CHICAGO – Illinois will pay a yield premium to borrow this week, but sentiments differ as to whether that penalty will amount a slap on the wrist or a deeper bruising.
The state, bleeding red ink and almost a year without a budget, hobbles into the market with a competitive $550 million general obligation bond sale Thursday.
Its prolonged political gridlock has left fiscal wounds to fester and is fueling debate over the market's role as a disciplinarian.
"The inherent powers that all states have are the only thing separating Illinois from being a publicly junk-rated credit at this point, and we would expect that any high-quality focused investors are avoiding the state," said Tom Schuette, co-head of credit research and portfolio management at Gurtin Fixed Income Management, LLC.
But that won't stop buyers, said Lyle Fitterer, senior portfolio manager at Wells Capital Management.
"They are a little bit weaker, but not materially in the secondary," he said.
"There's plenty of demand so it will depend on where people are on their Illinois exposure and are they willing to add to it," Fitterer said.
"Yes, their budget is a problem, but they have the ability to service" their debt based on the state's GO security provisions, he said.
The litany of bad Illinois news grew last week with two more downgrades. They dragged the state's ratings – already the lowest among states – further down, heightening swap and floating-rate risks and concern over the enforceability of the state's strong GO security.
The state's backlog of unpaid bills stood at $7.8 billion Monday and could approach $10 billion when the books are closed on fiscal 2016 on June 30.
Illinois is headed toward its second year without a budget come July 1.
While the state has a lousy credit story to tell, its deal joins a slate of roughly $5.7 billion in easily digested muni primary issuance this week with yields hovering in record low territory. Last week marked the 36th straight week of bond fund inflows and investors are hunting for yield.
Illinois GO paper was trading at a 170 to 180 basis point spread to the Municipal Market Data's top-rated benchmark before the recent downgrades. Tax-exempt spreads have since widened about five basis points, according to Markit. Taxable spreads have widened by about 10 to 15 basis points.
The low-yield environment masks the true cost of the state's political and fiscal woes because interest rates have come down from past periods when the state benefitted from narrower spreads but paid a higher true interest cost due to prevailing rates.
In its last sale in January, the Rauner administration highlighted the true interest cost rate of 3.99%, down from 4.08% on the state's last sale 20 months earlier.
Its spreads were wider on the January deal but prevailing rates lower.
Illinois' 10-year maturity paid a yield of 3.33%, 155 basis points over the top-rated MMD benchmark. The spreads marked a sharp jump from 95 to 110 basis points on deals in 2014 before the budget impasse took hold and the Illinois Supreme Court overturned a state pension overhaul that was seen as a serious effort to tackle retirement underfunding.
Blackrock strategists in a presentation last week expressed frustration over what they expect will be only a minor yield penalty come Thursday.
"We as municipal market participants should really be penalizing in some way, by almost not giving them any access to the market," said Peter Hayes, head of the municipal bonds group. "Think about it; they are a state without a budget, they refuse to pass a budget, they have the lowest funded ratio on their pension of any state, and yet they're going to come to market and borrow money."
The comments reflect the frustrations of many market participants.
Fitterer said that, while the idea of a buyers' strike has understandable appeal, he just doesn't see it succeeding.
"I would argue that the market is forcing a penalty" with the current spreads, he said.
"I think it expresses a real frustration with what's going on," said Howard Cure, director of Municipal Research at Evercore Wealth Management LLC.
"As a state selling GOs it's a very rare situation to lack buyers because there's no modern history of defaulting," said Matt Fabian, a partner at Municipal Market Analytics, adding that the market isn't built to impose to strict a form of discipline.
"Structurally, there are too many buyers for every available bond," he said.
Cure said as state's fiscal condition deteriorates and its impasse drags on, investment participation grows more sensitive to individual client profiles even though he doesn't believe the state is at risk for a default. Questions are more heightened over whether a client can handle ongoing headline and liquidity risks.
