Chicago’s tumble into junk-bond status is giving investors a chance to buy the Windy City’s safest debt on the cheap.
Yields on Chicago water bonds, which are repaid by customers’ bills, jumped to as much as 3 percentage points more than those on top-rated securities for debt maturing in 2042, the widest gap in at least two years, after Moody’s Investors Service cut the city’s rating last month. The spread on debt backed by sales taxes rose by almost a full percentage point.
Money managers at Wells Capital Management, which oversees about $39 billion of munis, and Belle Haven Investments say the market is overreacting to the fiscal strains that have left Chicago with a lower grade than any big city but Detroit. Both firms have been buying debt that’s paid from specific revenue collected by the third most-populous U.S. city.
“It’s just throwing out the baby with the bathwater,” said Brian Steeves, a portfolio manager in Rye Brook, New York, at Belle Haven Investments, which oversees more than $3 billion. “It’s purely headline risk.”
Pressure from Chicago’s $20 billion pension-fund shortfall led Moody’s to downgrade the city on May 12. It cut Chicago’s general-obligation and sales-tax debt to junk and knocked some water bonds to two steps above that threshold. Standard & Poor’s reduced Chicago’s ranking two days later to the fourth-lowest investment grade.
Water bondholders are guaranteed what’s left after maintenance and operating costs. In 2013, the system had $323 million available for debt payments, more than twice what was owed. It serves 5.3 million residents, including affluent suburbs. Chicago increased water prices by 15 percent in January, and rates will be raised to keep up with inflation beginning next year.
“Last time I checked, it didn’t matter who was running the city, the use of water stayed pretty constant,” said Lyle Fitterer, a managing director in Menomonee Falls, Wisconsin at Wells Capital, which bought water and sales-tax debt after last month’s downgrade.
Fitterer said the situation in Chicago echoes what happened in Detroit after it filed bankruptcy in July 2013. Prices on its water debt maturing in 2041 tumbled to as low as 77 cents on the dollar four months later. The debt wasn’t written down in court, and no payments were missed. The bonds traded for 105 cents on the dollar this month.
“You have an essential service, you have a dedicated revenue stream and obviously you survived a bankruptcy and bondholders were paid in full,” Fitterer said.
Unlike Detroit, Chicago isn’t permitted under state law to file for bankruptcy to restructure its debts.
Chicago’s revenue bonds, which aren’t as frequently traded as other securities, haven’t rebounded as much as its general obligations after the city was able to refinance debt. That move allowed it to avoid as much as $2.2 billion of payments and penalties triggered by the Moody’s downgrade.
The water bonds maturing in 2042 traded for a yield of as much as 5 percent on May 20, or 3 percentage points more than benchmark debt, after accounting for the city’s ability to repurchase the bonds early, according to data compiled by Bloomberg. That was the widest gap since the data begin in March 2013. It’s averaged 1.65 percentage points since then.
Chicago’s sales-tax debt has also been affected, even though S&P ranks it AAA. In a June 4 report, the company cited the city’s “deep and diverse economic base” and the “strong legal provisions” protecting bondholders.
Bonds maturing in 2041 yielded an average of 4.7 percent when they last traded on May 27, 2.9 percentage points more than benchmark securities. That’s up from an average spread this year of about 2 percentage points before the downgrade.
Steeves, the portfolio manager with Belle Haven, said the gap between Chicago debt and benchmark securities will probably narrow. His firm has been buying Chicago water, park and general-obligation bonds that are insured against default.
“You kind of have to act fast,” he said. “But there’s still value out there for sure.”