OPINION | Chicago’s Puerto Rican bonds

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NOBODY knows what market distortions the Federal Reserve’s prolonged ultra-low interest rates are creating, but count progressive local governments as big winners. Behold how Puerto Rico on Lake Michigan, otherwise known as Chicago, is financing budget deficits and public pensions with cheap debt.

Chicago has been seeking to take advantage of historically low interest rates by refinancing debt — even as its credit rating has deteriorated amid swelling budget deficits and pension payments. The city started the fiscal year $838 million in the hole, and its pension system is less than 25 percent funded.

In 2017 state and city politicians contrived a shell scheme to lower the city’s borrowing costs. The city essentially sold off sales-tax revenue that it receives from the state to a corporation specially created to pay creditors. State law declared city officials could not tap the revenue and gave creditors a lien if the city declared bankruptcy.

Voila, Chicago’s financial magicians spun junk into gold. Credit agencies rated debt from the new corporation triple A even though Chicago’s general obligation or GO bonds scored one notch above junk. Between 2017 and 2019 Chicago issued $2.6 billion in sales-tax bonds at yields between 200 and 300 basis points lower than what it had recently paid on general obligation bonds.

In January Chicago shaved $310 million off this year’s deficit by issuing another $1 billion in sales-tax bonds to refinance outstanding GO bonds. Investors didn’t seem to care that the new bonds are subordinate to the previous tranche. Tax-exempt bonds maturing in 2040 yielded 2.4 percent, which is on par with the 30-year Treasury. We know investors are hungry for yield, but are they famished?

Chicago’s budget woes are mounting, and financial alchemists are diluting the claims of existing creditors. If the city were to renege on its $8 billion in GO debt, those bondholders would surely demand a slice of the sales-tax revenue now pledged to other creditors. This is what happened in Puerto Rico.

Amid increasing economic and fiscal duress, Puerto Rico created a shell corporation to issue debt securitized by sales-tax revenue. But years later after declaring bankruptcy, it seized the sales-tax revenue, as well as revenue pledged to creditors of its highway authority, to pay for operating expenses and public pensions.

What happens if Chicago floats more sales-tax-backed bonds but revenue is insufficient to repay all the debt? Not to worry, Kroll Bond Rating Agency explained in a recent analysis. The sales-tax corporation has promised in its bond offering statement not to become overextended. But as investors should know, borrowers under financial stress often seek to amend covenants.

Chicago’s population has declined for each of the past four years, and taxpayers are getting tapped out. On top of a $50 million increase in property taxes this year, Mayor Lori Lightfoot has imposed a new “congestion” fee on Uber and taxi rides, doubled the tax on restaurant meals, and raised a special personal property tax on computer cloud software.

Yet a recession would probably blow a gigantic hole in its budget and could cause its pension funds to run dry. Does anyone think that city politicians wouldn’t prioritize public workers over bondholders?

Investors at least demanded a handsome interest-rate premium for buying Puerto Rico’s debt. Investors in Chicago’s debt are getting junk for the same price as a U.S. Treasury. They are likely to get what they’re paying for.

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