Alan Schankel of Janney Capital Markets expects "robust" retail demand to compliment strong institutional demand on Illinois GOs
"It's perfect timing for Illinois even though they don't have their budget done," said Alan Schankel of Janney Capital Markets.

CHICAGO – Illinois returns to the market in January with a $480 million bond deal after a 20-month absence during which its ratings fell and its unpaid bill backlog skyrocketed, and with a state budget six months overdue.

The state will take competitive bids on the general obligation bonds Jan. 14. State law requires Illinois to sell its first deal of the calendar or fiscal year competitively.

Proceeds will pay for ongoing capital projects.

While Republican Gov. Bruce Rauner and the General Assembly's Democratic majorities remain stuck in an impasse over a fiscal 2016 operating budget, Rauner did sign capital appropriations for the year that grant authority to spend the bond proceeds.

"Road construction and transit improvements are key factors in growing the Illinois economy, which is why Illinois is planning a bond sale in January," Rauner spokeswoman Catherine Kelly said. "There was no change in our general obligation bond ratings from the three major ratings agencies, but they did highlight the need for long-term structural reforms to improve our fiscal outlook."

While the state's fiscal profile has deteriorated, its timing is good and the deal should benefit from the need for reinvestment after Jan. 1 redemptions, investor hunger for yield, and a dearth of issuance, says Alan Schankel, a managing director in the municipal bond strategy and research department of Janney Capital Markets.

"It's perfect timing for Illinois even though they don't have their budget done," Schankel said. "The state could have the wind at its back," he said, due to "market fundamentals" and its extra yield.

Investors may also look favorably on the state's strong general obligation protections with debt service covered by a continuing appropriation and laws passed to fix appropriation snags that had impacted Chicago's motor fuel bonds and the Metropolitan Pier & Exposition Authority's debt because of the budget impasse.

The state has paid steep penalties in sales over the last few years although they have fluctuated based on various fiscal developments and market conditions. They shrunk after the state's 2011 passage of a temporary income tax hike and the 2013 passage of pension reforms.

Spreads rose after the Illinois Supreme Court threw out the pension reforms in May 2014.

The state saw spreads to the Municipal Market Data top rated benchmark for 10-year paper of between 95 basis points to 110 basis points on its most recent sales in the spring of 2014.

By January, the spreads had narrowed to 140 basis point to 150 basis point range from the 170 basis point range they had reached in the summer of 2014 after the pension legislation was thrown out.

Spreads widened again this year hitting nearly 200 basis points and have hovered between 170 to 180 basis points since then, according to market participants.

The state's unpaid bill backlog has shot up from roughly $4 billion to nearly $8 billion due to the budget impasse and shrinking tax revenues after the partial expiration of the 2011 income tax hikes at the end of 2014. Its pension obligations have grown slightly to $112.9 billion in the last fiscal year from $111.2 billion a year earlier while the funded ratio improved modestly 40.9% from 39.3% a year earlier.

Since its last GO bond sale in May 2014, two rating agencies – Fitch Ratings and Moody's Investors Service -- have lowered the state's rating from A-minus and A3 respectively to BBB-plus and Baa1. Fitch assigns a stable outlook, Moody's a negative one. Both rating were affirmed this month, ahead of the new deal.

The state was already the lowest rated among its counterparts at the low-single-A level. The state has $27 billion of outstanding GOs.

Standard & Poor's last week affirmed its A-minus GO rating and assigned a negative outlook, after removing the rating from CreditWatch with negative implications where it was placed in May 2014 after the state Supreme Court pension ruling.

The move was significant as it its signals that the rating agency's patience with state leaders has not worn out.

"Although the budget impasse clearly signals a breakdown in the fiscal policymaking process, we are affirming the rating because in our view, it has not significantly impaired the state's ability or willingness to make debt payments," said Standard & Poor's analyst John Sugden. "The substance of the agreements reached will be more predictive of future credit quality than the timing of when they are reached."

Rauner is pushing for governance reforms that include limiting unions' collective bargaining powers with local governments, tort reforms, and term limits as part of a budget package.

Democrats oppose them.

Rauner has suggested a budget deal could be reached in the coming months although publicly the sides have made little headway.

The state's rating benefits from strong GO protections, flexibility in adjusting disbursements to manage cash flow, roughly $4 billion in non-general fund cash surpluses, and a diverse economy anchored by Chicago.

The state's bill backlog nearly hit $10 billion in 2012 but higher revenues following the temporary income tax hike allowed the state to reduce the backlog.

Market sources have said the state is pondering a receivables borrowing to bring down the backlog but state officials have not commented on that speculation.

The state's precarious cash situation illustrates the importance of the state's bond protections, Standard & Poor's noted.

Protections include monthly set-asides and deposits of 1/12th of the next principal payment and 1/6th of the next interest payment.

State law explicitly provides bondholders the remedy to sue the state to compel payment and the constitution includes a non-impairment provision that prohibits the General Assembly from impairing the obligations of a contract between the state and its bondholders.

Moody's, in affirming Illinois last week, said its Baa1 rating reflects a financial position that has weakened after tax cuts at the start of this year and an ongoing budget stalemate.

"Structural budget imbalance, accounts payable, and other fiscal metrics are back-tracking, despite a favorable economic climate, leaving the state more vulnerable to the next economic downturn, barring unexpectedly strong and swift corrective actions," Moody's added.

Fitch said its BBB-plus rating reflects the continued deterioration of the state's financial flexibility during its extended budget impasse."

"Once again, the state has displayed an unwillingness to address numerous fiscal challenges, which are now again increasing in magnitude as a result," Fitch wrote. "As the fiscal year progresses, fewer options remain for closing the gap on a current year basis, pushing the potential solutions into fiscal 2017."

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