regular. However, despite those issuers facing very real challenges, investors should not necessarily have to turn and run from every edgy headline—they may even find buying opportunities in the market place—as Tom Hendrickson recently wrote, bearish can sometimes mean bullish. By following and understanding fundamental credit analysis and taking a holistic view, a headline villain may turn out to be the next underdog story.
The City of Chicago, the proverbial whipping post of the municipal market, was dealt serious market confidence blows over the past two months. Recent challenges have involved the inability to solve structural budget issues and the May 8th, Illinois Supreme Court decision that threw plans for pension reform into disarray. As such, on May 12th, Moody’s Investor Service lowered their general obligation rating on the City’s $8.1 billion worth of GO debt from Baa2 to Ba1. This moved the City to the junk level, a category that finds the City of Detroit as one of its peers. Two days later, Standard & Poor’s lowered their rating on the City’s GO debt from A+ to A-, still in the “investment grade” category of ratings. There is no doubt that rising costs of servicing rising pension costs is a challenge to the City in the near and far term. However, the question remains whether the “junk” label unfairly penalizes a City struggling to right its fiscal ship.
The City is not without its challenges. After peaking above 10.8% in mid-2012, the unemployment figures for Chicago have been cut almost in half. As of April 2015, unemployment within the City measured 6.5%, slightly higher than 6% for the State of Illinois and 5.5% for the US median. In fact, Mayor Rahm Emanuel frequently cited unemployment figures as his biggest challenge in the recent runoff elections. Yet, when examined in context of its peer group, the unemployment picture doesn’t look that terrible. The City and surrounding metro area ranks 45th out of the top 50 largest metro areas in terms of unemployment. It falls two notches below the New York metro area and is five notches ahead of Los Angeles, which carries a credit rating of Aa2, firmly in the investment grade category.
In evaluating whether Chicago is “junk” or not, it is important to note the role the City plays as a key economic driver to the regional economy. In fact, tourism within the City, which includes business and convention travel, grew over 4% from 2012 to 2013 and was in line for more positive growth for fiscal 2014. The economy is diverse and knowledge-based unlike the manufacturing-heavy areas surrounding Detroit. Chicago is close in composition to a City such as Philadelphia in the concentration of healthcare and higher education entities. While the wealth metrics on a per capita and median family basis are below the US averages, the metrics, like the City of Philadelphia (which is rated A2), are better at 84% versus 72%. In fact, Philadelphia is better rated and has the highest poverty level of any large US city at over 26%.
Chicago needs to figure out a way to overcome the large step-ups in pension payments over the next 24 months. The increases in pension payments are going to cause budgetary headaches that may have deep reaching ramifications that are not quite clear yet. However, it is a mistake to think that management is not keenly aware of what is at stake. City management made a large step in the right direction by converting all of its variable rate GO debt to fixed rate and spending almost $200m to terminate derivative contracts. What they did was take any uncertainty of debt service payments out of the equation so they could focus on the task at hand, which is budgetary stability. The City is further strengthened by its status as an Illinois home rule of government. Unlike other municipalities where increases in taxes need ballot approval, the Mayor and City Council of Chicago are allowed to raise property and sales tax rates without voter or state approval.
The Bottom Line
The key to mitigating headline risk is to understand the subject at hand and not just focus on one issue, i.e. pensions. While Chicago is a city that is still struggling with recovery post-recession, whether it deserves the “junk” label will be determined by time and investor sentiment. As seen above, the case can certainly be made that the end is not clearly in sight in the windy City, especially when viewed in comparison to some of its peers across the US such as Los Angeles, New York and Philadelphia. Nothing in muniland ever happens overnight and trends are fairly easy to identify. What is even more important is to understand the fundamental qualities of the issuer and make a determination if value is there from a quantitative and qualitative basis.