As published by Gunjan Banerji, debtwire.com

A beefed-up bond security structure laid out in offering documents, alongside high demand for municipals, has allowed Detroit to bring a USD 615m bond deal, said market participants. However, a complex financial relationship with Michigan could hurt the city down the line.

Investors took note, as price talk on the tax-exempt portion of the deal widened from
Wednesday to Thursday, before pricing roughly in line with the later indications yesterday,
market participants said. Price talk on a sliver of roughly USD 220m in Series 2016 tax-exempt debt maturing in five years widened 10bps, to 70bps above the AAA MMD curve, before pricing 69bps off the benchmark. Talk for one-year maturities inched out 5bps, to 35bps above the curve prior to pricing there, a municipal bond trader said.

“We experienced broad and deep investor participation and the savings certainly (significantly) exceeded our expectations,” said Detroit’s Finance Director John Naglick in a statement. When questioned by Debtwire Municipals on final pricing, the director declined to comment directly, but said that the all-in true interest costs were under 3%, selling at tighter spreads than bonds sold last year.

Barclays, the lead underwriter on the bond deal, declined to comment.

Not forgotten

But the cloud of the city’s bankruptcy—and haircuts dealt to bondholders—hangs over the
refunding deal. A similarly rated Michigan bond deal came to market recently with much tighter spreads, as reported. After exiting bankruptcy in 2014, a nine-member Financial Review Commission oversees the city, ensuring prudent fiscal management.

The city is now securitizing its refunding with state aid from Michigan and a “statutory lien” on revenues. It is essentially tapping different streams of money to bolster its financial position, said Pat O’Keefe, CEO of Michigan-based restructuring advisor O’Keefe LLC.

“People’s memories are not that short yet,” O’Keefe said. “[Detroit] needs additional credit enhancements to keep the rates at some reasonable level.”

Last summer, Detroit issued USD 245m in tax-exempt bonds backed by a similar lien on income tax revenues. The USD 615m refunding deal consists of four series of local government loan program revenue bonds—one of which is tax-exempt.

The Series 2016C-1 and Series 2016C-2 taxable bonds have first and third liens on state aid, respectively. The Series 2016C-3 tax-exempt and Series 2016C-4 taxable bonds both hold fourth liens on such aid. Series 2016C-1 bonds, are rated the highest: Aa2 by Moody’s and AA by S&P. Moving down the security structure, the Series 2016C-2 bonds are rated A1 and A+ by Moody’s and S&P, respectively. The tax-exempt Series 2016C-3 bonds and taxable Series 2016C-4 are both rated A2/A-.

The city issued USD 100m in second lien state aid bonds in 2010.

But with an underlying junk-rating of B2 from Moody’s, the robust municipal market is one thing working in favor of the Motor City.

“We just had over 40 weeks of positive cash flow to munis—a lot of that cash flow has been
concentrated in high yield funds,” said Hugh McGuirk, head of the municipal bond team at
T.Rowe Price, noting that the tax-exempt market has been buoyed by increasing demand and strong technical factors overall.

Strong legal structures vs. strong financials

“The city realizes that it needs to rebuild its GO credit rating following exit from bankruptcy in December 2014,” finance director Naglick said in an email. “To that end, our two entries into the market post-bankruptcy have been designed to sell highly rated bonds with extremely secure credit pledges to rebuild market credibility.”

In addition to the statutory lien on state aid revenues, the Michigan Treasurer will directly funnel funds to the trustee for the 2016 bonds, an added reassurance for bondholders, investors said. But some remain cautious about how legal structures may hold up in potential restructurings.

“Strictly speaking, you don’t know how these statutes are going to hold up unless a judge rules on it,” said Robert Christmas, a partner at Nixon Peabody. The restructuring attorney noted that the credit enhancements have not been decided by any Federal Circuit appellate court, at which point case law could serve as more definitive precedent for future restructurings.

Additionally, strong legal securities on paper may not shield the city from financial or budgetary wildcards down the line.

In tough economic times, the state has sometimes balanced its own budget by providing less money to local governments, said O’Keefe and Jeffrey Guilfoyle of Public Sector Consultants. This could dilute the collateral pledged to the bonds, which consists of “constitutional” and “statutory” state aid revenues funneled to Detroit from Michigan.

Distributable state aid allocated to Detroit fell by almost 30%, from USD 272m in FY07 to USD 194.4m in FY16.

“Any action by the governor and state legislature reducing or delaying distributable state aid in response to economic conditions affecting the state could have a material adverse effect on the city’s ability to pay debt service on the municipal obligations,” the offering documents stated.

Michigan could help, or hurt

“The state has its own set of issues” O’Keefe said, highlighting the interrelatedness of Michigan and its locals through various bond credit enhancement programs. For example, the School Bond Qualification and Loan Program extends the state’s credit to various school districts, including Detroit Public Schools (DPS), backing USD 13bn in bonded debt. Since Detroit exited its bankruptcy, Michigan has had to oversee both the Flint water crisis and DPS’s ongoing restructuring.

“The risk is that revenue-sharing payments could get lower,” Guilfoyle said, noting that the
statutory state aid allocations, subject to annual appropriation by lawmakers, hinge on the yearly whims of lawmakers.

Meanwhile, population loss is still a problem. The constitutional distribution component of its state aid from Michigan is calculated per capita.

If the city can’t maintain or grow its population, “the numbers aren’t going to work, period,” said Charles Moore of C.L. Moore & Associates, who has worked with local municipalities in the state.

“Population loss is a continued threat to Detroit’s revenue sharing, but it’s not all or nothing,” Guilfoyle said, adding that even if the city lost 3%-8% of its population, it would be left with most of its revenue-sharing dollars.