CHICAGO – Fighting headwinds from a downgrade and headlines over failed pension reform efforts, Illinois postponed Wednesday’s planned competitive sale of $500 million of general obligation bonds over concerns it would pay too steep an interest rate penalty.
“The indications were a lot wider and a bit higher than we anticipated so we felt it was prudent to pull the deal,” state capital markets director John Sinsheimer said of the spreads he was expecting in broker-dealer bids. “We were hearing that investors were still reacting to the rating agency actions and wanted to give the market more time to digest the news and settle down a bit.”
Friday, Standard & Poor’s lowered the state’ rating on $26 billion of GO debt one notch to A-minus from A and assigned a negative outlook ahead of the planned sale. The action puts the state’s rating on par with that of California although California carries a positive S&P outlook.
Fitch Ratings earlier this month put Illinois’ A rating on negative watch, warning that inaction by lawmakers over the next six months to shore up the pension system buried under $95 billion of unfunded obligations would drive a downgrade. The warning followed the General Assembly’s adjournment in early January without action on reforms despite pleas from Gov. Pat Quinn and civic and business groups. A new session has begun and pension reform legislation has been reintroduced.
Many traders Wednesday said it was wise to yank the sale and let the dust from the downgrades settle. “Who would want to buy it on a downgrade,” said one New York City-based trader.
Interest rates in the tax-exempt market have been on the rise so the delay could benefit the state, market participants said. The delay also allows trades to settle on state paper dumped after the downgrade.
On the flipside, the state runs the risk of further negative headlines or worsening market conditions. Several buyside representatives said they had already digested the downgrades and it’s their own analysts’ views that influence their purchases.
One portfolio manager said the state stands to benefit most if it can use the time to take concrete action on pensions. “It buys the state time to see if they can come up with a financial plan that is believable and sustainable,” said Robert Miller, senior portfolio manager at Wells Capital Management.
Moody’s affirmed Illinois’ A2 rating and negative outlook. Analysts said it reflects the strain of pension obligations, escalating pension payments that will rise by $1 billion in the next fiscal year, an $8 billion bill backlog, and the partial expiration of the 2011 income tax increase in 2015.
Illinois had been banking on scant supply and its strong GO statutes that give debt service a priority over most other state obligations to keep interest rate spreads in check. With investors starved for yield, the state expected sufficient bidding interest from at least seven broker-dealers looking to fill investor orders.
Sinsheimer said he was most concerned about the breadth of the spreads among potential bidders from early indications. “When you get such wide low to high spreads it indicates that the market has not settled on a price,” he said.
Sinsheimer declined to comment on the anticipated spreads broker-dealers shared with the state Tuesday and Wednesday that prompted its decision to pull the sale. Public Resources Advisory Group is advising the state.
The timing of the sale was driven by the need for cash to fund spring construction for capital projects. The state still has funds on hand but if the sale is delayed for a prolonged period it’s unclear how that may impact the upcoming construction season. Quinn has promoted the state’s $31 billion capital budget as an economic development boon and job creator.
Sinsheimer said the finance team will keep its eye on the market and continue conversations with broker-dealers to decide the deal’s timing but he could not say how soon it might appear again on the calendar.
The state typically enters a blackout period at least one week before and then a week to 10 days after major fiscal announcements. Quinn is scheduled to release his fiscal 2014 proposed budget and deliver a state of the state address in February although he asked lawmakers to push the budget release off until March.
The deal was to have marked the state’s first borrowing of the New Year, its first long-term GO issue since April, and first test of market reaction to the General Assembly’s failed session.
Illinois had seen spreads on its paper trading in the secondary market narrow in recent months to 130 basis points to 140 basis points from 175 basis points off the triple-A benchmark Municipal Market Data scale. That compares to California which has seen its spreads narrow to 40 to 50 basis points, market participants said.
A 10-year state GO traded at a spread of 144 basis points Wednesday morning. In the April sale, the state captured a yield 65 basis points over MMD on its shortest maturity, while the final maturity in 2025 came in at 171 basis points over MMD. Wells Capital Management’s Miller said he favored Illinois GO paper when its spreads were in the 170 basis point range and it has since sold some of its holdings after spreads tightened. “It’s not a credit issue. Illinois is not going to stop paying its GO debt service. It’s a relative valuation decision,” he said, due to the thirst for yield that has overcome credit considerations to keep Illinois paper in demand.
In its credit commentary this week, Bank of America Merrill Lynch tracked the history of Illinois GO spreads since early 2011. Illinois spreads to MMD peaked at 210 basis points in early 2011. With an income tax hike then taking effect, spreads narrowed to about 103 basis points by mid-2011. “The spread remains sizable, peaking at 133 basis points above MMD about nine years out, and only coming in to 115 basis points at 25 years before exhibiting some modest widening further out on the curve,” analysts wrote.
Municipal Market Advisors warned in its latest commentary that the state faces further credit deterioration. It expects Moody’s and Fitch to follow Standard & Poor’s. “There is no reason for downgrade trends on the state to soften,” it warned, adding that market access will continue given the strong GO statutes. “Unfortunately, this strong protection also means the bond market is unlikely to ‘discipline’ IL to advance more serious pension and budget reform ideas.”