June 19 (Bloomberg) -- Detroit’s brush with insolvency may elevate borrowing costs for the city’s independently run Water and Sewerage Department when it sells $600 million of bonds, the agency’s biggest offering in nine years.
The sale, which may be as soon as tomorrow, was delayed as a legal fight surrounding Michigan’s oversight of Detroit’s finances threatened last week to push the city toward a default on other bonds. Moody’s Investors Service on June 14 cut the department’s debt to two ranks above junk status.
The fallout shows how the struggles of cash-strapped municipalities such as Detroit, Alabama’s Jefferson County and Harrisburg, Pennsylvania, can reach beyond their borders. About three-quarters of the sewer department’s customers live outside Detroit, and the agency’s finances are kept separate from a city so strapped for cash that it’s getting rid of nearly half its streetlights.
“Because of the city’s potential bankruptcy and the fact that it’s a department of the city, that’s always in the back of your mind and gives you pause,” said Richard Larkin, director of credit analysis for Herbert J. Sims & Co. in Iselin, New Jersey. “You may want to get a little extra yield to calm your nerves.”
Detroit is reeling from a decades-long decline that since 2000 has depressed its population by 25 percent. In April, it narrowly averted state takeover because of its budget deficit and $12 billion long-term debt. The city is now under watch of a nine-member advisory board as part of an agreement with the state to prevent it from seeking bankruptcy.
The sewage system, overseen by a board appointed by Detroit’s mayor and officials from suburban counties, serves 2.8 million people, about 30 percent of Michigan’s population, which buffers it from the city’s shrinkage. Still, when Michigan took oversight of the city, the utility also was affected.
The move allowed banks, including UBS AG and JPMorgan Chase & Co., to break off interest-rate swaps, a type of derivative contract. The agency will use about $300 million from the bond sale to pay off the swaps.
Matthew Schenk, the water department’s chief operating officer, said the agency’s funds have always been kept distinct from the city and it has never risked default. The department can raise rates on suburban customers without needing the approval of the Detroit City Council, bond documents say.
“Investors are going to see through the headline risk and recognize that there’s inherent value to this transaction,” Schenk said. The sale is its biggest since 2003, according to data compiled by Bloomberg.
Last week, after Detroit’s brush with insolvency, Moody’s Investors Service and Fitch Ratings lowered the city’s rating deeper into noninvestment grade status. Moody’s also lowered water and sewer debt, saying it’s reviewing how bonds would be affected if the city goes bankrupt.
A Detroit Water and Sewerage Department bond maturing in 2031, backed by customer bills and with the same rating as the debt being sold this week, traded for an average yield of 5.19 percent between dealers on June 15. That was up from 4.44 percent when it was last traded in February. The debt is rated Baa2, Moody’s second-lowest investment grade, the same as the new issue.
The yield on top-rated securities with a similar maturity declined about 0.05 percentage point over the same period to 2.82 percent, Bloomberg data show. The interest rate on BBB bonds dropped 0.06 percentage point to 4.54 percent, the data show.
Detroit’s debt “is going to trade at a discount relative to other water and sewer bonds in the market just because it has Detroit in the headline,” said Michael Camarella, senior portfolio manager at OppenheimerFunds Inc., which oversees about $33 billion in municipal bonds.
The deal may draw demand from buyers seeking higher returns as yields hold near four-decade lows, said Bart Mosley, the co-president of Trident Municipal Research in New York, a bond analysis firm.
“People are frustrated with earning less than 2 percent on their money, and so every extra basis point of spread looms that much larger,” he said.
Revenue bonds aren’t always immune from municipalities’ fiscal struggles. Jefferson County filed for bankruptcy protection last year in part to escape from debt secured by sewer bills, which politicians said couldn’t be raised to cover the debt without punishing the poor. This month, Scranton, Pennsylvania, reneged on a pledge to back revenue debt sold by its parking authority, causing it to default before officials reversed their decision.
The Detroit department’s offering documents for investors say that the bonds should retain their claim on sewer funds in any bankruptcy. Still, it said no Michigan city has ever sought that protection, so the legal issue is not “free from doubt.”
Following are pending sales:
GEORGIA plans to sell about $742 million in general-obligation bonds via competitive sale as soon as June 21, according to an offering document. The proceeds will be used to fund capital projects and refund previously issued debt. Moody’s Investors Service rates the state Aaa, its top grade. (Added June 19)
WASHINGTON HEALTH CARE FACILITIES AUTHORITY plans to issue $525 million in revenue bonds as soon as this week, according to an offering statement. Moody’s rates the debt Aa2, third-highest. Bank of America Merrill Lynch is the underwriter. (Added June 19)
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