Illinois Losing Rally as State Fails to Fix Pension: Muni Credit
Investors in the $3.7 trillion municipal market assumed Illinois lawmakers would fix the worst-funded U.S. state pension system. The legislature’s latest failure is showing buyers the cost of inaction.
Legislators left Springfield, the capital, May 31 without mending underfunded retirement plans that they’ve neglected for two decades. Both Democratic-led chambers passed proposed bills in the first 10 days of May, spurring a 0.45 percentage point drop in the yield penalty on taxable Illinois pension bonds maturing in June 2033. That was the steepest monthly rally in at least three years, data compiled by Bloomberg show.
Richard Ciccarone at McDonnell Investment Management LLC and Bill Black at Invesco Ltd. (IVZ) said with a pension fix elusive, bond spreads for the lowest-rated state will rise. Fitch Ratings cut the state yesterday. The cost of protecting Illinois debt is the highest since April, according to data provider CMA, which is owned by McGraw Hill Financial and compiles prices quoted by dealers in the privately negotiated market.
“You had the house speaker, the senate president and the governor all working on the issue and not being able to reach some kind of compromise,” said Oakbrook Terrace, Illinois-based Black, whose company oversees $22.3 billion in munis. “That makes me worried about Illinois’s ability to do anything.”
Governor Pat Quinn, 64, a Democrat, said in January that the pension challenge “has confounded legislatures and governors for 70 years.” When lawmakers ended their 2012 session that month without a fix, Standard & Poor’s lowered the state to A-, four steps above junk, and said more cuts would follow if the systems weren’t improved. Another reduction from the New York-based company would give Illinois the lowest credit rating for a state since California in 2004.
The five Illinois pension systems are the worst-funded among U.S. states at about 43 percent, Bloomberg data show. The latest collapse of rescue efforts resulted from a standoff between House Speaker Michael Madigan and Senate President John Cullerton, Democrats who backed competing measures.
Madigan’s bill would have required retirees to accept diminished pension benefits, saving $187 billion over 30 years, he said. Cullerton called that approach unconstitutional and proposed a choice of pension or health-care reductions that would save an estimated $50 billion.
Quinn said he preferred the Madigan approach to resolving the liability, which grows $17 million daily.
“They were a long way apart going into this,” said Ciccarone, managing director at Oak Brook, Illinois-based McDonnell, which oversees $8 billion in munis. “They’ve moved another notch in the wrong direction, which justifies a bond downgrade and a slippage in bond prices.”
Legislators’ previous two failures to agree on the issue -- in January and August -- led to S&P downgrades. S&P, Moody’s Investors Service and Fitch have negative outlooks on the state. Fitch reduced its general-obligation rating to A-, joining S&P and Moody’s in giving Illinois their lowest grade among states.
Olayinka Fadahunsi, an S&P spokesman, referred to the company’s reports. David Jacobson at Moody’s said in an e-mail to “keep in mind” that Quinn can call back the legislature.
Even with the prospect of a rating cut, state law protects bondholders, giving the governor “no discretion to consider not paying debt service,” Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors, said in a report yesterday.
Illinois is one of seven states with the strongest legal provisions for paying debt service on its general obligations, according to a 2011 Fidelity Investments report.
Any rating cut and cheapening of the state’s bonds would offer a buying opportunity for investors holding the debt until maturity, Fabian said. Issuers from the state pay the highest yield penalty among the 19 tracked by Bloomberg.
Yesterday morning, investors demanded as much as 0.15 percentage point more to own the pension debt due in 2033, said Hardy Manges, head of muni trading at Mitsubishi UFJ Securities in New York.
It cost the annual equivalent of about $189,000 yesterday to protect $10 million of Illinois bonds for 10 years through credit-default swaps, the most since April 9, CMA data show.
While investors receive timely payments, Illinois faces about $6 billion in unpaid bills, Comptroller Judy Baar Topinka said last month. Lawmakers in April considered chipping away at the backlog with a $2.5 billion bond sale.
Quinn said in a statement yesterday that he plans to meet Cullerton and Madigan today to discuss a way to resolve the unfunded pension obligations. A special session requires a three-fifths vote to pass a measure, rather than a simple majority.
The Fitch downgrade is “no surprise,” Quinn said in the statement. “This will continue to happen until legislators pass a comprehensive pension reform bill and put it on my desk.”
With the missed opportunity, a video from the governor featuring “Squeezy the Pension Python,” a cartoon character that threatens to strangle the capitol building, will serve as the backdrop for the Illinois legislature. For investors and rating companies, it represents diminished creditworthiness. For residents, the snake squeezes out funds for essential services.
“Speaking as an investor, I’m disappointed,” said Black, a senior portfolio manager. “As an Illinois taxpayer and voter, I’m disappointed as well.”
Issuers from Massachusetts to Los Angeles are selling $5.6 billion of debt this week, up from $4.1 billion last week, Bloomberg data show. The increase comes after investors withdrew the most money from muni mutual funds in about a month.
At 2.17 percent, yields on benchmark 10-year munis are close to a 15-month high. The interest rate compares with 2.11 percent (USGG10YR) for similar-maturity Treasuries. The ratio of the yields, a gauge of relative value, is about 103 percent, close to the highest in a month. The greater the figure, the cheaper munis are compared with federal debt.
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