August 4, 2013
Chicago is receiving the type of notoriety no city would want. And its reputation is undermining investments individuals have made in the city's municipal bonds.
Chicago has become a national poster child for financial distress in the aftermath of the Detroit bankruptcy, as bond analysts have been warning investors about cities and states that could be financially risky in the future.
"Between Chicago's appalling murder rate, blubbery unfunded pensions and ratings downgrades, don't touch this credit with a 10 foot pole," Marilyn Cohen, chief executive of Envision Capital, wrote in a report to clients this week.
The Los Angeles-based bond manager warned individuals not to be lured by the extra yield they can earn by taking chances on risky cities and states.
"Illinois, Chicago and Puerto Rico are on the bottom of the barrel," she said. "The Chicago murder rate is a symptom of the city unable to grapple with its problems or its pension debacle. The unions have a stranglehold on the city and state and no one has been willing to raise revenue or do what needs to be done."
Cohen is just one of many analysts waiving red flags over Chicago municipal bonds since Detroit filed for bankruptcy and made investors aware that large U.S. cities may become so troubled that individuals can lose money in general obligation bonds they assumed were rock solid.
Matt Fabian, managing director of Municipal Market Advisors, noted in a report to clients that Chicago ranks below about 90 percent of local governments rated by Moody's. The ratings give investors a sense of how confident they can be about receiving all their interest and principal.
Chicago's general obligation bonds had been rated close to the top of the scales at Aa3 until the Detroit bankruptcy. But Moody's, in mid-July, decided Chicago was much riskier than the ratings had been implying. In what Fabian called a "superdowngrade," Moody's knocked Chicago's general obligation bonds down three notches to A3. That's an unusually sharp move since rating agencies usually warn investors about risks to their bonds more slowly, taking ratings down one notch at a time.
Until that downgrade, Chicago had looked safer than 45 percent of local governments scored by Moody's.
The downgrade didn't happen because Chicago had suddenly done something terrible. Rather, Moody's said the city simply hasn't grappled with pension obligations. The city hasn't been putting away enough money for many years to cover those expenses. By 2015, Moody's said, the pensions will be "placing tremendous strain on the city's operating budget."
Last week, the city projected a $1 billion shortfall in the city's budget for 2015. And the higher risk to bond investors means the city will have to pay higher interest to entice people to buy its bonds. Chief Financial Officer Lois Scott said higher interest payments will cost the city about $2 million more to borrow this year.
Cohen says Moody's downgrade is the first of more to come because other bond rating organizations such as Standard & Poor's and Fitch are starting to focus on major unfunded pension obligations that can undermine the ability of cities to pay for services like schools and police and fire protection.
Although Chicago bonds have lost value, investors could see deeper losses if there are more downgrades and they sell bonds after further losses, she said. That's one reason why Heidi Hukriede, director of fixed income at Stonebridge Capital Advisors, said she will not buy Chicago or Illinois bonds even though she specializes in riskier municipal bonds.
Chicago remains a strong city compared with Detroit, but bond analysts say Chicago's crime problem could put more pressure on city finances. While data collected by the Chicago Tribune indicate the city has had a drop in crime since the heavily reported spike in 2012, bond investors have been alarmed by headlines and the fact that this year Chicago has more murders than New York.
Bond analysts note that if the city can't control crime and residents move out, Chicago eventually could face the urban flight issue that left Detroit with the need to spend more on safety while the number of homeowners paying taxes was in decline.
Investors are in no mood to take chances on municipal bonds that seem questionable.
When Detroit filed for bankruptcy, it challenged a promise it had made investors in its municipal bonds. It has argued that the so-called "general obligation" to repay bondholders in full is not as binding as people assume. If that's true, and the courts agree, investors everywhere will have to be more leery of investing in a municipal bond on the presumption that they will be repaid in full.
The realization has been so unsettling that during the past four weeks investors have pulled about $5.9 billion out of municipal bond funds, according to Lipper. Part of that has to be attributed to investors shying away from a wide array of bonds as interest rates climb and inflict losses. Yet, during the same period investors added $6.2 billion to non-muni bond funds, Lipper says.
During the past week, Morningstar says people pulled about $1.6 billion out of municipal bond funds while adding $1 billion to other bond funds.
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