OREANDA-NEWS. Fitch Ratings has affirmed the following city of Chicago, IL (the city) bonds:

--$37 million senior lien water revenue bonds at 'AA+';
--$2.2 billion second lien water revenue bonds at 'AA'.

The rating is removed from Rating Watch Negative and assigned a Negative Outlook.

SECURITY
The first lien bonds are secured by net revenues of the city's water system (the system) after the payment of operations and maintenance expenses and any moneys transferred to the rate stabilization fund. Second lien bonds are secured by net system revenues after payment of the first lien bonds.

KEY RATING DRIVERS

NARROWER MARGINS DRIVE NEGATIVE OUTLOOK: Strong financial performance has been evidenced by robust operating margins, debt service coverage (DSC) and free cash flow. However, the Negative Outlook reflects projected weakening in financial metrics due to increased pension contributions and anticipated new debt service combined with limited expected revenue growth over the next few years.

SHORT-TERM LIQUIDITY RISKS ABATED: The removal from Negative Watch reflects the city's successful renegotiation and/or novation of financing and swap agreements, which have eased the liquidity risks posed by the system's variable-rate debt and swaps exposure.

STABLE OPERATIONS, AMPLE CAPACITY: The system is a large regional provider serving roughly 5.2 million area residents either directly or through wholesale contract. High-quality water from Lake Michigan is sufficient to meet long- term customer demand and treatment capacity is ample.

INDEPENDENT RATE-SETTING, AFFORDABLE RATES: City council has full authority to set rates. Customer charges remain affordable despite a significant increase in rates since 2012. Inflation-adjusted increases going forward provide some baseline revenue growth for the system.

MANAGEABLE DEBT BURDEN, LARGE CIP: The capital improvement plan (CIP) anticipates funding roughly 40% of the $2.1 billion in proposed spending from internal sources. The debt burden is expected to rise but remain manageable with metrics somewhat elevated but still well below the levels demonstrated by most comparably-rated urban systems.

SIZABLE SERVICE AREA: The city serves as the economic engine for the region with a broad and diverse employment base and solid underlying economic fundamentals.

RATING SENSITIVITIES

FURTHER OPERATING PRESSURES: Continued incremental erosion in system key metrics, including particularly DSC, would likely lead to a downgrade of the credit.

DEVELOPMENTS AFFECTING SYSTEM: The current rating paradigm, which is based on system operations, could shift depending on future actions by the city as well as from continuing pressure on the city's general credit quality. Specifically, diversion or increased likelihood of diversion of system resources to support non-system expenses would be expected to lead to negative rating action.

CREDIT PROFILE

STRONG FINANCES BUT NEGATIVE OUTLOOK ON RISING COST PRESSURES
The system's financial profile is strong following full implementation of a multi-year rate plan that increased operating revenues by nearly $321 million (a 70% increase) from fiscal 2011-2015 (projected). Strong revenue performance coupled with limited operating expense growth have boosted the system's margins and free cash flow (FCF), providing significant financial capacity to fund rehabilitation and renewal of aging infrastructure.

In fiscal 2014, DSC on the first lien bonds totaled a robust 18.2x, while coverage of all debt service including second lien revenue bonds and state loans was a healthy 2.6x. Prior to the rate plan, DSC totaled 12.5x on the senior lien bonds but just 1.5x on all debt in fiscal 2011. In fiscal 2014, FCF provided by existing rates was a very healthy $238 million, which is over 4x annual depreciation. System liquidity has also improved since fiscal 2011 to 261 days cash on hand.

Similar financial results are projected for fiscal 2015. However, margins in subsequent years are projected to trend downward, primarily from rising operating expenses related to pensions and increases in debt service costs. In particular, costs related to city general fund reimbursements for services rendered to the system are expected to jump more than 42% by fiscal 2017 taking into consideration associated police and fire pension ramp-up costs during those years.

The city currently projects that total DSC will dip to 2.1x and 1.8x in 2016 and 2017, respectively. While coverage at 1.8x is still solid, Fitchwe believes DSC may come under additional pressure if operating costs continue to escalate at a pace beyond the inflation-adjusted automatic rate hikes begining in fiscal 2016. Also, the current pace of additional debt, if realized, would likely pressure financial performance beyond the current forecast period. Additional deterioration in financial expectations would be expected to result in negative rating action in the future.

