Illinois offers investors mixed messages ahead of $500 million deal

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CHICAGO – Illinois officials are trying to shake market skepticism about the state's credit by casting its fiscal health in a more positive light, even as offering documents lay out a starker assessment.

In a recorded investor presentation ahead of Wednesday's $500 million competitive general obligation sale, Gov. Bruce Rauner’s finance team highlights fiscal gains following adoption of income tax hikes and more recent positive fiscal news.

The modest gains are due in large part to measures opposed by Rauner, and the positive portrayal runs counter to the position he often strikes in public appearances to promote his policy initiatives. Rauner’s team made similarly positive statements ahead of a deal last year after a two-year budget impasse ended last year despite the governor’s veto.

Wednesday's sale comes as widening spreads reflect investors' concern about whether ongoing partisan bickering could trigger renewed gridlock that would drive the state's rating to junk.

“Recent positive developments by the state include passage of the fy 2018 budget, increases in projected revenues,” and passage of school funding overhaul as well as the reauthorization of business tax credits and a reduction in the state's unpaid bill backlog, state capital markets director Kelly Hutchinson told potential investors.

Illinois expects to end fiscal 2018 June 30 with the backlog down to $7.7 billion, which is “less than half of what it was at its peak in 2017,” Hutchinson said. The backlog hit a peak last November of more than $16.7 billion but has since been whittled down to $8.2 billion due to $6 billion in bond borrowing late last year. That borrowing yielded $6.5 billion in proceeds because of a premium structure and leveraged $2.2 billion of federal matching Medicaid dollars.

The backlog “may increase unless balanced budgets are enacted in the future,” warns the offering statement, which must present investors with a full fiscal picture and description of potential risks to prevent an issuer from running afoul of regulators.

“There can be no assurance that a general funds budget will be enacted for fiscal 2019 or in future fiscal years,” the offering statement says.

Putting the emphasis on the positive gains could help keep “more aggressive investors interested in Illinois paper,” said Richard Ciccarone, president of Merritt Research Services LLC.

“We would expect the state to remark about their positives while the analysts will then dwell on the negatives,” Ciccarone said, adding that in the end, the state’s spreads speak loudest and it’s not likely to see an appreciable, longer-term improvement in its fiscal position.

On Friday, the state’s 10-year GO bond was at a 210 basis point spread above Municipal Market Data’s AAA benchmark, up from 177 bp at the start of the year. Illinois saw a 170bp spread on its November sale.

State budget director Hans Zigmund highlights the state’s “inherent credit strengths” including its strong economic base, status as one of the largest states by population, improving employment base, and growing per capital income – data Rauner often portrays negatively in speeches attacking Democrats’ opposition to his economic proposals.

Rauner and the general media have also drawn attention to the state’s loss of population and businesses over the course of the budget stalemate.

Revenues are on the rise, Zigmund notes, with more than $4.5 billion in additional cash expected from the income tax hikes that lifted the personal rate to 4.95% from 3.75% and the corporate rate to 7% from 5.25%. Rauner vetoed the budget last summer because of the tax hikes but it was adopted after a handful of Republican lawmakers sided with majority Democrats to override the veto.

Current spending exceeds a projected $36.8 billion in revenue by about $600 million this fiscal year, but that’s expected to decline as one-time revenue sources tied to the bill backlog borrowing are accounted for in the general fund.

Deputy budget director Charlie Weikel notes some “key highpoints” in the state’s pension system including most recent annual investment returns of 10%, the lowering of assumed returns, and the state’s contributions that have accounted for between 74% and 89% of what would be an actuarially determined contribution.

In other words, the payments last year totaling $7.6 billion fell short of an actuarially determined contribution by 26%. The offering statement notes that the pension funds “have deteriorated dramatically” over the last 10 years.

Bondholders benefit from the state’s conservative $31 billion GO debt portfolio which is mostly fixed-rate with level principal, the pre-funding of debt service, and strong statutory protections offered bondholders who can sue to compel the state to make good on GOs. The state has about $12 billion in non-general fund accounts that can be tapped for repayment. All are highlighted by the administration and backed up by rating reports.

But the offering statement notes that legal remedies for bondholders could be delayed if the matter ever ended up in the court system.

Ahead of the sale, Fitch Ratings affirmed the state’s BBB rating and negative outlook, Moody’s Investors Service affirmed its Baa3 and negative outlook, and S&P Global Ratings affirmed its BBB-minus and stable outlook.

The offering statement warns any revision of the ratings could have “material adverse effect” on the bonds’ future market -- one more downgrade from S&P or Moody's would make Illinois debt junk.

Illinois’ five-year spreads are up 25 bp from its November 29 sale and its 25-year bond is up 35bp, MMD’s analysts team said in a report Monday.

“Illinois may have to be sold at even higher spreads this round for this upcoming issue to clear the market,” the report says.

The Illinois 10-year spread of 210 bp is significantly higher than the BBB benchmark spread of 84 bp, the 88 bp spread seen by single-A rated Connecticut, and the 75 bp spreads for single-A rated New Jersey, both states facing severe pension funding strains, MMD said. “This analysis highlights the market’s opinion that Connecticut is seen as a BBB rated credit while Illinois is not viewed as investment grade,” the report says.

Illinois will take bids on a $450 million series that matures from 2019 through 2043 with a 10-year par call. A second series $50 million matures from 2019 through 2028 and does not include a call. Investor calls were held last week and on Monday. Chapman and Cutler LLP and Pugh, Jones & Johnson PC are bond counsel and PFM Financial Advisors LLC is municipal advisor.

Proceeds will fund capital projects under the state’s capital plan to finance information technology projects, and pay cost of issuance of the bonds.

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