Illinois Incompetence Gives Bondholders More Yield: Muni Credit

Illinois lawmakers return to their chambers today with the goal of bolstering the weakest state pension system. Investors are skeptical of their resolve, demanding a record yield cushion to own the state’s obligations.

The elevated borrowing costs serve as a backdrop for the latest legislative session aimed at curbing an unfunded retirement burden that the Civic Federation says has swelled to about $100 billion. Illinois Senate President John Cullerton, who championed a pension fix in May that would have cut the shortfall by about $50 billion, is now pushing a plan that could save $138 billion over 30 years.

A wider yield spread shows investors are more pessimistic than in May, when Illinois debt rallied the most since 2011 on bets lawmakers would agree on a pension measure. Legislators have failed to enact a fix at least five times in the past 14 months. Over that period Illinois has become the lowest-graded U.S. state by the three biggest rating companies. Its A- rank from Standard & Poor’s, six below the top, is three levels above Puerto Rico’s.

“Illinois’s backlog of unfunded liabilities just continues to get worse -- there are no steps being made to stabilize the situation,” said Bart Mosley, co-president of Trident Municipal Research in New York. “Until you get beyond somebody having a plan, it’s very hard to change the outlook.”

Confounding Case

Illinois’s five state pension systems had 43 percent of assets needed to cover obligations in fiscal 2011, the lowest ratio among U.S. states, data compiled by Bloomberg show. Democratic Governor Pat Quinn, 64, has said coming up with a fix “has confounded legislatures and governors for 70 years.”

Heading into the session starting today, which lasts at least through Nov. 7, Cullerton downplayed the urgency of the issue.

“I don’t think you can use the word ‘crisis’ to describe it at the state level,” Cullerton said in an Oct. 20 interview with Chicago’s WGN Radio. “It’s something we have to deal with, but it’s not something that we’re on the verge of bankruptcy on.”

Investors in the $3.7 trillion municipal market are betting the impasse will drag on. The extra yield buyers demand to own 10-year Illinois general obligations instead of top-rated munis rose to 1.9 percentage points on Oct. 15, the most this year, Bloomberg data show.

Climbing Cost

Illinois’s spread is the widest among 17 states tracked by Bloomberg. While it’s one-third of the premium demanded on securities from Puerto Rico, which has commandeered the attention of investors in recent months, the penalty is almost six times as great as that on California.

Lawmakers’ inaction has had consequences beyond the state’s credit rating. Moody’s Investors Service in July dropped its grade on Chicago, the third-most-populous U.S. city, three levels to A3, the same rank it assigns the state. Mayor Rahm Emanuel presents his budget proposal for fiscal 2014 tomorrow.

Moody’s has lowered at least $41.5 billion of debt from Illinois issuers since the state’s last legislative session ended May 31, including the University of Illinois, Cook County and the Chicago Board of Education because of ties to the state. That represents about 1.1 percent of the U.S. municipal market, Bloomberg data show.

‘Snowball Effect’

Dan Cronin, who as board chairman of DuPage County, Illinois, is the jurisdiction’s highest-ranking elected official, said issuers in the state have to pay a penalty of as much as 0.35 percentage point because of the political dysfunction. Cronin, a Republican, is a former state legislator.

“Every day that they wait only makes it harder for the Chicago-area governments,” said Richard Ciccarone, chief research officer at Oak Brook, Illinois-based McDonnell Investment Management, which oversees $8 billion of munis. “There’s a snowball effect.”

Taxable Illinois pension-obligation bonds maturing in June 2033 yielded an average of 6.23 percent yesterday, or 3.11 percentage points more than Treasuries, close to the most since at least February, Bloomberg data show. In comparison, A rated corporate bonds yield about 4.69 percent, according to a Moody’s index.

Taxable Chicago general-obligation debt maturing in January 2042 traded yesterday at 3.6 percentage points more than Treasuries, compared with an average of 3.1 percentage points since the Moody’s rating cut.

May Failure

In May, each legislative chamber approved a separate pension-overhaul bill. The house plan would have saved $187 billion over 30 years, while the Senate version, endorsed by public-employee unions, would have cut the shortfall by about $50 billion. The proposals spurred the steepest rally in the Illinois pension bonds in at least three years.

The subsequent collapse of pension-rescue efforts was the result of a standoff between house Speaker Michael Madigan and Cullerton, both Chicago Democrats. Cullerton said Madigan’s proposal was unconstitutional, while Madigan argued the senate plan didn’t go far enough. The inaction led to the appointment of a committee to develop a compromise. Members haven’t agreed on a plan.

This time, Cullerton enters the legislative session with a proposal that narrows the savings gap between his original plan and a competing one backed by Madigan.

‘Striking Distance’

The latest proposal backed by Cullerton and some Democrats would save $138 billion over 30 years by cutting retirees’ 3-percentage-point annual compounded cost-of-living allowance to half the rate of inflation. It would also reduce employee contributions by one percentage point.

“We are unbelievably close and well within striking distance,” said Senator Daniel Biss, a Democratic member of the committee trying to develop a compromise.

Familiar obstacles lie ahead, including creating bipartisan support and passing a bill that would withstand any legal challenge. The Illinois constitution says retirement benefits “shall not be diminished or impaired.”

Lawmakers are scheduled to be in session today through Oct. 24 and Nov. 5-7.

“We’re hopeful that we’re going to be surprised when the legislature comes up with a more significant plan than we’re expecting,” Ciccarone said. “We’re all anticipating it may not be much of a fix at all.”

Issuers from Connecticut to California are offering about $8.1 billion in long-term debt this week, the most since July. They’re issuing with yields near a one-month high.

The interest rate on AAA 10-year munis is 2.82 percent, Bloomberg data show. That compares with 2.6 percent on similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 108 percent, compared with an average of 94 percent since

2001. It has been above 100 percent since June 24. The higher the figure, the cheaper munis are compared with Treasuries.

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