CHICAGO - Illinois' poor reputation with investors cost it at least $80 million of additional interest costs on general obligation bonds sold between 2005 and 2010, according to a new academic report.

The report released Monday by the University of Illinois Institute for Government and Public Affairs' Fiscal Futures Project seeks to quantify the impact of the so-called Illinois "penalty" or "effect," of the interest rate premium demanded in excess of the assumed credit default risks.

The state, government watchdog groups, and analysts have sought in past reports to ascribe a cost to the state's credit deterioration. Some have examined the well-known added premium imposed for headline or reputational risks on top of assumed credit risks, but most have been limited to the impact on individual deals.

Reputational risks stemming from headlines about the state's longstanding pension and budgetary challenges translate into a premium of between seven and 21 basis points depending on maturities, the report found.

The state's five-year maturities carry a premium of 21 basis points, 10-year maturities a 12 basis point penalty, and its 20-year bonds a seven basis point penalty, according to the study.

"Our findings suggest that the investors in the municipal secondary markets demand a risk premium for Illinois general obligation debt that is greater than the financial, economic, and fiscal conditions warrant," the report's authors write.

The premium is "statistically and economically significant," according to the report - authored by Martin Luby of DePaul University and the University of Illinois Institute of Government and Public Affairs, and Tima Moldogaziev of the University of South Carolina.

"Once again, this is not an estimate of the total cost of Illinois' fiscal struggles as reflected in the bond markets but an estimate of the portion of this cost that we suggest is related to the decline in its fiscal reputation," it says.

After arriving at the calculation based on a review of secondary market trading, the report applied the penalty to new money issuance between 2005 and 2010.

Market participants who follow the state's credit said the report's estimated dollar amount for added borrowing costs is conservative because the period reviewed precedes the state's more pronounced credit deterioration within the A rating category as its pension woes mounted amid legislative gridlock on reforms.

The state dropped out of the double-A category into the single A category in 2009. Its GOs are currently the weakest among states at the A-minus level. Fitch Ratings and Moody's Investors Service assign a negative outlook while Standard & Poor's assigned a developing outlook after the passage of a sweeping reform package in December.

Any positive credit movement awaits the outcome of a legal challenge mounted against the reforms and an explanation of how Illinois will deal with an expiring income tax hike. Without action to replace the expiring tax, the state faces a $3 billion deficit.

The state's structural budget pressures are underscored by a more than $5 billion backlog of bills expected to carry over into fiscal 2015.

The report suggests that some of risk premium is due to investor flight from Illinois bonds due to concerns related to its budgetary politics.

"The only way to change investors' minds towards Illinois debt is to get the state's fiscal house in order," the report's authors write.

Gov. Pat Quinn's administration did not have a comment on the report.

While the report didn't look past 2010, it noted the reported impact of the pension reforms on more recent state bond sales including an estimated $20 million of savings on the state's December sale compared to a similar April 2013 issue.

"On the other hand, the pending legal challenges to the pension reform law show the precariousness of such financial benefits. These legal challenges, if fully or partially upheld, likely will result in greater interest costs due to both the state's actual default risk increasing and its fiscal reputation declining," the report cautioned.

"Additional fiscal improvements in concert with the legal implementation of the pension reform law could raise Illinois' fiscal reputation in line with California, which would likely produce significant financial benefits resulting from lower interest costs on future state bond issues," the report said.

Illinois put a price tag of $60 million on the savings it believes it captured on its sale of $1 billion of GOs in February due to improved market perception after passing its pension overhaul.

Though its rating was not changed, the state saw its spreads narrow from more than 160 basis points on the 10-year maturity in a similar deal sold last June to about 129 basis points last month.

Luby said the report only begins to touch on the added costs of the Illinois "effect" because it did not take into account the extra costs imposed on local governments, universities, and other borrowers in Illinois, especially ones with exposure to state appropriations and delayed state aid payments.

Luby said the report's results also support the idea that risk premiums are demanded of the state in other types of transactions with vendors and suppliers. "One could speculate that such additional compensation could be many times as high as the reputational risk premium on the state's debt as estimated in the analysis," the report says.

To reach their conclusions, Luby and Moldogaziev collected data on all fixed rate state general obligation bonds sold in the primary market between 2005 through 2010 and followed these bonds in the secondary market tracking their market prices.

They factored in various controls that can impact prices such as the size of a bond, volume, market conditions, ratings, and economic factors. They also factored in the interest rate penalty tacked on to state bonds because their interest lacks an exemption from state taxes. They arrived at the 7 to 21 basis point differential on Illinois bonds and then applied it $10.4 billion of borrowing conducted over the five year period.

Luby said the goal of the report is to underscore for policy makers and the public the cost of the state's ongoing fiscal challenges and benefits of shoring up its fiscal foundation beyond pension reform.

The Quinn administration in June put a $130 million price tag on the added interest rates imposed on a $1.3 billion GO sale due to its credit deterioration in recent years.

The state was hit with fresh downgrades after lawmakers ended their spring session without acting to rein in pension costs. A 10-year maturity yielded 164 basis points over the Municipal Market Data benchmark, compared to 141 basis points in an April sale prior to the new downgrades.

The Civic Federation of Chicago last April said the state appeared to pay roughly $20.6 million more on its $450 million of tax-exempt bonds issued that month when held up next to California which at the time carried a similarly low rating.

In 2010, the federation published a comparative analysis of the added costs of borrowing on $9.6 billion in bonds issued between September 2009 and July 2010. It estimated the state may have paid as much as $551 million in extra costs due to its deteriorating rating.

The new report cites another study released last year that examined the state's borrowing penalties based on default risks. It found the state's weakened fiscal condition and battered ratings translate into steep borrowing penalties for taxpayers even though there's little risk of default given the state's stringent GO statutes that put it before most other debts.

That study was authored by Marc Joffe, principal consultant with Public Sector Credit Solutions, and commissioned, funded, and published by The Mercatus Center at George Mason University.

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