Why Chicago Bonds Are Junk, in 7 Charts

By Michael Johnston

 

The Windy City’s financial woes are unlikely to blow over any time soon.

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Following an Illinois Supreme Court ruling earlier this month, Chicago’s bonds received a downgrade to “junk” status by Moody’s. The ratings agency reiterated a negative outlook on all of the city’s long-term ratings, expressing concern about the narrowing pool of options for rescuing a badly underfunded pension system.

The journey to junk status started more than a decade ago with borrowing to fund pensions, and at least one major agency is concerned that the risk of default is increasing. Chicago’s fiscal troubles are a complex story, but a handful of charts can provide a bit of context to the current situation.

Chart #1: Massive Debt Burden

Simply put, Chicago is shouldering an enormous amount of debt. By some calculations, the city is on the hook for as much as $63 billion when pensions, long-term notes, and health insurance obligations are included. That amounts to a staggering $23,300 for every inhabitant of the city, representing a huge chunk of the annual income for the city’s residents and nearly 10 times the size of the per capita annual budget.

Chart #2: Growing Payments

While the current state of the city’s balance sheet is dismal, the real problem relates to what is expected to develop over the next decade. Chicago pension plan payments are expected to double from 2014 to 2015, and will then continue to rise for another decade before they begin to decline. By the time payments peak in 2026, they will be four times the 2014 level.

Chart #3: Limited Taxing Ability

The easiest way for a government to boost revenues is through tax increases. For cities, property taxes are often a primary revenue stream. While it is certainly possible that Chicago will raise property taxes — in fact, it’s a near certainty — there will be a limit to the increases possible. Illinois residents already pay the second-highest property taxes in the country.

Chart #4: Unrealistic Expected Rates of Return

The city’s pension liabilities have ballooned in part as a result of unrealistic expectations for the returns on the assets. For fiscal 2013, Chicago’s various pension plans were assuming annual rates of returns ranging from 7.5 percent to 8.25 percent.

Unfortunately, the actual performance has failed to live up to these lofty expectations. The Municipal Employees’ Annuity & Benefit Fund of Chicago (MEABF) reported a 10-year average return of just 5.6 percent as of 2014. The Laborers & Retirement Board Employees’ Annuity & Benefit Fund of Chicago (LABF) reported a “gross of fees” return of 6.3 percent for the 10 years ended March 31, 2015.

When the actual results fall short of expectations for an extended period of time, the gap between assets and liabilities can begin to rapidly grow. That’s exactly what has happened to Chicago’s pension plans; despite paying millions of dollars in fees — the police pension fund doled out over $8.6 million to managers and consultants in 2013 — returns have fallen far short of expectations.

Chart #5: Compounding Unrealistic Rates of Return

When it occurs over the course of a single year, the disconnect between the expected returns used by Chicago’s pension funds and reality are disappointing. But when they continue over an extended period of time, this gap can spell economic disaster. The difference between 7.75 percent and 5.60 percent in annual returns may not seem like much, but when these rates of return compound, a massive gap appears:

The MEABF pension fund has been assuming that its approximately $5 billion of assets will grow to about $9.8 billion over the course of 10 years. Based on historical returns, it will actually grow to $8.2 billion — leaving a gap of nearly $600 per resident. This same scenario is playing out across multiple pension funds, for even longer periods of time.

Chart #6: Accelerating Expenses

Although Chicago has increased revenue through a number of different tax strategies, expenses have been rising considerably in recent years as well.

Chart #7: Actual Junk

While Chicago’s budget issues are largely related to an underfunded pension system, the city isn’t exactly frugal in the way it spends money for other services. Many of the day-to-day aspects of city operations are extremely inefficient and expensive relative to other major metropolitan areas.

Reducing the cost of trash pickup obviously won’t solve all of Chicago’s problems; this service accounts for only a small fraction of the city’s budget. But the cost differences relative to other major American cities highlight the general lack of fiscal discipline that plagues the city.

 

 

About the Author: Michael Johnston

Michael Johnston is the Senior Analyst for Fixed Income Database, and also serves as the COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.