Illinois returns with $4.5 billion test of investor appetite

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CHICAGO – Illinois heads back into the market as soon as Monday with a $4.5 billion general obligation sale to wrap up its bill backlog borrowing with Gov. Bruce Rauner’s finance team pitching the state’s “improving” credit fundamentals and position as the Midwest “powerhouse.”

They are marketing points that contradict the governor's own public arguments but helped sell buyers on $1.5 billion of paper the state sold competitively last week.

Illinois will sell the tax-exempt, fixed-rate deal in $500 million maturities between 2020 and 2028 with Barclays Capital, Bank of America Merrill Lynch, Citi, JPMorgan, Loop Capital Markets, and Siebert Cisneros Shank & Co. as senior managers.

The $6 billion will go toward paying down a roughly $15 billion backlog of unpaid bills. A first glimpse at possible spreads from a pre-marketing scale distributed Thursday suggests spreads close to current trading levels, but wider than seen on the $1.5 billion competitive pricing Tuesday.

Illinois held its spread penalties in check on the $1.5 billion. “Unless market conditions change, I would think the state would see a similar outcome,” said Richard Ciccarone, president of Merritt Research Services.

The deal's size could help the perception of good secondary market liquidity to lure mutual fund managers who like the state’s strong GO statutes, while rich yields and short maturities provide near-term incentives. It's the largest Illinois deal since its $10 billion 2003 pension sale.

While the state's ratings still remain at risk of sinking to junk, default risks remain low and that along with the size “should prove attractive to today’s reinvestment plagued investors,” said Municipal Market Analytics partner Matt Fabian in an outlook piece.

A pre-marketing scale suggests spreads that fall between five basis points wider or narrower than recent trading levels for comparable maturities, ranging from a spread of 115bp on the short end to a high of 175bp.

The scale suggests a 115bp spread to the triple-A benchmark yield of 1.09% on the 2020 maturity. The state’s three-year bonds have been trading at the same level. The spread on the 1- and 2-year maturities in the $1.5 billion sale landed at a 70bp spread to the triple-A benchmark.

The pre-marketing scale's 2022 suggested spread of 150bp to the triple-A is slightly narrower than the 155bp spread the state’s five-year bond has been trading at lately.

The 2027 bond suggests a spread of 175bp to the triple-A yield of 1.92%. The 10-year has recently traded at a 168bp spread. The 12-year bond in the $1.5 billion sale landed at a 166bp spread.

MMA believes Illinois spreads will end the year around 170 basis points but investors shouldn’t expect those levels will hold steady. “Spreads may reasonably widen thereafter assuming the politics of balancing fiscal 2019 (and FY18) budgets erode with election-year posturing,” Fabian warned.

MMA also cautions that the state is far from out the woods credit-wise. “Investors who plan to hold and not just trade the new bonds should assume a material risk of at least 20-30% of a downgrade to junk occurring over the next five years,” MMA wrote.

Traders and analysts attributed the state’s ability to hold its spread penalties steady to passage of a budget and permanent tax hikes.

The Republican Rauner administration’s investor presentations claim improving credit fundamentals.

“Recent positive developments by the state include passage of the fy 2018 budget, passage of the Senate bill 1947 which provided for evidence based method of allocating funds among the state’s school districts, a permanent increase in personal and corporate income tax rates resulting in over $4 billion in additional revenue,” capital markets director Kelly Hutchinson told investors.

The administration's portrayal of Illinois as a Midwest economic powerhouse economy cites positive momentum on income per capita, gross domestic product growth, and unemployment.

They are descriptions that contradict Rauner’s public portrayal of the state’s fiscal picture and could provide fodder for Democrats in their efforts to unseat him next year.

They also underscore the delicate political balance of selling investors on the state’s credit by promoting a budget, tax hikes, and borrowing, all of which Rauner publicly opposed and vetoed because they were not accompanied by governance and policy reforms.

The budget took effect only after the Democrats who control General Assembly received help from some Republicans who crossed over to override Rauner's vetoes. Publicly, Rauner has slammed the tax hikes, blasted the budget as out of balance, and initially resisted the backlog borrowing authorized in the budget saying it was a poor choice to deal with state finances.

Rauner has also warned of the state’s faltering ability to grow and attract businesses without structural reforms he is seeking and played up the competitiveness of neighboring states.

“The governor’s comments remain in the back of the minds of sophisticated investors who know that the state’s situation is far from cured,” said Ciccarone. “The overhang of the state’s liabilities is in the backdrop and the politics have been divisive and worked against the state’s credit quality and as well as risk perception in the marketplace.”

But at the forefront, investors see the state as now having some breathing room. “The short term risk has been mitigated,” Ciccarone added.

A week ahead of the $1.5 billion competitive pricing, when the state’s annual fiscal policy report and forecast were released, the Rauner administration slammed the budget for being $1.7 billion out of whack. That could have been “avoided if the General Assembly had enacted $2 billion in reforms proposed by the Rauner Administration and Republican leaders earlier this year,” a statement said.

The administration's press release aimed at a general audience that provided details on the bond sale results included little boasting of the market’s confidence in the state. Budget director Scott Harry wrote only: "The state received strong bids today for its bonds and is pleased with the market’s favorable reception of the sale. This bodes well for the state’s financing coming next week.”

In a sale from June 2016, the Rauner administration boasted of the results: “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.”

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