Los Angeles heads to market Wednesday with a hybrid tender offer and refunding as it struggles to close a pandemic-induced deficit that brought a negative outlook from Kroll Bond Rating Agency.
The deal marks the second by a California issuer to make a tender offer ahead of a taxable refunding in the hope of taking out some of the debt with tax-exempt bonds.
“The city is pursuing the exchange as an enhancement to a taxable refunding to achieve greater refunding savings,” said Richard H. Llewellyn, Jr., the city administrative officer.
He wouldn’t predict how much savings Los Angeles hopes to achieve on the deal.
The city will close Monday on the tender offer on the Municipal Improvement Corporation of Los Angeles lease revenue bonds, and then follow with a refunding on Wednesday. The preliminary offering documents estimate $256 million in taxables for the series A bonds, but have a blank amount for the B series.
Goldman Sachs is lead manager with Academy Securities and Siebert Williams Shank & Co. LLC as co-managers. Omnicap is municipal advisor and Nixon Peabody is bond counsel.
The city established MICLA as a non-profit corporation to allow it to enter into lease agreements for public buildings and capital equipment. Debt service on MICLA lease revenue bonds is paid with annual lease payments from the city’s general fund.
The tender offer is designed to capitalize on unmet demand for tax-exempt debt, with so much debt being refunded with taxable bonds since the 2017 federal tax bill eliminated advance refundings.
Morgan Stanley forecast $220 billion in taxable muni issuance for 2021 in a January report, of which about 80% would be driven by advanced refundings.
Limited tax-exempt supply was a contributing factor in the decision to offer a bond exchange as part of the refunding, Llewellyn said.
“If successful, we expect there will be meaningful savings over our taxable refunding base case, since the exchange allows us to issue tax-exempt refunding bonds,” Llewellyn said.
Foothill-Eastern Transportation Corridor Agency, an Orange County toll road operator, used a similar approach in January on what could have been a straight-up $785 million advanced refunding. It had so much interest from the tender offering that it only sold $53 million in tax exempt and $187.7 million in taxables on the open market. F-ECTA achieved $154 million in net present value savings on its hybrid transaction.
Los Angeles is refinancing two 2019 MICLA series totalling $189.3 million and two 2014 MICLA series of which $50.6 million is outstanding, according to the offering documents.
Kroll lowered its outlook for Los Angeles to negative from stable ahead of the deal.
It affirmed the AA rating for the lease revenue MICLA debt, a notch below the city’s AA-plus general obligation rating, which also now carries a negative outlook.
“The negative outlook reflects the impact to date of the pandemic on revenue,” Linda Vanderperre, a Kroll senior director and the lead analyst on the report, said in an interview.
The city’s budget deficit for the current fiscal year 2021 has grown to $750.7 million, up substantially from the $400 million estimated when the city approved the budget in July. The city also reached an agreement with city workers to defer raises in fiscal year 2022 and 2023 in exchange for no furloughs this year. While the raise deferrals improves the city’s fiscal outlook in the out years, scrapping furloughs makes this year’s budget situation bleaker.
The outlook “reflects KBRA’s view that the city’s financial performance, reserve position and operating flexibility have been adversely impacted by the pandemic, “ Vanderperre wrote in the report. “Despite efforts to reduce spending, there now remains relatively few politically palatable solutions for achieving near- to mid-term budgetary balance absent additional federal funding and the city’s full recovery from the grip of the pandemic.”
The city has proposed spending $274 million from three different reserve funds leaving $184 million in reserves, equivalent to 2.75% of the budget in reserve. A future $150 million MICLA deficit-borrowing bond sale also has been proposed.
The reserve draw would place the city well below its policy target of having a 5% reserve, a policy that Kroll has recognized as a strength, Vanderperre said.
“We also recognize that reserves are there for a rainy day and this might be that rainy day,” Vanderperre said.
Though a number of factors have reduced the city’s operating flexibility, the Kroll analysts also emphasized that the city has made decisions — like maintaining the 5% reserve since the 2008 recession — that cushioned the blow of the once in a 100-years event represented by the pandemic, said Karen Daly, a Kroll director.
With Los Angeles planning to spend its remaining $69 million in CARES Act coronavirus relief funds, and not knowing how much more federal funding it might receive and how much longer the pandemic might go on, the city has less operating flexibility going forward, Daly said.
S&P Global Ratings affirmed the AA-minus rating on the MICLA debt with a stable outlook ahead of the deal. Fitch Ratings, which wasn’t asked to rate this MICLA series, revised the outlook on Los Angeles’ AA general obligation rating to negative in December.
“We understand why Kroll changed its rating outlook on the city,” Llewellyn said. “The pandemic has impacted the city’s finances significantly resulting in an estimated $600 million revenue shortfall. This is not unique to L.A.; all municipalities have been impacted.”
Kroll and S&P also included the city’s strong financial management practices and policies as credit positives, Llewellyn said.
The budget balancing plan includes cutting $157.5 million from the budget, using $274.1 million in reserves, spending the remaining $68.9 million in COVID-relief funding, the $150 million in deficit financing, and $22.7 million in labor concessions, Llewellyn said.
That plan still leaves a $77.5 million budget gap, as well as any additional shortfalls that might arise from revised revenue forecasts or expenditure increases, Llewellyn said. The city will have to take actions like making additional cuts, additional transfers from special funds, using Federal Emergency Management Administration reimbursements and other pandemic-related federal funding, he said.