Illinois' $10 billion taxable general obligation pension bond deal - the state's largest-ever debt issue and one that drew the interest of international buyers - was honored by The Bond Buyer as the Midwest Deal of the Year.
The transaction's complex pricing began with underwriters compiling a book of orders early in the week of June 2. The state and financial team approached the market with the ability to sell as much as $10 billion of bonds, but officials initially planned on pricing no more than $6 billion.
The deal - which had been months in the making - was unprecedented in its size and that it came from a highly rated municipal issuer. With its proceeds being invested, the state had to forgo a tax-exemption due to Internal Revenue Service limits on investment earnings. So the deal priced in the corporate market alongside the nation's top private companies.
But interest rates that week in the taxable corporate market hit near-record lows, dipping several basis points from their lows of recent weeks, and both domestic and international investor interest was strong enough that the state decided to move forward with the entire $10 billion authorization.
The offering priced with yields ranging from 2.53% for a 2008 maturity to 4.07% for a 2015 maturity. Longer maturities priced in the 5% range, with a 2033 maturity for $7.65 billion being priced as 5.10s to yield 5.1%. Prices were set on Wednesday that week and the allocations made on Thursday. The true interest ended up at 5.0474%.
While the bonds sold domestically were priced at spreads against the Treasury market, those sold to European buyers were priced off the London Interbank Offered Rate. Roughly 30% to 35% of the bonds were sold internationally where demand was high for the debt of a sovereign state of the U.S.
Many market participants have said that the deal has set the base for secondary market trading of subsequent issues.
The state's position was aided by the fact that the Illinois General Assembly earlier in the spring had given budget officials the ability to use derivatives in debt transactions. State budget director John Filan said at the time: "Buyers knew we have an alternative."
The deal originated early in 2003 after newly elected Gov. Rod Blagojevich's budget office estimated the combined deficit in fiscal 2003 and 2004 at $5 billion. At the same time, the state's obligations to its pension system - which at $36 billion was ranked as the worst in the county - continued to mount. The deal's prospects were also aided by the dip this year in Treasury rates.
Former state budget officials had proposed smaller pension offerings, but were never able to win legislative support. Blagojevich, a Democrat aided by Democratic control of both the Senate and House, was able to win lawmakers' endorsement.
In moving forward with the sale, budget officials saw an opportunity to reduce some of Illinois' unfunded pension debt, on which it pays an interest rate of about 8%, trading that rate for one in the 5% range. Another benefit of the deal was that it permitted the state to reduce the need to dip into its general fund to cover upcoming payments owed to the pension system.
The state used $2 billion of the proceeds to cover much of its payments owed in fiscal 2003 and fiscal 2004, allowing the governor to avoid cutting into education and health care programs to help balance the budget. The remainder was handed over to the state pension managers to invest. Through the transaction, the state brought its pension system up to a 63% level of funding from 54%.
Though the state compared the deal to a mortgage refinancing, critics of the plan warned that the play on arbitrage - investing the bond proceeds in hopes of earning enough to both cover the interest rate on the bonds and to reduce the pension liability over the long term - was risky.
The state also defended the plan as simply trading a pension debt for a bonded debt with better interest rate terms. Some rating agency analysts, however, disputed the comparison because Illinois retains more flexibility in repaying a "soft" debt owed to the pension system but has little room to maneuver in repaying GO debt.
Officials also billed the pension deal as part of a larger overhaul of the state's fiscal health - one piece in a puzzle designed several years down the road to restore the state's budget to structural balance. The budget relied on a series of one-time revenues, new recurring revenues, and cuts to fully eliminate the deficit in fiscal 2004's $52.4 billion budget.
Fitch Ratings knocked the state's credit down a notch to AA due in part to the deal. Moody's Investors Service had also recently downgraded Illinois one notch to Aa3 and Standard & Poor's has left the state's AA credit intact though it carries a negative outlook.
Most investment banks with a presence in Illinois aggressively competed for a slot on the deal. The team included Bear, Stearns & Co. and UBS Financial Services Inc. as co-book-runners. ABN Amro Financial Services Inc., Citigroup Global Markets Inc., and Goldman, Sachs & Co. served as co-senior managers and a handful of others acted as co-managers.
The fees for underwriters totaled $35 million, with Bear Stearns receiving $8 million, UBS receiving $5.5 million. Co-senior managers received payments in the range of $4 million to $5 million and co-managers received payments between $250,000 to $1.2 million.
Firms hired new consultants with political ties to the freshman governor, or relied on current consultants or other political ties to help secure a spot. The deal received widespread media attention across Illinois when Bear Stearns this past fall disclosed in filings with the Municipal Securities Rulemaking Board that it paid Springfield Consulting Group an $809,000 fee in connection with its role in the lead book-running spot. No one from the governor's office, state budget office, Bear Stearns, or lawmakers has said what work the firm did on Bear Stearns behalf.
The deal piqued the interest of a broad market, both domestically and internationally, with buyers looking at the state's issue to provide a yield above U.S. Treasuries without the risks that accompany corporate credits. "There is a fair amount of interest," Charles Mires, senior managing director at Allstate Investments, said of the overall market, just before the pricing.
In an effort to widen its list of buyers, state officials and members of the finance team traveled overseas to talk to international investors interested in diversifying their U.S. holdings by adding the debt of a sovereign state. Moody's assigned a corporate equivalent rating of Aaa to the global piece of the overall offering.
"The rating reflects the very high creditworthiness of the state's obligation on these bonds in terms of expected default risk and loss severity," the agency stated in a release.
