CHICAGO – The end of a two-year-old budget logjam drove a sharp narrowing of Illinois’ spread penalties last week as the market looked favorably on passage of a spending plan with $5 billion in tax hikes.
“So far, the market’s reaction to the budget compromise has been swift and substantial,” Triet Nguyen, a managing director at NewOak Capital LLC, wrote Friday in the firm’s publication MuniCredit Insights.
Illinois isn't out of the credit woods, as the one-year budget doesn’t tackle bigger structural issues and the state could still see at least one of its ratings cut to junk. Moody’s Investors Service put the state’s Baa3 rating on review for a downgrade last week over implementation risks of the budget package and lack of concrete measures to tackle a $126.5 billion pension tab or to rein in a future buildup of unpaid bills.
The first trading rally came Wednesday after the Democratic-led Senate followed the House in passing a budget package and then succeeded in overriding Gov. Bruce Rauner’s immediate veto. Spreads narrowed by 40 to 55 basis points in general.
The second came Friday after the Democratic-led House finished the job by narrowly overriding Rauner with the help of 10 Republicans who broke ranks with the GOP. Spreads again narrowed from 13 basis points on the 10-year to as much as 20 to 40 basis point on other maturities.
“The declining spreads are breathtaking,” said Daniel Berger, a strategist at Municipal Market Data.
Illinois’ 10-year spread to the MMD’s top-rated benchmark began last Monday at 278 basis points, when only the House had passed a budget and it was unclear whether the Senate could muster sufficient votes to pass the plan or override a veto.
On Wednesday, after the Senate action, the 10-year narrowed to 218 basis points and on Friday after the House’s final action on the override ended the impasse, the spread narrowed again, landing at 205 bp, according to data from MMD.
The 10-year began the year around a 235 bp spread, hit a prior low in March and April of 215 bp, and then steadily rose hitting an all-time peak of 335 bp on June 8 after an adverse court ruling on Medicaid payments. It had since had hovered between 273 and 292 bp.
A 2023 maturity sold Friday at 3.43%, a spread of 198 bp, which was about 20 basis points narrower than a day earlier, Berger said.
IHS Markit's Edward Lee said the 30 to 40 bp narrowing it observed in trades Friday came on top of the Wednesday improvement. On Friday, a 2033 maturity with a 5.5% coupon traded at 4.34%, a spread of 180 bp that was 30 to 40 basis points better than prior levels.
Fitch Ratings and S&P Global Ratings offered initial, positive comments that the budget package makes progress in the state’s efforts to stabilize its finances. Both have the state on a watch. Fitch rates the state BBB and S&P BBB-minus.
“Whether or not Moody's does anything, I think the spread should be around 200 anyway, since the budget really didn't address many of the structural issues. The prospect of more supply is probably also a factor,” Nguyen said of the 10-year.
The package paves the way for at least $3 billion of general obligation borrowing with an up to 12 maturity to help pay down a nearly $15 billion backlog.
The budget raises taxes and authorizes bonds to pay down the state's bill backlog, but it doesn’t include measures that trim unfunded liabilities or raise pension funding or deal with local property taxes as Rauner has sought, Nguyen wrote in the publication Friday.
“For that reason, Illinois GO spreads probably don’t have much more room to tighten from here, and a downgrade by one of the rating agencies (probably Moody’s) could still happen. Downstream credits within the Illinois ‘cluster,’ such as City of Chicago or CPS, may still have room to rally further, depending on what kind of specific financial relief they may get from the new budget agreement,” he added.