Alan Schankel of Janney Capital markets

CHICAGO —Investors endorsed Illinois’ newly adopted pension restructuring, trading the state’s paper at tighter spreads Wednesday, while rating agencies called the overhaul a positive step but said they want to dig into the actuarial details before offering a full assessment.

“We are seeing a positive reaction today,” Jon Barasch, director, municipal evaluations at Interactive Data Corp, said Wednesday. 

Illinois lawmakers ended two years of political gridlock on Tuesday when they passed in a bipartisan vote a plan backers say will trim $160 million off scheduled payments to the system, about $21 billion off $100.5 billion of unfunded liabilities, and $1.5 billion off upcoming annual state contributions.

Gov. Pat Quinn said he would sign the legislation “promptly” after it hits his desk but labor leaders plan to quickly challenge the constitutionality of the changes.

The positive impact on the value of Illinois paper also trickled down to Chicago, which faces its own near-term and long-term pension challenges. The city and school district have been clamoring for reforms and is banking on lawmakers in the coming months applying some form of the state-level changes to local governments systems.

Spreads were tighter Wednesday for both Chicago and Illinois general obligation paper by 10 to 35 basis points, with the Chicago Board of Education also seeing improvement, according to Interactive Data.

Other Illinois-based credits including Lake County, the Chicago suburb of Schaumburg, and Springfield electric revenue bonds also were trading at improved spreads. Illinois credits –especially ones reliant on the state for aid – have long traded at a penalty simply for being located in the troubled confines of Illinois.

Taxable Illinois GOs were the most heavily traded early Wednesday and several other traders said they were seeing even stronger improvements later in the day.

Municipal Market Data in its closing market commentary Wednesday reported active trading on short to intermediate Illinois GO paper.  Five year Illinois paper traded at 2.89% and 2.82%, 143 and 136 basis points over the MMD benchmark, and 10 year maturities were at 4.28% and 4.23%, 163 and 158 basis points over MMD. “These trades seemed 10 to 15 basis points stronger than activity seen in this range over the past week,” the report read.

Even with a union challenge looming, the vote alone provides a boost to investor attitudes.

“Illinois spreads have been very wide so I would expect to see some improvement now,” said Alan Schankel, managing director at Janney Capital Markets. “The vote shows that they are finally willing to take the steps needed and approve reforms in a bipartisan vote. That says to investors that they recognize how important an issue pension reform is.”

Several rating agencies agreed, but the impact on the state’s GO credit ratings and outlooks awaits a deeper assessment after the state sends actuarially based data to support their contention on the savings. The legal challenge unions will mount also poses an obstacle to positive credit action.

The three major rating agencies rate Illinois at the low-single-A level, the weakest among states, and all assign a negative outlook. Reports over the summer warned that without action on a pension solution the state could fall further, down to the triple-B category.

“The legislature’s action in and of itself appears positive. It seems to bring to a close a period of political paralysis,” said Moody’s Investors Service’s lead Illinois analyst Edward “Ted” Hampton. “At first blush the reform legislation appears significant. These appear to be substantial changes affecting the unfunded actuarially accrued liabilities.”

However, the agency needs “the actuarial information from the state to do our analysis in order to assess what these reforms will mean for the accrued liability and the state’s future contribution requirements,” he said. “Past reforms approved in Illinois and elsewhere have not always delivered on all the reductions of unfunded liabilities that were promised.”

Fitch in a special commentary called the action a positive, but it too is awaiting actuarial data.

“Fitch has stated that pension reform that enhances the funding levels of the pension systems and controls the growing impact of pension payments on the budget is necessary to stabilize the credit, and will analyze the reform to determine the extent to which it does so,” lead Illinois analyst Karen Krop wrote.

“Further, legal protection of pension benefits is particularly strong in Illinois and Fitch believes legal challenge to the reform is likely,” Fitch added.

While the state’s pension strains drove its most recent downgrades, Illinois faces other financial challenges that the pension overhaul may ease, but won’t solve, such as a liquidity struggle underscored by a current bill backlog of $5.4 billion.

“In addition to action on pensions, maintenance of the rating will require timely action on a more permanent budget solution to the structural mismatch between spending and revenues in advance of the expiration of temporary tax increases” beginning in fiscal 2015, Fitch noted.

The state will see the first direct impact of the legislation’s passage in the primary market next week when it sells $350 million of taxable GOs.

Municipal Market Data said last week Illinois has the widest state GO spread to the MMD benchmark of any state with bonds maturing in 2025 trading recently at a 175-basis-point spread.

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