Illinois Pension Bills Squeeze Penalty to 2011 Low: Muni Credit
Investors betting the worst is over for Illinois have driven its debt to the strongest level in two years as the state offers $800 million of general-obligation bonds, its biggest sale in 11 months.
Lawmakers are advancing measures to fix the worst-funded U.S. state pension system, encouraging investors to look past events of the first quarter. Illinois in January became the state with the lowest credit rating, causing it to postpone a debt sale. Last month it settled with the Securities and Exchange Commission over claims it misled bond buyers.
With annual pension costs projected to grow by more than $900 million in next year’s budget, lawmakers in both chambers last month passed bills to rein in retirement costs. The House plan would cut Illinois’s unfunded liabilities by $20 billion immediately and save $100 billion over 30 years, according to Democratic Representative Elaine Nekritz.
“There’s more upside than downside at this point,” said Eric Friedland, head of muni research in New York at Schroder Investment Management North America, which oversees $2 billion of local debt, including Illinois general obligations. “The legislature is getting the message. Investors want to see pension reform.”
Four months after Democratic Governor Pat Quinn released a video showing a cartoon of “Squeezy the Pension Python” threatening to strangle the capitol building in Springfield, investors are looking to Illinois debt to pad returns. Buyers demand 1.3 percentage points of extra yield on 10-year debt from Illinois and its localities, close to the smallest since February 2011, data compiled by Bloomberg show.
That spread will be put to the test tomorrow when the state offers its first issue since Standard & Poor’s cut its rating to A-, six levels below AAA.
Friedland and Wendy Casetta at Wells Capital Management said the state’s 10-year general-obligations will probably price to yield about 1.5 percentage points more than AAA munis, about where they’re trading in the secondary market. Both said they would consider adding the debt.
“We don’t expect to see them go below A-,” said Casetta, who helps oversee $32 billion in munis for Wells Capital in Menomonee Falls, Wisconsin. “We’ve been big buyers of Illinois debt in the past, and we’ll continue to support the state, particularly now that they’re trying to do the right thing.”
Illinois lawmakers still have to agree on legislation. While the House bill passed March 21 by 66-50 with bipartisan support, legislators are in recess and are scheduled to return the week of April 8. The budget session is set to end May 31. Democrats have majorities in both chambers.
Beyond the obstacles of producing a consensus is the question of legality. The state constitution says pension benefits “shall not be diminished or impaired,” and opponents of the bills, led by employee unions, have said changes in retirement payments would be challenged in court.
Moody’s Investors Service said in a March 26 report that litigation “may once again deter action or lead to reforms with little effect.” The New York-based company affirmed Illinois’s A2 rating, also its worst state grade, with a negative outlook, meaning its credit could be cut further.
Pension-overhaul skeptics include Peter Hayes, head of munis at BlackRock Inc., the world’s biggest money manager. Even though the company’s Intermediate Municipal Fund (MAMTX) counts Illinois general obligations as its biggest bond holding, he said he’s more likely to buy when proposed fixes are signed into law.
“Most people don’t make investment decisions on slivers of hope,” said Hayes, who oversees $109 billion in munis for New York-based BlackRock. “They need to have actual initiatives get passed in order for that spread to tighten up and investors to maintain more confidence.”
The state is grappling with a $97 billion pension-system shortfall. Last month it settled with the SEC without admitting or denying the regulator’s findings, which claimed the state failed to disclose the degree of underfunding for its pension plans from 2005 to 2009 as it sold $2.2 billion in bonds. The agreement didn’t include fines or penalties.
Still, investors in the $3.7 trillion municipal market are confident they will get paid. Illinois has one of the seven strongest legal protections among state general-obligations, as measured by Fidelity Investments in a 2011 report.
Even with the added security, the yield spread on Illinois issuers relative to AAA tax-exempts is the highest among 19 states tracked by Bloomberg. The fifth-most-populous state may have to increase interest rates by as much as 0.1 percentage point to get its deal done, Hayes said.
California last month raised yields on some debt to complete a $2.1 billion general-obligation sale. Before the offer, California debt was the strongest since 2008, after Governor Jerry Brown, a Democrat, proposed a budget with a surplus, California’s first in almost a decade.
“It didn’t take much positive news for California spreads to tighten significantly and quickly,” Friedland said. “If you think Illinois is reaching a bottom, this would be a good time to buy.”
John Sinsheimer, the state’s director of capital markets, didn’t respond to calls for comment.
The state has the advantage of selling after a two-week rally pushed muni yields down from an 11-month high. At 1.96 percent, yields on tax-exempt benchmarks due in 10 years still exceed the 1.85 percent interest rate on federal debt. That has been the case since March 13, the longest span since September, signaling munis are relatively cheaper than Treasuries.
Illinois’s offer includes a $350 million taxable portion and is part of about $5 billion that localities plan to borrow this week, Bloomberg data show. Issuance is up from last week’s $3.1 billion, the smallest slate since early January.
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