First chunk of $6 billion in Illinois paper goes down easy

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CHICAGO – Illinois held spread penalties in check as enticing yields lured buyers to its $1.5 billion general obligation issue Tuesday.

The sale – divided into three competitive series each for $500 million -- marked the first of two deals totaling $6 billion for bill payment relief.

The yield on the long, 12-year maturity landed nearly on par with where the state’s 12-year had recently traded and were slightly improved from the state’s last sale in 2016. The one- and two-year maturities fared better with tighter spreads than seen in recent trading.

Ahead of the issue, traders and analysts had said it was difficult to predict what penalty the market might impose on the state’s paper. The state remains on the verge of junk with the lowest investment grade rating from two rating agencies and is facing deep budgetary and pension pressures along with ongoing political dysfunction. After going two years without one, the state does now have a fiscal 2018 budget that includes $5 billion in new annual income tax revenue.

In addition to “strong strong demand for yield….by passing a budget which wasn’t an easy thing to do they managed to get the spreads tighter,” said Dennis Derby, portfolio manager and senior research analyst at Wells Fargo Asset Management. “They now have a revenue stream coming in that isn’t going to sunset” like the 2011 income tax hike.

“It’s good result. I think it’s a nice cost of capital,” said one Chicago-based trader. “I think it was a demand for yield and not any structural change in the state’s finances, although passage of a budget is a start.”

Gov. Bruce Rauner’s administration said the deal captured an all-in borrowing cost of 3.5%.

“The state received strong bids today for its bonds and is pleased with the market’s favorable reception of the sale,” said budget director Scott Harry. “This bodes well for the state’s financing coming next week.” Rauner, who vetoed the budget package only to see it enacted through a veto override, initially opposed the borrowing plans.

Proceeds of the competitive issue along with a $4.5 billion negotiated GO issue next week will chip away at a bill backlog that swelled during the state’s two-year budget impasse that ended in July. It stood at $15.98 billion Tuesday.

“We will have to wait and see what interest rates the other $4.5 billion brings and how much demand there is out there for Illinois,” the trader added.

The state pays interest rates of 9% and 12% on some of its accumulated bills, so the borrowing will shave millions off the interest tab going forward. It should also ease debt service pressures on the fiscal 2018 budget that already has a projected $1.5 billion hole. The budget plan accounted for debt service on only $3 billion of borrowing.

Comptroller Susana Mendoza’s office said recently borrowing at a 6% rate would add about $75 million more to the state’s roughly $225 million set aside monthly for GO debt service.

The Tuesday sale offered one, two, and 12-year maturities while the negotiated deal will offer three- to 11-year maturities. The budget package limited the financing to 12 years and required level principal repayment.

Bank of America Merrill Lynch won the auctions for the one-year and 12-year maturities in the deal and JPMorgan won the two-year maturity.

The 12-year series was won with a true interest cost bid of 3.949%. It came with a 5% coupon and paid a yield of 3.78%, 166 basis points over the triple-A benchmark of 2.12% and 76 basis points over the triple-B benchmark of 3.02%. The state’s 12-year had been trading in the secondary market most recently at a 163 bp spread, according to MMD.

The cover bid came from Goldman Sachs with a TIC of 3.983%. Nine bids came from Bank of America, Goldman, Wells Fargo Bank, Morgan Stanley, RBC Capital Markets, JPMorgan, Barclays, Jefferies, and Citi. The high bid was 4.0328%, according to data provided by sources.

The one-year landed at a 1.64% yield and true interest cost, a spread of 70 bp to the comparable AAA and 22 bp over the comparable BBB benchmark. The state’s one-year had most recently been trading at a 100bp spread to the AAA. The TICs ranged from 1.641% to 2.291% with JPMorgan submitting the cover bid for 1.657%. The high bid was 2.29%.

The two-year yield landed at 1.7%, a 70 basis point spread to the AAA and a 13 basis point spread to the BBB. The state’s two-year bond had been trading at a 125 bp spread to the AAA. JPMorgan won the bidding with a 1.74% TIC. Wells Fargo submitted the cover bid with a TIC of 1.812%. The high bid among nine was 2.511%.

Banks were especially interested in the short-term paper given its yield, short-term risk, and client demand, market sources said.

Illinois paid a 200 basis point spread on the 10-year in its last GO sale for $480 million in November 2016. It saw spreads of 193 basis points on a $1.3 billion GO refunding in an October 2016 sale and 185 basis point spread on a $550 million June 2016 sale.

Spreads have fluctuated depending on fiscal developments. They hit an all-time peak of 335 on June 8 after an adverse court ruling on Medicaid payments. The spreads rebounded and hovered between 273 and 292 basis points until July after the budget passed when they dropped to about 200. They had further narrowed leading up to the sale.

PFM Financial Advisors and Public Resources Advisory Group advised the state. Six firms -- Barclays Capital, Bank of America Merrill Lynch, Citi, JP Morgan, Loop Capital Markets, and Siebert Cisneros Shank & Co.-- are senior managers on the coming $4.5 billion negotiated deal.

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Primary bond market Government finance Sell side General obligation bonds State of Illinois Illinois