Illinois Pension Fix Seen in Best Rally Since 2011: Muni Credit
Illinois debt is rallying the most since 2011 as investors bet lawmakers will end two decades of inaction and pass a measure to fix the worst-funded U.S. state pension system.
With 11 days left in the budget session, each legislative chamber has approved a pension-overhaul bill. The house plan will save $150 billion over 30 years, while the senate version, endorsed by public-employee unions, would cut the shortfall by about $50 billion. Passing either may halt downgrades that have made Illinois the lowest-rated state.
Illinois would join states such as New York and Rhode Island that have moved to reduce pension costs. States and localities faced more than $2 trillion in unfunded public-employee retirement obligations in 2010, according to Moody’s Investors Service.
“I would think they get a compromise this time -- the market will be pretty disappointed if they don’t,” said Tim McGregor, who oversees about $30 billion as director of municipal fixed-income at Northern Trust Corp. in Chicago. “Spreads have rallied in on the news, and they could widen pretty quickly if they don’t come to terms with anything.”
Taxable Illinois pension-obligation bonds maturing in June 2033 yielded 2.29 percentage points more than benchmark Treasuries May 13, four days after the Senate bill was approved, data compiled by Bloomberg show. That’s the smallest penalty since August 2011, when Standard & Poor’s rated the state two steps higher than its current A- grade.
Governor Pat Quinn, a 64-year-old Democrat, said in January that the pension challenge “has confounded legislatures and governors for 70 years.” The degree of underfunding accelerated in the past two decades as the state skipped required annual payments and issued general obligations starting in 2003 to cover pension costs. In March, the state settled with the U.S. Securities and Exchange Commission over charges it misled investors from 2005 to 2009 about retirement shortfalls.
The state’s public-employee retirement systems had about 43 percent of the assets needed to pay for pension obligations as of 2011, compared with the national median of about 72 percent, Bloomberg data show. The state faces a $97 billion retirement liability that’s crowding out other spending. Lawmakers are trying to resolve the squeeze by May 31, when the budget session is scheduled to end.
The resolution hinges on whether legislators can decide between the house bill and the senate measure, which senate President John Cullerton, a Chicago Democrat, said wouldn’t run afoul of the state constitution’s protection of pension benefits. The governor applauded the house version when it passed.
McGregor said a compromise would probably resemble the senate measure more than the house’s. Yet investors such as Richard Ciccarone at McDonnell Investment Management LLC questioned whether a middle ground is possible.
“That’s a pretty big hurdle,” said Ciccarone, managing director at Oak Brook, Illinois-based McDonnell, which oversees about $8 billion in munis. “They’re pretty far apart, and we’ve got just until the end of the month to make that happen.”
“The spreads are kind to them, quite frankly, given what the problems are,” he said. “They already consider some potential resolution.”
S&P said in its January report downgrading Illinois that even though it’s unusual for states to fall into the lowest investment-grade tier, “lack of action on pension reform” could prompt another rating cut. S&P, Moody’s and Fitch Ratings give the state a negative outlook.
Complicating the political challenge is language in the Illinois constitution saying pension benefits “shall not be diminished or impaired.”
Cullerton argued the pension bill approved by the senate would survive a constitutional challenge because it gives employees a choice on benefits.
House Speaker Michael Madigan’s bill, passed May 2, requires workers to contribute two percentage points more of their incomes to pay for retirement earnings. The senate leader is also a Democrat from Chicago.
“We’ve been saying for five or six years, ‘Well, they can’t possibly not deal with this,’ and they’ve managed not to deal with this,” said Kent Redfield, a political science professor at the University of Illinois Springfield. The chances of lawmakers passing a bill are “probably 60 to 70 percent,” he said in an interview.
Across Illinois, localities are getting cheaper borrowing costs as the state moves closer to a pension fix. Buyers demand 1.42 percentage points of extra yield on 10-year debt from Illinois and its localities relative to top-grade securities, down from 1.48 percentage points on May 1, Bloomberg data show. That’s still the widest spread among the 19 states tracked by Bloomberg.
Illinois also faces $9 billion in unpaid bills to vendors. The state may chip away at its backlog with a $2.5 billion bond sale approved by a house committee last month. It will also pay some of the bills with a one-time surge of about $1.3 billion of income-tax revenue, the governor said this month. S&P said there’s “limited upside potential” for Illinois’s credit rating in the next two years because of its liabilities.
“They’ve dragged their feet longer than any state,” McGregor said. A pension overhaul “isn’t their only issue, and it’s not going to all of a sudden mean the credit is AA.”
Still, “the market is pretty focused on this” legislative session, McGregor said. “They need to get this right.”
Issuers in Illinois are planning to offer $44 million of debt this week, the least since January, as supply is poised to drop below its 2013 average. Nationwide issuance may tally $6.3 billion, about $600 million less than the weekly average this year.
The ratio of the two interest rates, a gauge of relative value, is about 94 percent. It has been below 100 percent for eight straight sessions, the longest streak since February. The lower the figure, the more expensive municipal bonds are compared with federal securities. The ratio has averaged 92 percent since 2001.
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