Muni analysts unfazed by legal challenge to Illinois bonds
Municipal market analysts are brushing off the efforts of a New York hedge fund and conservative think-tank to invalidate $14.3 billion of outstanding Illinois debt as a legal long shot that even if successful would likely draw state support to make bondholders whole.
“We will limit our discussion to the justification behind this lawsuit and quite frankly, we do not think there is any,” Citi’s Vikram Rai and Jack Muller wrote of the legal arguments in a “Global Municipals Flash” report after the firm was “inundated” with calls from clients worried about the impact of the litigation filed Monday.
“Even in the hypothetical situation that the debt is ultimately invalidated (which is extremely unlikely), what will it mean for the GO bond holders? The state will not want to pay zero to the bond holders as it was never their intent to harm the investors,” Rai and Muller wrote. “They are more likely to want to make the bond holders whole…thus, even in this unlikely scenario, the net impact on the market is likely insignificant.”
Illinois Policy Institute head John Tillman, acting as a taxpayer, and Warlander Asset Management LP, which holds $25 million of Illinois debt, filed the taxpayer/bondholder litigation Monday. They are asking the court to allow them to file a taxpayer lawsuit against the state to halt further repayment of 2003 and 2017 bonds they argue violate the state constitution.
About $14.3 billion of principal is owed on the $10 billion 2003 pension obligation bond issue and $6 billion of general obligation debt in two issues to pay down the state’s bill backlog.
Market participants appear skeptical of the legal arguments given the broad powers and limited rules guiding state issuance and the multiple layers of legal review.
“From all appearances it’s just a crank lawsuit,” said Matt Fabian, partner at Municipal Market Analytics. “Even if these guys do win, which seems unlikely, the state is going to do right by bondholders. Concerns over invalidation are really only a problem when it’s the borrower making the claim. It’s very unlikely to change demand for state bonds.”
Fabian said it’s a big leap to believe that the layers of legal review from bond counsel and underwriters’ counsel to the state attorney general failed in their jobs.
But the negative headlines did spark some widening of spreads and if the lawsuit is not resolved in the state’s favor quickly or it drags on, some warn the filing could add some uncertainty to the value of Illinois’ general obligation paper given the state’s weak ratings — with two at the lowest investment grade level — and its heightened susceptibility to headline risk.
“While the tactic of attempting to repudiate bonds or contractual obligations is not unprecedented, they tend to occur during bankruptcy or restructuring, such as Puerto Rico earlier this year or when Detroit sought to invalidate” its pension certificates, Janney Investment Strategy Group wrote in its Daily Fix report Wednesday.
While the state “is not attempting to reject its payment obligations,” the suit’s focus on interpretation of legal documents “introduces uncertainty until sorted out in court and shows aggressive stances not typically seen in munis,” Janney added.
Lawsuits, wherever one stands on its merits, can’t just be dismissed as meritless because there is the potential to “cause erosion in pricing stability of a security,” and “if that happens then it’s done its damage, whether it’s legitimate or not,” said Richard Ciccarone, president of Merritt Research Services LLC. “You want this done quickly because if it lingers it has the potential for more serious damage.”
The litigation also highlights the evolving market views of GO credit quality following challenges in Detroit and now Puerto Rico’s bankruptcy case and is likely to fuel the idea that recent PR legal developments have emboldened investors, market participants said.
IHS Markit strategist Ed Lee observed trades about 12 basis points wider on Tuesday while a taxable bond from the 2003 deal being challenged traded 25 bps wider.
Municipal Market Data set the state’s 10-year bond spread to its AAA benchmark at 159 bps compared to the 139 bp spread it had been around last month. “It’s generally a very quiet market this week so I would say it's because of this headline risk,” MMD-Refinitiv strategist senior market strategist Daniel Berger said.
Illinois spreads shrunk in May with the state’s 10-year ending the month at a 139 basis point spread compared to 178 bps where it opened. That’s due to both the market’s opinion that the state’s ratings will hold steady for now and marketwide steep demand for high-yielding paper.
