Worst Losers Turn Winners in Illinois Repayment Bet: Muni Credit
Illinois’s deteriorating finances are tainting debt from issuers across the fifth-biggest U.S. state, drawing investors to the extra yield on top-rated Chicago revenue bonds and borrowings of local school districts.
As municipal interest rates fell toward generational lows in the past year, Schroder Investment Management North America bought sales-tax bonds sold by Illinois, Chicago and the agency running the biggest U.S. convention center. All have AAA ratings from Standard & Poor’s and yields twice as high as benchmark munis, data compiled by Bloomberg show.
The money manager favored those bonds over Illinois general obligations, which are graded lower than any U.S. state, as lawmakers failed to fix the nation’s weakest pension system and amassed $9 billion in unpaid bills. The penalty extends to local school districts, drawing buyers such as Wells Capital Management.
“In Illinois, pretty much every bond there now is trading with a penalty,” said Eric Friedland, head of muni research in New York at Schroder, which manages $2 billion of munis. He spoke at a Bond Buyer conference this week in Fort Lauderdale, Florida.
“Some of the best purchases we’ve made this year have been based on this ‘guilt-by-association’ trade,” said Friedland, who correctly predicted in January that the state’s credit would be cut.
Illinois is the latest state to face heightened scrutiny in the $3.7 trillion municipal market after the worst recession since the 1930s. After Jefferson County, Alabama, filed the biggest U.S. municipal bankruptcy in November 2011, buyers demanded about 0.25 percentage point more from issuers in the state. California yield spreads widened to a six-month high in July after Stockton, California, became the biggest U.S. city to file for Chapter 9 protection.
S&P downgraded Illinois Jan. 25 to A-, six steps below AAA, after lawmakers were unable to produce a plan to shore up the state’s pensions, which have just 39 percent of assets needed to cover projected obligations. The state of about 13 million delayed a general-obligation sale five days later.
Sales-tax debt from Illinois has gotten caught up in the state’s financial spiral, even though the revenue tallied about $1.7 billion in the third quarter, the highest for the period since 2007, according to data from the state.
Sales-tax-backed bonds issued by Illinois in 2009 as part of its Build Illinois program were valued this week at a yield spread about 2 percentage points above benchmark munis, BVAL pricing show. That’s about 33 percent wider than revenue debt sold by the New York State Dormitory Authority with the same rating and maturity, the data show. Illinois securities aren’t tax-exempt at the state level.
The rating cut “woke people up” to look for opportunities in bonds that sold off along with the state, said Wendy Casetta, a portfolio manager in Menomonee Falls, Wisconsin, at Wells Capital, which oversees about $32 billion in munis.
The company is looking to increase its Illinois holdings, and bought school-district debt in the last six months of 2012, she said.
In Chicago, the third-most-populous U.S. city, yield spreads on some sales-tax debt are about 1.8 percentage points, BVAL data show.
The gap is even higher for the Metropolitan Pier & Exposition Authority, which owns the Chicago convention center McCormick Place. Some debt sold for the complex yields about 2.4 percentage points more than AAAs, according to BVAL pricing.
The bonds are penalized even as Illinois’s economy shows signs of improving. The state jobless rate fell 1 percentage point in the year through December to 8.7 percent, outpacing the nation’s 0.7 percentage point drop, according to Labor Department data. The national rate was 7.8 percent.
Illinois legislators have proposed changes to the state’s pension systems, including a bill to make the 2011 income-tax increase permanent and direct the funds toward retirement payments. Such steps mean Illinois probably won’t be lowered to the BBB level, Friedland said.
“As soon as the market sees some progress, as little as it may be, then spreads are going to begin to tighten” on Illinois general-obligations, which could reduce penalties on other debt from the state, he said.
Until then, Schroder plans to buy the sales-tax securities “whenever we can find them,” he said.
Following is a pending sale:
TEXAS’S LOWER COLORADO RIVER AUTHORITY plans to issue $308 million of revenue bonds as soon as March 5 through competitive bid, data compiled by Bloomberg show. Proceeds will refund debt, according to bond documents. (Added Feb. 28)
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