Illinois Trails California After Pension-Fix Bungle: Muni Credit

Democratic Governor Pat Quinn
Democratic Governor Pat Quinn has likened the $97 billion of unfunded liabilities to a python strangling the state’s finances. Photographer: Scott Eells/Bloomberg

Illinois is losing in the battle of lowest-rated U.S. states as its debt approaches the weakest in at least 18 years relative to California’s.

Lawmakers failed to repair the nation’s worst-funded pension system this month, leading Standard & Poor’s to downgrade Illinois and threaten more cuts. In contrast, California, with the same A- credit grade -- six steps below AAA -- is set for its first surplus in a decade and may earn a rating increase.

Investors have been voting with their wallets as Illinois plans to sell $500 million of general-obligations this week. Buyers demand about 0.82 percentage point of extra yield to own debt of Illinois issuers rather than California. That’s up about 50 percent in the past month and close to the highest since at least 1994, data compiled by Bloomberg show. For Robert Miller at Wells Capital Management and Chris Alwine at Vanguard Group Inc., Illinois bonds are still too expensive.

The state “should expect continued wide spreads if these problems aren’t addressed,” said Alwine, head of muni funds at Valley Forge, Pennsylvania-based Vanguard, which manages $106 billion of local bonds. “The market has to put more pressure on issuers in these types of situations.”

January Trigger

Even as investors favor riskier, higher-yielding debt amid the lowest muni yields in a generation, the case of Illinois shows there’s a limit to investor tolerance.

The extra yield on Illinois and its localities has grown since lawmakers ended their 2012 session Jan. 8 without restructuring the retirement system. The plans had about 43 percent of assets needed to cover obligations in 2011, the nation’s lowest ratio, data compiled by Bloomberg show.

Democratic Governor Pat Quinn has likened the $97 billion of unfunded liabilities to a python strangling the state’s finances. S&P cited inaction in cutting Illinois’s rating Jan. 25.

After beating California last year for the first time since 2008, bonds of Illinois issuers trail the Golden State in 2013, returning 0.78 percent to the latter’s 0.84 percent, S&P data show. California finances are on the mend thanks in part to voter approval of higher taxes in November.

Different Treatment

Illinois issuers have also paid a higher yield on general-obligations compared with other A- localities since February 2011, data compiled by Bloomberg show.

“There’s still a penalty for Illinois,” said Miller, a senior portfolio manager in Menomonee Falls, Wisconsin, at Wells Capital Management, which oversees $32 billion in munis. “Just because it’s rated the same as something else, the market’s not necessarily going to treat it the same.”

Miller said he would buy bonds from Illinois’s planned sale if the securities yielded 1.75 percentage points more than AAAs, similar to levels from a deal that priced in May. Dan Solender at Lord Abbett & Co., which manages $19.5 billion in munis, said a spread of 1.5 percentage points “would definitely be worth looking at.”

Those levels may not materialize, according to Vanguard’s Alwine, who said the yield penalty for this week’s sale may be about 1.25 percentage points. J.P. Morgan Securities LLC’s Peter DeGroot wrote in a Jan. 25 research note that 10-year Illinois general-obligations were trading at 1.35 percentage points above AAAs.

Pricing Issue

John Sinsheimer, Illinois’s director of capital markets, declined to comment before the sale.

“The state is not going to default on its debt -- that’s not the issue,” Miller said. “The issue for us has been pricing” and whether yield levels are attractive enough, he said.

In trading yesterday, munis sold off along with Treasuries as stronger-than-forecast orders for durable goods added to signs the U.S. economic recovery may be accelerating.

Yields rose across most maturities in the $3.7 trillion muni market. The interest rate on benchmark AAA tax-exempts due in 20 years saw one of the biggest increases, by 0.07 percentage point to 2.47 percent, Bloomberg Valuation data show.

Following is a pending sale:

NORTH CAROLINA plans to issue $326 million of bonds as soon as tomorrow, Bloomberg data show. The refunding debt will be sold competitively. (Added Jan. 29)

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