“For now, we do not anticipate a material impact on Illinois GO bonds as a result of this lawsuit. While the bonds could cheapen marginally in light trading activity as the market absorbs this headline, this weakness is likely to be temporary,” Citi wrote. “That being said, as we have noted, we believe that Illinois GO spreads are tight relative to their fundamentals and thus at these levels, have more downside than upside.”
The state has bill backlog, pension buyout, and capital borrowing needs for the current fiscal year and the new $45 billion capital budget relies on billions in new borrowing, but nothing is imminent, finance officials said.
While the state’s trading value was initially hurt, spread movement this holiday week can’t necessarily be trusted, said Howard Cure, Director of municipal bond credit research for Evercore Wealth Management.
“This is a tough week to draw conclusions from so let’s wait a couple weeks and see how this plays out. If they were issuing right now they might pay a penalty,” he said, adding that he too is skeptical of the case’s legal merits and like others believes the state — to avoid rating agency and investor fallout — would take some action in support of bondholders should the plaintiffs succeed.
The complaint equates the transactions to deficit financings that it argues violated state rules that link issuance to a “specific purpose” as well as requirements under the state’s balanced budget act. The purpose of the 2017 backlog bonds “was to pay various unspecified, unrelated bills that had gone unpaid in fiscal years 2016 and 2017 due to the state’s lack of funding. The debt was not incurred for a ‘specific purpose,’ … but to pay past-due operating expenses,” argues the lawsuit.
About $8.3 billion of the taxable 2003 pension bonds were loaned to the pension system to bring down the unfunded liability, with about $2.7 billion going to cover contributions owed over two fiscal years, a form of deficit financing. “Using bond money to cover general operating expenses or to speculate in the market in hopes of turning a profit is not a qualifying ‘specific purpose,’” the lawsuit argues.
Market participants counter that the definition of special purpose is vague and so the state can argue it honored the rules with a broad outline of the spending plans. The constitution also requires that repayment is outlined and both carried a GO pledge which allows for the general fund and other non-general fund accounts to be tapped for debt service.
“The language in the Illinois Constitution allows debt to be incurred as long as the law details the specific purpose of the debt and how it will be repaid. Similarly, the general funds can be used for a wide array of purposes including debt repayment and it is difficult to prove that proceeds from the GO debt were used to fund operating expenses,” Citi wrote.
The Democratic office holders named in the lawsuit, Gov. J.B. Pritzker, Comptroller Susana Mendoza and Treasurer Michael Frerichs, hit back hard pointing to the IPI’s past attacks on state finances and its connections to former Gov. Bruce Rauner, a Republican whose feud with the legislature’s Democratic majority led to a two-year budget impasse.
“This is simply a new tactic from the extreme right to interfere in capital markets. We’re done with the far right’s dangerous financial games to pull Illinois underwater. We saw this repeatedly under Bruce Rauner, who funded and executed on John Tillman’s pathological focus to drive Illinois into bankruptcy,” the administration said.
Rauner “was an agent of chaos and this appears to be more of the same,” Fabian said.
The Puerto Rico Oversight Board in Puerto Rico's Title III case earlier this year moved to invalidate $6 billion of GOs on the argument that the commonwealth had exceeded its constitutional debt limit, and, contrary to the constitution, used proceeds for deficit spending. Some hedge funds support the board's effort. The First Circuit Court of Appeals recently upheld a lower court ruling that the commonwealth may, but is not required, to continue paying some special revenue-backed bonds, a ruling that runs counter to the long-held position that such debt was insulated during bankruptcy proceedings.
Direct comparisons to the lawsuit can’t be made especially given that Illinois opposes it, but market participants say the developments along with new players in the market may be contributing to actions previously unseen before.
“Some clients have openly questioned the ethical motivation behind the lawsuit and wondered if the recent surprise ruling by the First Circuit Court of Appeals has incentivized opportunistic investors to try their luck in the courts challenging other varieties of debt,” Citi wrote in its report.
“The municipal world is changing as hedge fund and other corporate style parties have come into the business after the financial crisis opened the door for higher yielding parties and they bring with them the concepts of the corporate market so things that might not have been challenged in the past are being challenged,” Ciccarone said. “It’s new lawyers, new bankers, new investors, and new expectations where they are not accepting the customs of the municipal market.”
Several rating agencies said they would follow the case but had no additional comment.