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Widening Spreads Cost Illinois $12 Million on Deal, New Report Says

CHICAGO – The political and financial dysfunction of Illinois cost the state $12 million on Thursday's $550 million bond pricing compared to its previous sale in January, a new report said.

The relative penalty rises to $70 million when the new sale's results are held up against a decade-old sale that benefitted from double-A level ratings, according to an academic analysis published Friday that seeks to put a dollar figure on the financial toll of the state's widening spreads.

Those costs were disguised Thursday by record low yields in the overall municipal market.

"Due to a decline in overall market interest rates and favorable conditions in the municipal market at the time of the bond sale, the state realized a historically low overall borrowing cost…from an absolute interest rate level perspective," writes Martin Luby, author of the analysis published by the University of Illinois Institute of Government and Public Affairs.

"However, on a relative basis, the state could have realized significantly higher prices," bringing lower yields and borrowing costs, "if its credit had not deteriorated over the last 10 years or even over the last six months," wrote Luby, an associate professor at DePaul University who also works as a financial consultant and independent registered municipal advisor.

Illinois paid the highest yield penalty over the triple-A curve imposed on a sovereign state Thursday. The deal's 10-year maturity priced at a yield of 3.32%, 185 basis points over the Municipal Market Data top-rated benchmark and 111 basis points over the BBB benchmark, up from its last sale in January.

But the deal captured a record low true interest cost of 3.7425% because the widening spreads were more than outweighed by lower overall yields in the market that has seen record lows across scales, disguising the true cost of the state's fiscal deterioration.

The yields landed on par to slightly over recent secondary trading spreads as investors shrugged off negative headlines over a record budget impasse and worries over its sinking bond ratings.

A market flush with buyers – including foreign investors -- and a dearth of yield staved off more severe damage for the competitive sale won by Bank of America Merrill Lynch, even as the state gushes red ink after almost a year without a budget in place.

“Given the decade of fiscal mismanagement at the hands of the Democrats, we are pleased with the record-low interest rate on the bond sale,” Gov. Bruce Rauner’s administration said when asked about the results of the report.

Since the state's $480 million sale in January, Moody's Investors Service and S&P Global Services both dropped the state one notch, to Baa2 and BBB-plus, respectively, and Fitch Rating has put the state's BBB-plus rating on negative watch.

To reach his conclusion on what the report calls the state's "financial condition penalty," Luby looked at the state's relative prices on the January bonds and bonds sold 10 years ago when the state carried double-A level ratings.

The total dollars received for the June 2016 bonds based on bond prices was approximately $575.9 million compared to $645.5 million the state would have received if its narrow spreads of a decade ago remained.

The "relative prices" used in the analysis are based on the state's bond yields relative to the MMD top-rated bond index. Luby said he uses the prices as they represent the present value of all the principal and interest payments on the bonds discounted at the investor's required rate of return.

The 185 basis point spread on the state's 10-year bond in Thursday's deal marked a dramatic jump from the 18 basis point spread on a 2006 bond sale and a 30 basis point jump just since January.

Applying the same comparisons of Thursday's sale to the January issue, the state would have received $587.6 million if it carried the same spreads Thursday as it did in January. That puts the financial penalty at $12 million.

"The $70 million and $12 million financial condition penalty estimates only relate to the June 2016 bonds. Assuming that future debt sales will be at typical levels of about $1 billion each year, this financial condition penalty will be much larger," the report says.

Despite the steep penalty costs, Luby said given the record lows it remains a good time to borrow and the state should take that into consideration given its capital needs. The state's $31 billion capital program is winding down and a new one has taken a backseat to the budget gridlock.

The Civic Federation of Chicago, a local government research organization, earlier this year estimated the state paid an additional $43 million over what other single-A credits paid to borrow on the January sale.

The Rauner's administration sought to portray the state's record low TIC as a reflection of investor support in its efforts to implement governance and policy reforms. The year-old budget impasse is driven by Democratic opposition to those reforms and Rauner's refusal to consider tax hikes without their passage.

"It's clear from today's bond sale that investors realize Illinois now has a governor that is trying to turn the state around and right its fiscal ship," Rauner spokeswoman Catherine Kelly said in a statement Thursday.

Several buyside market participants countered that assessment.

"The bonds were sold based on rabid demand for yield with minimal regard for credit quality. Kudos to the state for perfect market timing. It's a great time to be an issuer," said one investor.

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