Fitch Rates Chicago, Illinois Second Lien Water Revs 'AA'; Outlook Revised to Stable

Fitch Ratings has assigned an 'AA' rating to the following city of Chicago, Illinois (the city) bonds:

--$400 million second lien water revenue bonds, series 2014 rated 'AA'.

The bonds are scheduled to sell via negotiation during the week of Sept. 8. Proceeds will be used to fund improvements to the city's water system (the system) and pay costs of issuance.

Fitch also affirms the following city ratings:

--$49 million in outstanding senior lien bonds at 'AA+';

--$1.9 billion in outstanding second lien bonds at 'AA'.

The Rating Outlook is revised to Stable from Positive.

SECURITY

Senior lien bonds are secured by net revenues of the system after the payment of operations and maintenance expenses. Second lien bonds are secured by net revenues of the system on a basis subordinate to the senior lien bonds.

KEY RATING DRIVERS

OUTLOOK CHANGE ON PENSION CLARITY: The Outlook revision to Stable from Positive reflects quantification of ramp-up costs to meet the system's pension funding requirements which are higher than previously envisioned although still manageable. This escalation in annual pension costs offsets to some extent positive considerations associated with the city's adopted rate package and expected revenue gains.

COSTS SHIFTING COULD ALTER LEVERAGE: Fitch expects debt service coverage to remain ample but less than originally projected as pension costs consume more of the budget. Under the current rate package, Fitch believes less surplus revenues will ultimately be available for pay-as-you-go capital which, when combined with recent acceleration of projects, will likely increase borrowing needs.

RATES REMAIN AFFORDABLE: Even with the magnitude of the approved rate package, user charges should remain competitive relative to other large utilities and below Fitch's affordability threshold.

SIZABLE SERVICE AREA: The system serves a broad and diverse service territory, including the city and a large and growing suburban customer base.

FAVORABLE SUPPLY AND TREATMENT CAPACITY: The system has a high-quality water source from Lake Michigan and sufficient amounts to meet long-term demands. In addition, treatment capacity is ample.

RATING SENSITIVITIES

CITY SPILLOVER EFFECTS: Direct or indirect weakening of the system's credit fundamentals arising from the city's pension and/or related budgetary pressures could have negative ramifications on the system's credit.

CONTINUED DEBT ESCALATION: Continued growth in planned system borrowings could offset positive considerations relating to the financial profile.

CREDIT PROFILE

PENSION COSTS DIM POSITIVE IMPACTS OF APPROVED RATE PACKAGE

The rate package approved for 2012-2015 enhances the system's operating performance and financial capacity to address the aging infrastructure. The multi-year rate package passed by the mayor and city council will result in cumulative rate hikes approaching 90% from 2011 levels.

The 2012-2014 rate increases of 25%, 15% and 15% have been implemented to date, with the final 15% adjustment scheduled to take effect Jan. 1, 2015. In addition, annual inflationary adjustments beginning in 2016 have been approved that require no additional action by the city council before being implemented. Despite the magnitude of the rate package, user charges are expected to remain moderately below Fitch's affordability benchmark.

The positive impact on revenues is partially offset by significant increases in pension contributions as the system ramps up to the actuarially required contribution (ARC) in fiscal 2020. Legislation recently signed into law by the state's governor begins to address the underfunding of two of the four city pension funds (municipal and laborers). The vast majority of the system's employees and retirees are covered by these two funds.

The city projects that annual system pension costs would increase around 447%-to roughly $74 million by 2020. This results in a ramp-up in pension costs from 7.8% of spending in fiscal 2015 to an estimated 17.6% in fiscal 2020. While the increased expense is material, Fitch believes the increases are manageable given the system's robust recent financial results and remaining rate flexibility.

CONTINUED IMPROVEMENT IN FINANCIALS

Total DSC remained high at 2.2x net of transfers to the rate stabilization account compared to 2.1x the prior year. Financial forecasts provided by the city point to total DSC remaining at or above 2.0x through at least 2016 including projected pension costs increases discussed below. Beyond the forecast period, Fitch expects that the city would, and maintains the flexibility to, increase system rates to help absorb the out-year costs and maintain financial ratios.

Key liquidity and cash flow metrics also have experienced positive performance which is expected to continue or improve further over several years. For audited 2013, days cash jumped to a solid 269 days. Cash flows improved even more, with free cash relative to depreciation accelerating to a strong 354% in 2013 from a very good 288% in 2012. Continued demonstration of strong results that enhance the system's financial profile further could lead to a rating upgrade.

LARGE CAPITAL NEEDS BUT ROBUST PAY-GO

The system's 2014-2018 capital improvement program (CIP) is sizeable at $2.3 billion and has risen 14% from last year as the city has accelerated system renewal and replacement plans. Debt levels are elevated and will increase further as a result of the CIP. However, the scope of the adopted rate package is anticipated to yield surplus revenues sufficient to allow a still significant portion of pay-go funding. The current plan calls for cash to fund approximately 41% of capital funding needs but Fitch believes this value will likely be reduced given pension cost increases.

The balanced mix in capital funding is a marked departure from recent CIPs which relied almost entirely on borrowable resources. Pay-go funding should somewhat improve debt ratios over time as the system is able to address deferred maintenance and then scale back on capital spending closer to depreciation levels. Capital spending relative to depreciation was an exceptionally high 746% in 2013, and this will rise based on planned CIP spending. While not an immediate concern, continued sizeable borrowing plans could erode financial gains expected from the 2012-2015 rate package and become a credit issue in the future.

BROAD SERVICE TERRITORY AND SUFFICIENT CAPACITY

Encompassing a region that is the economic engine for the state and includes over 5 million people, the system's diverse city and suburban service area is a credit strength. The region was hard hit by the recession and recovery has been sluggish. The utility's two water purification plants on the Chicago lakefront are reportedly the largest in the world and have more than enough capacity to meet future growth needs. Water supplies, which are drawn exclusively from Lake Michigan, are also sufficient to meet customer demand for the foreseeable future.

TANGENTIAL RISK FROM CITY FINANCIAL PRESSURES

The city's unlimited tax general obligation rating has dropped markedly over the course of the last 14 months to 'A-' with a Negative Outlook. The drop is a result of significant underfunding of pensions, which has the potential to put tremendous fiscal strain on the city's general fund in the near future. As the city addresses its pension requirements and determines revenues to fund increasing costs, system rate flexibility could be tangentially impacted over the longer term as the overall cost of government rises.

Additional information is available at 'www.fitchratings.com'

In addition to the sources of information identified in Fitch's Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria', June 2013;

--'U.S. Water and Sewer Revenue Bond Rating Criteria', July 2013;

--'2014 Water and Sewer Medians', December 2013;

--'2014 Outlook: Water and Sewer Sector', December 2013.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715275

2014 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724358

2014 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=861834

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