Illinois Leads A+ Debt Poised to Rally on Yield Gap: Muni Credit

Municipal bonds rated A+, four levels below the highest grade, are yielding the most compared with top-ranked tax-exempts since July and may rally later this year as demand for riskier debt grows, according to strategists at JPMorgan Chase & Co. and Morgan Stanley Smith Barney.

Yields on the 10-year debt rated A+ were 3.25 percent yesterday, about 1.07 percentage point more than top-grade municipal bonds, according to Bloomberg Fair Value indexes. The spread reached 1.11 percentage points on July 5, the widest since at least 1994, when the Bloomberg data begins.

Borrowers rated A+ by Standard & Poor’s include Illinois, where Democratic Governor Pat Quinn said Sept. 8 that he may have to cut more than 1,900 government workers because the $33.2 billion general-fund budget approved by legislators won’t cover the cost of state services through the end of the current fiscal year. The cost of insuring Illinois debt for 10 years has risen 56 percent since May 20, according to credit-default prices, from CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

“The low-yield environment motivates investors to move down the credit curve to achieve returns that they had typically achieved in higher interest-rate regimes,” Peter DeGroot, head of municipal research at JPMorgan said in a telephone interview.

Spreads between AAA and A+ securities may narrow “through year-end,” DeGroot said. An Illinois bond maturing in January 2015 traded at an average yield of 1.28 percent on Sept. 7, compared with a 0.56 percent rate on typical top-ranked debt due in four years, according to BVAL pricing data.

Debt sold by Illinois issuers has returned 3.67 percent in the past three months, the best among states tracked by S&P Municipal Bond Indices.

Rise From Low

The 10-year index of top-rated municipals was 2.09 percent yesterday, up from 2.05 percent on Sept. 12, the lowest level since January 2009, when Bloomberg’s data for the securities begins.

Yields on top-rated 30-year tax-exempts were 3.64 percent yesterday, after falling to 3.56 percent on Sept. 12, also the lowest since the Bloomberg records start.

“We are still finding good values in A rated and lower investment-grade municipal bonds such as BBB,” John Flahive, senior vice president and director of fixed-income at BNY Mellon Wealth Management in Boston, said in today’s issue of the Bloomberg Brief: Municipal Market newsletter.

“The continuing concern about the credit quality of municipal bonds has hampered demand for lower investment grade securities but we are selectively finding opportunities that offer historically attractive relative yield in those categories,” Flahive said.

Narrower Spread

The yield spread between A rated debt and AAA bonds will probably narrow later this year by about 20 basis points and further in 2012 as more investors realize that states and cities are balancing budgets and meeting their obligations, John Dillon, chief municipal bond strategist for Morgan Stanley Smith Barney in Purchase, New York, said in a telephone interview. A basis point is 0.01 percentage point.

State budget deficits are expected to drop to $32 billion next fiscal year, about a third of the level for the current period, according to the National Conference of State Legislatures in Denver.

U.S. states have already dealt with four straight years of imbalances and have closed gaps totaling about $511 billion, the group said.

The difference between A+ rated bonds and AAA securities has averaged 25 basis points since 1994, compared with an average of 82 basis points in 2011.

‘Passage of Time’

“The simple passage of time without major negative muni events and the overall tone of the market should facilitate that spread compression,” Dillon said.

Municipal bond defaults this year totaled $951 million, compared with $3.6 billion for all of 2010, according to the Distressed Debt Securities Newsletter, published by Miami Lakes, Florida-based Income Securities Advisor Inc. The number has fallen as officials cut spending and lawmakers stepped in to prevent insolvencies.

The total return on municipal debt, including price changes and interest income, is 8.49 percent this year, 6 basis points less than Treasuries and 198 basis points more than corporate bonds, according to Bank of America’s Merrill Lynch Municipal Master Index.

Following is a description of a pending sale of municipal debt:

MASSACHUSETTS, which had its rating upgraded to AA+ from AA last week by S&P, is set to sell $475 million of tax-exempt general obligation bonds through competitive bid as soon as tomorrow. The bond proceeds will finance capital projects. (Updated Sept. 20)