"For the right client" Illinois paper offers a good yield, he said, but "there certainly are clients who want no part."
Cure said the state may not yet be at a point where traditional buyers abandon the paper, leaving it to high-yield funds, but as the budget impasse continues those questions will arise.
Fabian agrees that headline risks increasingly will keep some traditional buyers at bay and some may even promote their "conservatism and prudence" with a decision to forgo yield and steer clear of the paper.
Fabian also sees current market conditions as mixed for the state. While there is strong demand for municipals, especially paper with some extra yield, investors are penalizing a handful of "headline risk credits more than ever."
Gurtin takes a hard stance with Illinois, having shed it long before the budget impasse began.
"We believe the general municipal market has gradually come around to this same view as Illinois' dysfunction and irresponsibility have reached new heights,'' Schuette said.
Investment consideration warnings begin on page eight of the offering statement and include the budget impasse, the 2015 rollback of an income tax hike, floating-rate debt and swap risks, pension liabilities and the potential for "delays in exercising remedies" for bondholders in the event of a default.
The state's strong GO security gives debt service a priority lien on state revenues, pre-funds debt service which is paid under a continuing appropriation, and allows holders to pursue court action.
The state warns of judicial discretion in any pursuit of bondholder remedies and that "any delays in the ability of the bondholders to pursue remedies may result in delays of payment of the bonds."
"Although we don't foresee this in the immediate future, challenges to the state's debt payment priority could emerge should liquidity dwindle to the point where it affects Illinois' ability to provide essential services," S&P Global Ratings said last week when it downgraded Illinois one notch to BBB-plus. That came after Moody's Investors Service dropped the state one notch to Baa2, two notches above junk.
Both assign negative outlooks.
Fitch Ratings affirmed its BBB-plus rating Thursday but placed it on negative watch.
Deep rancor between Gov. Bruce Rauner, a Republican, and the General Assembly's majority Democrats has prevented a budget compromise and the parties have shifted to work on a stopgap plan to get the state past the November elections and into January.
Illinois is in rare rating territory. Moody's said the only state at the same level since the 1970s is Massachusetts which from 1990 to 1992 was rated Baa. Moody's did not assign 1, 2, or 3 modifiers then.
S&P rated California BBB in 2003 and 2004. It rated Louisiana BBB-plus in 1988 and Massachusetts was at BBB in 1989. Fitch rated California BBB before ratings calibrations in 2003 and 2009.
The Moody's cut puts Illinois one downgrade away from triggering termination events on five interest-rate swap agreements tied to $600 million of variable-rate debt while the S&P cut puts it two notches away. The swaps are negatively valued at $155 million.
The floating-rate paper is supported by six direct pay letters of credit that expire Nov. 26. The state currently pays a 2.85% fee that increases to 3.35% if one of its ratings falls to BBB-minus, and to 5.35% at the junk level. If the state fails to renew the LOCs, the bonds have a three-year term out at a higher rate, according to S&P.
Some investors, including Cure, say the most acute worry about the Illinois budget crisis is the collateral damage being imposed of issuers like schools, local governments and higher education.
"The price will be borne by other municipalities within the state who will bear the headline risk of the states inertia and inability to address their problems," said John Mousseau, director of fixed income at Cumberland Advisors Inc.
Several market participants said some broker-dealers are starved for inventory so they thought the state will benefit from selling the deal competitively. The state must bid at least 25% of it bonds annually. Its $480 million January sale sold competitively.
Rauner defended the state's timing on the deal amid the ongoing budget gridlock, saying it's appropriate now to go to the market to borrow "for long-term infrastructure projects" that will aid the state economy and development. He said he would oppose any borrowing to cover operations.
Rauner said Tuesday he couldn't predict how steep a penalty the state might be forced to pay over the prolonged budget impasse. He said he's talked to some bond buyers and they have told him "they are fed up with financial mismanagement" and "many have expressed confidence in our efforts."
Rauner was referring to items on his turnaround policy agenda opposed by Democrats.
