Illinois Bond Slump Seen After Pension Plug Falters: Muni Credit

Illinois bonds are set to weaken after a judge struck down a plan to shrink a $111 billion pension shortfall, threatening to strain the finances of the lowest-rated U.S. state.

Illinois 10-year obligations yield 3.68 percent, or about 1.4 percentage points above top-rated municipal debt, data compiled by Bloomberg show. At that spread, the smallest since July, the bonds aren’t worth buying given the legal developments, said Robert Miller, who helps oversee $35 billion of munis at Wells Capital Management.

The Nov. 21 ruling that the Illinois constitution protects against cuts to public pensions increases the fiscal stress on the nation’s fifth-most-populous state. Moody’s Investors Service said yesterday it weakens the state’s credit. Even as Illinois plans to appeal the decision, Governor-elect Bruce Rauner, who takes office Jan. 12, also has to grapple with a $2 billion budget hole from expiring increases to income-tax rates.

“You would expect on this news that spreads would widen,” said Miller, who’s based in Menomonee Falls, Wisconsin. “The pension is definitely a looming problem and something they need to deal with. And if they don’t deal with the decline in income taxes, you could see a pretty dramatic widening.”

Illinois Reminder

Illinois, with credit ratings four steps above junk, is a reminder of how retirement benefits promised to public workers are the main threat to states’ financial health, Michael Zezas, chief muni strategist at Morgan Stanley in New York, wrote in a report released yesterday. The 25 biggest public plans face $2 trillion in unfunded liabilities, Moody’s said in September.

Investors should examine pension funding when choosing which states to invest in, Zezas said. Alaska, Arizona, Hawaii, Louisiana, Michigan, New York and Texas also have explicit constitutional protection for retiree obligations, according to Morgan Stanley.

Some Illinois bonds weakened after the pension decision. Taxable debt maturing in June 2033, the state’s most frequently traded securities, changed hands yesterday at yields as high as 5.46 percent, the highest since Nov. 18, Bloomberg data show. The debt’s spread to Treasuries was about 0.3 percentage point more than the five-month average.

History’s Guide

If history is any guide, the court decision will inflate the state’s relative borrowing costs. In July, Illinois yields climbed to a six-month high after a separate court ruling protected government retirees’ health-insurance premiums, signaling that the 2013 pension fix might be in jeopardy.

The law would save an estimated $145 billion over 30 years by reducing cost-of-living adjustments and raising the retirement age. In fiscal 2013, the state’s pension liability was 268 percent of revenue, compared with a median of 60 percent for all states, according to Moody’s.

“The credit-rating agencies and everyone who cares about the state of Illinois will be watching to see if they address the issues or find reasons to let them get worse,” said Laurence Msall, president of the Civic Federation, a Chicago-based nonprofit that researches government finance.

“The pension lawsuit is a significant concern, but there are many other issues that have to be dealt with before the Supreme Court rules,” Msall said.

Appeal Plan

Illinois Attorney General Lisa Madigan, a Democrat, said she’ll appeal the ruling and ask the state Supreme Court to fast-track the review.

The state’s most immediate fiscal concern relates to income-tax increases that are set to expire in five weeks. The sunset of the higher levies would create a projected $2 billion hole in the budget for the year through June 2015. Lawmakers adjourned in May without deciding the fate of the 2011 tax boost, leaving until after this month’s election the task of replacing the revenue or cutting the budget by that amount.

Rauner, a Republican and former venture capitalist, opposed extending the tax during his campaign. He has urged lawmakers not to act on the matter until after he takes office. He hasn’t said how he’ll proceed.

“While maybe this ruling was to be expected, the bigger thing is going to be the temporary income-tax hike,” said Adam Buchanan, vice president of sales and trading at Ziegler, a broker-dealer in Chicago. “That, coupled with these pension issues, is really going to put some downward pressure on the rating.”

Rauner’s Chance

For now, rating companies want to see how the state will act. Standard & Poor’s said in a report after the pension ruling that it will maintain its A- rating and negative outlook on Illinois because the grade already incorporated legal hurdles. Karen Krop, an analyst at Fitch Ratings in New York, said this month that Rauner needs a chance to present his plan.

Illinois hasn’t issued general-obligation bonds since April, when it capitalized on a rally following the December passage of the pension measure to lock in borrowing costs close to the lowest since 2009.

Illinois’s yield spread to benchmark munis has shrunk since August as money pours into the $3.7 trillion market. Individuals have added to muni mutual funds for 19 straight weeks, the longest stretch since 2012, Lipper US Fund Flows data show.

“You’re seeing Illinois spreads hold in because of general market strength,” Buchanan said. “Now if you saw the market turn and saw outflows, you’d see people exit.”

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