CHICAGO – Illinois spreads widened after Thursday's two downgrades, and investor confidence is waning that the state will soon resolve its budget deadlock.

The state's troubles may be opportunities for some investors.

The appeal and value of Illinois bonds – which now has two ratings at the lowest investment grade level -- depends on their place on the yield curve, investor tolerance for risk, and investment rules.

“We maintain that passage of the Illinois budget before July 1st is still a possibility though we must admit that we are rapidly losing hope,” says a Citi Research report authored by Vikram Rai, Jack Muller, and Loretta Bu.

While the new downgrades and the threat of losing investment-grade status may help “political will,” Citi said “If we do not see a budget by July 1st, 2017, the outlook is decidedly bleak” and the state could potentially end up in a downward credit spiral given its fiscal challenges, the team wrote.

Moody’s Investors Service and S&P Global Ratings whacked the state’s ratings on Thursday for lawmakers’ failure to resolve a two-year-old budget deadlock before adjourning their session May 31.

Both dropped the state’s $26 billion of general obligation paper one notch to the lowest investment grade level of Baa3/BBB-minus leaving its appropriation bonds in junk territory. S&P made clear the state faces another hit if it state enters a new fiscal year July without a sound budget plan.

Citi said in the Thursday report it prefers intermediate paper in the five to seven range vs. longer dated paper given that there’s no fix in sight for the state’s increasing pension liabilities. That makes the case for a steeper rather than a flatter yield curve that could put upward pressure on long dated yields.

“We expect intermediate GOs to reverse some of their recent underperformance as we see more value in terms of spreads towards the front and intermediate sectors, in our view,” Citi said.

As investors digested the news about the downgrades, Illinois spreads felt the impact.

Citi said long-dated GOs were 20 basis points wider Thursday and intermediate GOs had widened as much as 35 bp to Municipal Market Data’s top-rated benchmark.

Brian Battle, director of trading at Performance Trust Capital Partners, said the state’s mid-term GOs at mid-day Friday were trading at a 260 bp to 270 bp spread compared to 250 bp Thursday.

Chris Taddoni, a vice president at IHS Markit, said data he reviewed showed the state’s 10-year paper was trading about 10 to 20 basis point wider than a month ago.

“These downgrades are no surprise to market participants who have seen spreads on IL GO bonds widen during the past few months,” MMD’s Daniel Berger wrote in a market report.

Illinois’ 10 year began March at a 213bp spread, jumping to 220 bp in early April and rose to 231 bp by the end of April. It continued inching up through May hitting 240bp on May 31 and then 258 on June 1, according to MMD data.

With the threat of a junk rating looming, Citi said for high-grade investors it advocates “a cautious stance on GOs because a drop to speculative grade could cause a rush to the exits for holders with IG-only mandate restrictions.”

Illinois could still be held by investment grade funds if only one rating falls to a speculative grade.

For high-yield buyers, Illinois presents a opportunity. “We believe the spreads are attractive given that the GO bonds trade about 150 – 195 basis points cheap to the BBB MMD index,” Citi added.

Other investors say they also see opportunities although they are losing confidence in the state’s ability to stave off more downgrades by solving its budget mess before the new fiscal year.

“It is our firm belief that there will not be an enacted budget for fiscal 2018. We also project that it is highly likely 2 of 3 agencies downgrade Illinois into junk status in 2017 which will cause their debt to exit investment grade rated indexes,” said Mark Paris, chief investment officer at Invesco Municipal Funds.

“The market has yet to react to the downgrade given that it has been expected for some time, and we are sitting tight,” Paris said.

“Should there be imbalances in the supply/demand that results in the bonds trading cheaper than they should, we would see this as an opportunity to marginally add to our exposure,” Paris added.

Paris doesn’t see a broader market impact. “The issues affecting Illinois are very specific to the political climate of the state, but we don’t believe it is a harbinger of the future for other states,” Paris said.

The harm of a potential “downward credit spiral” and impact on holdings was raised by multiple buyside representatives and analysts Friday.

A one notch rating cut to the Baa3/BBB-minus level “is a negative event, but the next one-notch step, should it occur, is to below investment grade, aka junk or high yield, which could accelerate the downward spiral of creditworthiness and bond valuations” because it “could trigger selling pressure and higher yields and credit spreads,” wrote Alan Schankel, municipal strategist in the investment strategist group at Janney Capital Markets.

“Should the state fail to enact a budget by month end, further downgrades and bond price declines are likely. Even if political agreement is reached, producing revenue and spending measures which set the state on the road to fiscal balance, it will take years to recover fiscal balance, limiting the likelihood and magnitude of rating improvements in coming years,” Schankel added.

Also on Friday, state comptroller Susana Mendoza and Treasurer Michael Frerichs highlighted that even the state can not invest in its own bonds at their current rating. State rules limit investments to products rated at an A-minus level or above. The state’s rating for some time has been below the threshold.

“This is the lowest Illinois’ bonds have been rated in the state’s 44-year history of bond ratings. The Fiscal Year ends June 30 and the agencies warn more downgrades could happen then if the impasse continues,” the two said in a statement.

--Chip Barnett contributed to this story.

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