By Mike Cherney And Aaron Kuriloff
A big pension shortfall is buffeting the Windy City. Fearing
that the multibillion-dollar gap might undermine Chicago's
finances, some bond investors and credit-ratings firms are becoming
wary.
Four pension funds in the nation's third-largest city are facing
a combined funding gap of about $20 billion after years of
underfunding and market losses during the recession. In comparison,
Chicago has a $3.5 billion annual budget for general operating
expenses.
Moody's Investors Service cut the city's credit rating in
February to Baa2, two notches above junk status, and maintained a
negative outlook. The firm warned that the city's "highly elevated"
unfunded pension liabilities could increase, "placing significant
strain on the city's financial operations." Other ratings firms
give the city higher grades.
The concerns come as an April 7 mayoral runoff election
approaches, pitting Mayor Rahm Emanuel against Jesus "Chuy" Garcia,
a county commissioner. The city's finances have featured
prominently in the election campaign.
To make matters worse, there is a real possibility that Chicago
may have to pay higher interest rates to issue new bonds.
Three bond insurers, Assured Guaranty Ltd., National Public
Finance Guarantee Corp. and Build America Mutual, already have
backed billions of dollars combined of Chicago bonds and are at or
near their limits for how much Chicago debt tied to property taxes
they are willing to insure, said people familiar with the matter.
An insurer agrees to make payments if the municipality defaults, so
no insurance means Chicago would have to offer higher interest
rates on any new bonds to compensate investors for the added
risk.
The situation is an example of how municipalities across the
country still are struggling to fill gaps in their pensions, which
sustained losses on investments during the financial crisis. The
troubles are prompting investors to avoid debt from municipalities
with large pension-funding gaps, like New Jersey, fearing officials
would have to choose between promises made to bondholders and
employees.
In a statement, the mayor's office said Mr. Emanuel has "worked
to right the city's financial ship." The statement also said the
mayor has been clear that "Chicago's pension obligations were the
biggest threat to the city's financial security."
Burton Mulford, a portfolio manager at Eagle Asset Management
Inc. in St. Petersburg, Fla., said his firm has been staying away
from Chicago bonds and is waiting until the pensions are in better
shape.
"There's going to be a lot more pain before there's
improvement," said Mr. Mulford, whose firm oversees $2.2 billion in
municipal bonds.
Some Chicago bonds have largely missed out on a bond-market
rally due to the concerns. The price of a 30-year Chicago bond sold
in March 2014 has risen 2.7% over the past year, compared with a
22% jump in the price of a similar-maturity U.S. Treasury bond. The
yield on the Chicago bond decreased from 6.3% at the time of sale
to 6.1% when it last traded in mid-March, while the 30-year
Treasury bond decreased from 3.6% to 2.5% over the same period.
Yields fall when prices rise.
The pension gap in Chicago has some analysts warning the city
could in a decade or more face the same fate as Detroit, which also
had pension shortfalls before it filed for bankruptcy protection in
2013. Although Chicago's economy is more robust, some investors
said Chicago needs to address its pension situation.
"Chicago is Detroit 10 to 15 years from now, if they do not deal
seriously with this pension problem," said Tom Metzold, senior
municipal portfolio adviser at Eaton Vance Management, with $28.3
billion of assets under management. Mr. Metzold said his firm has
"virtually no holdings" in Chicago debt.
Mr. Emanuel has supported overhauling the city's pensions, which
are governed by state law. Last year, state lawmakers agreed to
reduce benefits for city workers and retirees in two of the plans.
The overhaul, however, has been challenged in court.
Another problem for the city: The ratings cut by Moody's
triggered potential fees of about $38 million on interest-rate
swaps tied to Chicago bonds. The swaps were designed to protect the
city from increases in interest rates, but rates fell instead. The
city has said it is in discussions with Wells Fargo & Co.,
which is a party to the swaps, regarding the fees. Wells Fargo
declined to comment.
Financial problems aren't limited to the city itself. The
Chicago Board of Education, which is separate from the city but
whose board members are appointed by the mayor, is facing $228
million in potential swap fees after a series of credit downgrades.
The school district said it is working to renegotiate the swap
terms.
Not everyone sees Chicago's situation as dire. Fitch Ratings
gives Chicago a single-A-minus rating, two notches above Moody's,
and Standard & Poor's Ratings Services rates the city at
single-A-plus, four notches above Moody's. And some traders sense
an opportunity in Chicago bonds.
Dominick Mondi, president of global markets at Mesirow
Financial, a Chicago-based financial firm, said yields on Chicago
bonds are reasonable compared with other bonds, like debt from
hospitals, that carry ratings similar to Chicago's Baa2 mark from
Moody's. "There is a vibrant, alive downtown," said Mr. Mondi,
highlighting one of the city's economic strengths.
Some investors said there will be appetite for Chicago debt,
even without insurance guarantees, if yields are high enough.
"Chicago's economy is doing fairly well," said John Miller,
co-head of fixed income at Chicago-based Nuveen Asset Management
LLC, which oversees about $100 billion in municipal debt, including
some Chicago bonds. "Education and health-care institutions are
really strong."
Mark Peters contributed to this article.
Write to Mike Cherney at mike.cherney@wsj.com and Aaron Kuriloff
at aaron.kuriloff@wsj.com
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