TANGENTIAL RISK FROM CITY FINANCIAL PRESSURE REMAINS
The city's unlimited tax general obligation rating of 'BBB+'/Negative Outlook reflects significant underfunding of pensions along with an ongoing structural deficit in the city's general fund. On the positive side, the city passed a 2016 budget that provides the resources needed to meet the expected phased-in increases in required pension payments, including a sizable increase in ad valorem taxes and other fees.

However, several challenges remain, including legislation allowing for the phase-in for police and fire pensions that has yet to be signed into law and resolution of pension reform for the municipal and laborers pensions that has been overturned by a lower court and is being appealed to the state Supreme Court. Oral arguments are expected to begin later this month.

While Fitch views the potential for spillover of financial pressures to the city's utility funds as unlikely beyond pension payments and rising indirect costs, indications of such spillover could be expected to result in negative rating action. Fitch believes severe liquidity stress within the non-enterprise funds (including the general fund) would likely pose the greatest threat to the utility.

Consequently, diversion of utility monies for non-utility purposes (e.g. transfers out, borrowable resources); a shifting of non-utility costs to the system (e.g. increased headcount); and/or other potential indicators of possible stress that might lead the city to divert system resources (e.g. slowed capital spending to preserve cash) would be considered a significant departure from prudent system management and counter to Fitch's current expectations and rating approach.

LARGE CAPITAL PLAN, DEBT BURDEN MANAGEABLE
The system's 2015-2019 CIP is a sizable $2.1 billion and expected to continue to fund system renewal and improvement projects including replacing 450 miles of water mains and adding/updating 100,000 water meters. The multi-year rate plan was designed to provide adequate funding for the capital spending program, which will consist of additional debt but also increases the amount of pay-as-you-go resources.

In total, the city expects to issue approximately $1.1 billion in additional debt (through a combination of revenue bonds and state loans) over the next four years (2016-2019). This more balanced approach to capital funding is viewed positively by Fitch as previous CIP's were almost exclusively debt-financed.

The city has been more aggressive in funding system capital needs over the past five years. Since fiscal 2010, the city has spent roughly $250 million annually on infrastructure improvements leading to greater system reliabitlity, but has also increased system leverage. As of fiscal 2014, the system had $2.6 billion in total debt outstanding consisting mainly of second lien bonds.

Debt metrics are somewhat mixed. In fiscal 2014, debt totaled an affordable $497 per capita and carrying costs comprised just 22% of gross revenues. However, debt-to-net-plant was an elevated 75% in fiscal 2014 and principal amortization is somewhat slow with 33% retired over the next 10 years. The debt burden is expected to rise as the city continues to fund its CIP. Fitch does not anticipate the additional debt will greatly change the system's overall debt profile, but may pressure financial performance.

VARIABLE RATE DEBT STILL OUTSTANDING, RISKS MITIGATED
The system retains its relatively large variable rate debt portfolio. Of the roughly $2.3 billion in total debt outstanding, approximately $455 million (or about 20%) consists of two series of variable rate demand obligations issued on the second lien. After rating downgrades triggered events of default under swap and liquidity facilities, the city successfully renegotiated terms and/or obtained waivers to remove near-term liquidty risks.

The series 2000 variable rate bonds, outstanding in the amount of $100 million, are backed by a liquidity facility from J.P. Morgan, while liquidity for the series 2004 bonds is provided by both State Street Bank and the Bank of Tokyo under a single letter of credit and reimbursement agreement ($355 million outstanding). Rating triggers associated with the liquidity facilities are similar (to non-investment grade, or NIG), although only the series 2000 bonds would be due and payable immediately if the bonds were downgraded to NIG. The liquidity agreement for the series 2004 bonds also contains rating triggers to NIG, but remdies include mandatory tender with a three-year term out.

The bonds also carry three floating-to-fixed-rate swaps with a total mark-to-market valuation of negative $105 million. Bond rating thresholds for all three swaps were either lowered to NIG from high triple B category (via novation of the swap to a different counterparty) or the rating agencies were updated to remove the agency that currently carries the lowest rating on the city's water bonds.

While not completely eliminated, the liquidity risks associated with variable rate debt are sufficiently lowered and, coupled with existing cash resources, provide adequate time for the city to potentially address a longer-term solution if bonds are downgraded further.

BROAD AND DIVERSE SERVICE AREA ECONOMY
The city is the economic engine for the state and serves as a regional employment hub for the mid-west. The economy is exceptionally broad and diverse, with significant business and financial service sectors and a well-educated work force. The unemployment rate for the entire Chicago metropolitan area has improved to 5.6% in August 2015, from 6.8% one year prior, due to a combination of employment growth and a slight drop in labor participation. The unemployment rate remains slightly above state and national averages.