Illinois Trading Near Junk Means Buy on Pension Fix: Muni CreditBrian Chappatta
Illinois municipal bonds are set to rally from near-junk yield levels after lawmakers passed measures to help fix the worst-funded U.S. state pensions.
As investors anticipated a deal, the extra yield they demanded to own Illinois general obligations due in 10 years instead of AAA munis fell to 1.7 percentage points Nov. 29, the lowest since August, data compiled by Bloomberg show. The gap is still wider than on revenue bonds with a BBB rank, two steps below the state and two levels above speculative grade.
“The spread for Illinois G.O. debt is at low BBB- levels, well below where rating agencies have them,” said Eric Friedland, head of municipal credit research in New York at Schroder Investment Management North America, which oversees about $4 billion in local debt. “The market was looking for momentum from positive action by the legislature.”
The Illinois yield spread set a 2013 peak of 1.9 percentage points in October after lawmakers failed in five attempts since August 2012 to address the retirement systems. The plans face $100 billion in unfunded liabilities. Even after the improvement from October, the state’s relative borrowing cost is still more than four times greater than that of California, whose Standard & Poor’s credit grade is just one step higher.
The pension bill is designed to save $160 billion over 30 years. Illinois will test investor sentiment next week with a $350 million general-obligation sale, its first since June. That was the month it became the lowest-rated U.S. state by the three biggest rating companies.
The agreement “is a historic step and certainly is very helpful in our discussions with the rating agencies and the bond buyers who purchase the issuances of the state,” Governor Pat Quinn, a Democrat, said in an e-mailed statement.
In June, Illinois paid 17 percent more extra yield than two months earlier after plans from House Speaker Michael Madigan and Senate President John Cullerton stalled. Illinois debt staged its best rally in at least three years in May on speculation that lawmakers would reach a deal.
Cuts to Illinois’s bond ratings have cost taxpayers about $180 million this year, according to Abdon Pallasch, the state’s assistant budget director. Lower-rated debt has trailed higher-grade securities this year after Detroit’s record $18 billion bankruptcy and as Puerto Rico’s debt slumped.
The state’s bonds are “getting lumped in with a lot of distressed credits like Puerto Rico and Detroit, and they’re nothing like either of those two,” said Robert Miller, who helps oversee $33 billion in munis, including Illinois bonds, at Wells Capital Management in Menomonee Falls, Wisconsin. “I’d expect we’ll see spreads tighten.”
A shrinking yield gap typically shows growing investor confidence in the state’s finances.
The most frequently traded Illinois securities are taxable pension bonds due in June 2033, according to data from the Municipal Securities Rulemaking Board. The debt traded yesterday at an average yield of 5.8 percent, for a spread of about 2.29 percentage points, the slimmest since February.
Ebby Gerry, who helps oversee about $15 billion of munis at UBS Global Asset Management in New York, said his company has boosted Illinois general obligations to as much as 7 percent of some portfolios, from 3 percent in the first quarter.
“Illinois is one of the cheapest-trading single-A’s in the marketplace,” Gerry said.
The average muni bond with that rating yields about 4.2 percent, according to Bank of America Merrill Lynch data. Illinois debt with a maturity similar to the index yields 5.25 percent, Bloomberg data show.
Though the votes this week may signal a turning point in the state’s effort to halt the slide in its credit rating, unions promise to challenge the bill.
S&P has said that “it could be several years before reform translates into improved funded ratios and budget relief” because of the legal hurdles. Fitch Ratings echoed the expectation of a court battle in a report yesterday. Both have the state at A-, four steps above junk, with a negative outlook.
Ted Hampton, the Illinois analyst at Moody’s Investors Service, said in an interview that “the reforms appear substantial at first blush.” Yet he also said he needs to see actuarial numbers and how any legal challenges play out to assess fiscal gains from the bill.
“There’s a number of factors that still have to be worked out before you can say Illinois is on a path to recovery,” said Bill Black, a senior portfolio manager in Oakbrook Terrace, Illinois, at Invesco Ltd., which oversees about $20 billion of munis. “If the challenges can be overcome and the legislation is valid, that should be a sign to the rating agencies that we’re finding a bottom.”
S&P and Fitch also cite the risk that the state’s 2011 income-tax increase, the largest in its history, will begin to be phased out in fiscal 2015. The boost in the tax rate to 5 percent from 3 percent helped close a $13 billion budget deficit.
The state also has a backlog of about $5.4 billion in unpaid bills, according to Comptroller Judy Baar Topinka’s website.
“A few weeks ago, we didn’t appear to have anything in place, and now we have something very real,” said Chris Mier, chief muni strategist at Loop Capital Markets in Chicago. “It’s unequivocally good news and a strong step in the right direction. I’d think Illinois bondholders should be pleased.”
Issuers nationwide are offering about $7.3 billion in long-term debt this week with yields at the highest since September.
Benchmark 10-year munis yield 2.9 percent, compared with 2.84 percent on similar-maturity Treasuries.
The ratio of the yields, a gauge of relative value, is about 102 percent, compared with an average of 94 percent since 2001. The higher the number, the cheaper munis are compared with federal securities.