CHICAGO – Illinois will move forward with $6 billion in general obligation borrowing authorized in the fiscal 2018 budget package to chip away at the state’s record $15 billion backlog of delinquent bills, Gov. Bruce Rauner announced Thursday.

The budget that took effect in July after the General Assembly’s Democratic leadership overrode the Republican governor’s vetoes with the help of some GOP members authorized the sale of $6 billion of GOs with level principal repayment over 12 years by Dec. 31.

After resisting pressure to move on the borrowing for two months, the governor directed his staff to initiate the borrowing to refinance the high interest paid on the backlog at lower GO rates to achieve state savings, his statement said.

Illinois Gov. Bruce Rauner
"It’s better to have Wall Street carry our debt than Main Street Illinois,” Gov. Bruce Rauner said Thursday.

“We’re choosing to exercise borrowing authority because it’s better to have Wall Street carry our debt than Main Street Illinois,” Rauner added.

Under the state’s Prompt Payment Act, most bills that are more than 90 days old accrue interest at 1% per month, or 12% annually, while bills from healthcare providers accrue at 9% after 30 days under the Illinois Insurance Code.

The administration had few additional details to provide on the sizing and timing of the borrowing.

Under state law, it must sell the first 25% of the deal competitively, complicating the issuance, according to market participants. The team could be drawn from existing rotating advisory, underwriting, and legal pools or the state could conduct a special request for proposals.

“We are still evaluating structure for the bonds and the composition of the deal team,” said Rauner spokesman Jason Schaumburg.

The state’s GOs are trading at around a 200 basis point spread over the Municipal Market Data’s top-rated benchmark. The 10-year benchmark was at 1.85% Thursday. Market participants said it’s difficult to pinpoint where rates would land because penalties could widen due to the size of the deal, so rates could top out at 4% to 6%.

“It’s definitely going to be fiscally prudent to get rid of what is effectively a credit card debt rate” and it’s “morally” the right thing to do given the state is so far behind on social services payments, said Brian Battle, director of trading at Performance Trust Capital Partners.

Multiple factors will influence the spread penalties. “Because the state is bringing so many bonds, the market is going to demand more spread to digest them, but they will have no problem getting the deal placed,” Battle said.

Supply has lagged so there will be demand, but fourth-quarter issuance can also be tricky with market fluctuations. The state’s position as a sub-sovereign credit that will offer richer yields because of its low ratings and persistent fiscal troubles should “attract international interest,” Battle added.

The need to sell a portion of the bonds under state rules competitively “complicates” the issuance, especially for underwriters bidding on the bonds, Battle said. Selling all the bonds in one, negotiated issue, given the deal’s size, is preferable because the price is set and the size offers secondary liquidity.

The budget package accounts for debt service payments on only $3 billion of borrowing in the form of a projected ending balance. The administration said it was identifying several hundred million dollars in possible cuts to cover the remainder needed.

Comptroller's office spokesman Abdon Pallasch said 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.

Rauner’s announcement makes clear he only reluctantly came around. Rauner had until Thursday refused to tap the authority, saying borrowing alone without a direct means to repay the bonds was not the answer.

He maintained his position amid growing pressure from Democratic lawmakers, and Comptroller Susana Mendoza and Treasurer Michael Frerichs, who are both Democrats. They argued that the refinancing would more swiftly pay off old debts to struggling social service providers while cutting interest costs that were accruing at $2 million daily.

Democrats’ arguments were bolstered by S&P Global Ratings’ commentary late last month that, given the state’s strained liquidity, it could ill afford to pass up the opportunity to lower its interest rate on the backlog.

“Refinancing a portion of the state's high interest bill backlog could offer a modest layer of potential cushion to its liquidity” and “to a limited degree, protect Illinois' credit quality to the downside,” S&P wrote.

Interest payments could reach between $6 billion and $8 billion over the next 12 years if the backlog is not paid down, according to a “rough estimate” in a report by the non-partisan Commission on Government Forecasting and Accountability. Interest on a $6 billion GO borrowing using a 12-year term would carry interests of about $1.76 billion to $2.54 billion, the report said.

Passage of the budget with $5 billion in new taxes staved off threatened cuts of the state's bond ratings to junk. S&P rates the state’s GOs BBB-minus with a stable outlook. Moody’s Investors Service rates them at Baa3 with a negative outlook, and Fitch Ratings assigns a BBB with a negative outlook.

In affirming the state in July, Moody’s said it anticipated at least a $3 billion issue. It raised concerns that the budget doesn’t include a “specific mechanism to contain future growth in accounts payable” which it’s concerned “risks increasing its bonded debt burden to achieve an only temporary reduction in its unpaid bills.”

The legislation amended the state’s General Obligation Bond Act to allow for the issuance of up to $6 billion of GOs as Income Tax Proceed Bonds to pay for expenses vouchered from general funds or state employees’ group health insurance costs incurred before July 1. The state could leverage several million in federal matching Medicare payments, further reducing the backlog.

The state paid yield penalties of between 185 bp and 200bp on its 10-year bonds in deals that sold in June, October, and November of 2016. Its spreads jumped as it neared the start of fiscal 2018 without a budget to about 273 bp to 292bp, hitting a high of 335 bp on June 8 after an adverse Medicaid court ruling.

Mendoza had warned before the budget’s passage that the state would fall $185 million short of what was needed to just meet core obligations in August even before accounting a judge’s order to begin paying nearly $600 million more a month toward Medicaid payors.

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