Illinois Reaps Benefit of Market Timing
CHICAGO – Illinois paid a steeper penalty to borrow Thursday after a fresh round of downgrades but a municipal market offering historically low yields helped disguise the spreads.
A market flush with buyers and a dearth of yield staved off more severe damage for the $550 million competitive general obligation offering from a state gushing red ink after almost a year without a budget in place.
Municipal professionals said the outcome indicates that the state of the bond market and belief in the strength of Illinois' GO bond statutes outweighed its morass of fiscal woes and political gridlock.
"People showed up to buy," and the bonds sold at relatively expected levels, said Brian Battle, director of trading at Performance Trust Capital Partners. "That is a good sign in the confidence investors have in Illinois' ability to pay."
Illinois paid the highest yield penalty over the triple-A curve imposed on a sovereign state, one that's risen since it last sold bonds in January.
But the deal captured a record low true interest cost as widening spreads were more than outweighed by lower overall yields in the market.
The yields also landed on par to slightly over recent secondary trading spreads as investors shrugged off negative headlines over a record budget impasse and worries over its sinking credit rating.
Bank of America Merrill Lynch submitted the lowest bid, offering the state a true interest cost of 3.7425%.
Sources said Citi offered the cover bid with a TIC of 3.776%. Bank of America had a balance remaining of about $155 million to $160 million late in the day, which one source described as a “good sale result and underwriting.”
"This is the lowest TIC the state has ever received for a general obligation bond sale with a similar final maturity," Gov. Bruce Rauner's administration said in a statement. The TIC on the state's January sale landed at 3.99%, down from 4.08% on its last sale in 2014.
The state's spreads have risen but prevailing rates have fallen.
The state received 10 bids with other bids coming from RBC Capital Markets, Jefferies, Wells Fargo Securities, Goldman Sachs, JP Morgan, Morgan Stanley, PNC Capital Markets, Barclays Capital, and Citi. The state received nine bids on its January competitive sale.
The deal's 10-year maturity priced at a yield of 3.32%, 185 basis points over the Municipal Market Data top-rated benchmark and 111 basis points over the BBB benchmark. Recent trading on the state's 10 year has ranged from 170 to 185 basis points.
The state last week was downgraded one notch to Baa2 by Moody's Investors Service and one notch to BBB-plus by Standard & Poor's. Both assign a negative outlook. Fitch Ratings affirmed its BBB-plus rating but put the state on negative watch.
The deal's long, 25-year bond priced at a yield of 4.11%, 199 basis points over the AAA based on the 5% coupon scale and 128 basis points over the BBB. The maturity carried a 4% coupon bringing the spread to the AAA down to 172 basis points. The deal offered coupons between 3.5% and 5%.
The state's 10-year maturity in January yielded of 3.33%, 155 basis points over MMD's AAA while the long 25 year bond paid a yield of 4.27%, 161 basis points over the top rating benchmark. The state priced at spreads between 95 to 110 basis points on deals in 2014 before the Illinois Supreme Court overturned state pension reforms and the budget impasse took hold.
"The only obligor followed by MMD with a higher spread is the (Caa3/CC/CC) Commonwealth of Puerto Rico," MMD said.
"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," Rauner spokeswoman Catherine Kelly said in a statement.
Market participants offered a different picture.
"I don't think they would have gotten that spread so narrow in a different bond market with less favorable conditions," said Richard Ciccarone, president at Merritt Research Services. The market is flush with cash and an infusion of global interest against a backdrop of record low interest rates that have investors in search of income opportunities.
"For investors looking for yield this is relatively attractive," Ciccarone said, adding that the market gives significant credence to the breadth of the state's economy and the constitutional and statutory protections offered to general obligation holders.
Battle said in addition to strong state GO protections, the deal benefitted from the hunt for yield and a raging Treasury rally but added "I think for all the headlines over Illinois and Chicago and that Illinois is operating without a budget, Illinois pulled off a great sale."
But he added that the rate levels simply "empower" an issuer to "keep doing what they do."
The pricing also drives home the distinction the market places on the state's ability to pay its debt compared to Chicago or Chicago Public Schools. both of which have seen much more bruising spreads, Battle said. The state has greater flexibility to adjust spending and revenues and to push expenses off on to local government units.
Blackrock spurred debate over the market's role as a disciplinarian when strategists there last week suggested that the market might consider denying the state access as a penalty for its gridlock that has allowed fiscal wounds to fester. The state's bill backlog is approaching $8 billion and it's saddled with $112 billion of unfunded pension obligations.
Battle said he sees the decision to invest as a personal one based on individual investment policies. "If you are going to buy Illinois then you are going bear the consequences," he said.
Just ahead of the sale, Illinois received some good news to share with investors in a supplement to its offering documents. Deutsche Bank, one of five counterparties on swaps tied to $600 million of floating-rate debt, agreed to lower the rating threshold at which termination events would occur by two notches, to BB from S&P and Ba2 from Moody's.
The state's five swaps are negatively valued at $155 million and Deutsche Bank accounts for $99 million of that tab. Termination triggers on the other swaps remain at the BBB-minus and Baa3 rating level. The state is one notch away from triggering the defaults due to its current Moody's rating.
The state will spend much of the proceeds on road and transit projects as well as state capital facilities but lacks the ability to fully put the funds to work unless lawmakers agree on a proposed stopgap budget that buys more time for the General Assembly's Democratic majority and the Republican governor to resolve their budget differences.