The appeal that's coming after a judge rejected the lawsuit seeking to invalidate $14.3 billion of Illinois debt shouldn’t keep Illinois out of the primary market, says Citi’s municipal strategy group head.
While the state would face the “overhang” of the lawsuit during an appeal process that could last through the year, “I don’t think it makes sense for the state to wait,” said group head Vikram Rai. “I think there’s enough demand for Illinois bonds at these levels” or in near range where he potentially sees yields landing.
Sangamon County Circuit Court Judge Jack D. Davis II
Illinois GO spreads have gained much, but not all, of the ground lost when the lawsuit was filed July 1.
Rai noted the relative value in Illinois GOs at their current levels. Municipal Market Data’s AAA 10-year is at 1.22% with the BBB benchmark at 1.82 % for a 60 bp spread. The Illinois 10-year is at 2.77% so it packs a punch for investors looking for yield.
Rai noted that even if the spread recovery holds, the state has already suffered by missing the market in a summer marked by a dearth of supply and hunger for higher-yielding credits. “They were not able to take advantage of the richness of the market,” Rai said.
The lawsuit also has cast a national municipal spotlight on the state’s pension and structural budget woes.
“The scrutiny on Illinois has increased,” Rai said. The firm continues to receive calls from clients about the lawsuit and Rai hosted a call Tuesday to discuss the latest developments and potential impact on the state.
Rai believes buy side apprehension will remain throughout the appeals process, which will likely go to the Illinois Supreme Court.
“We breathed a sigh of relief but we are not out of the woods yet,” Rai said of the case's first-round defeat. “There will always be a specter of worry until the matter is addressed” the state’s high court.
The Governor’s Office of Management and Budget has said its next scheduled sale is a $1.2 billion deal to reduce the state's backlog of unpaid bills. Officials will decide this fall on the timing based on the comptroller’s need for bond proceeds and state officials say the timing is not linked to the lawsuit. The backlog stood at $6.5 billion Wednesday.
The deal is similar to a 2017 deal challenged in the lawsuit. It's designed to give the state a lower bond interest rate, instead of the higher rate accruing on the unpaid bills. Market participants have said they were told to expect the deal over the summer and attributed the timing change to the lawsuit which would have driven up rates and cut into savings.
State spreads in secondary market trading shot up generally by about 35 basis points after the lawsuit’s filing. The state’s bonds rallied after Thursday's ruling, recovering much of their lost ground.
The lawsuit accused the state of violating constitutional debt provisions by failing provide specific enough language on the use of proceeds on the 2003 $10 billion pension bond sale and $6 billion 2017 bill backlog borrowing. It also argued the partial use of proceeds for deficit financing violated state law.
Davis ruled last week the legislative language was sufficient to meet the constitutional test and said to allow the case to proceed would result in the improper interference with the application of public funds.
Plaintiff John Tillman’s lawyers filed their notice of appeal Tuesday which will be heard by the Fourth District Appellate Court. Warlander Asset Management LP, a New York-based hedge fund that holds $25 million of state GOs and had hedges that would benefit from a state default on the bonds in question, was a participant in the lawsuit also but not named as a petitioner.
State GOs 10 years and out had jumped to a high of a 175 bp spread to the AAA benchmark over the last two months compared to a 140 bp spread before the lawsuit’s filing.
A 2028 maturity with a 5% coupon traded after Thursday's ruling at a 150 basis point spread to the Municipal Market Data’s AAA benchmark compared to a previous spread of 178 bps, said IHS Markit strategist Edward Lee. A 2029 maturity with a 5% coupon traded at the same 150 bp spread compared to a prior level of 173 bps. On Tuesday, a 2029 bond traded at a 161 spread, down from 146, a 2021 bonds traded at 116 compared to 89, and a 2024 bond traded at 145 compared to a previous trade of 140, Lee said.
Illinois GOs in the 2026 to 2029 range were generally trading at a 150 bp spread to the AAA compared to 170 before the ruling, said Daniel Berger, senior market strategist at MMD-Refinitiv.
The 2003 and 2017 challenged bonds have been punished by even wider spreads of five to 10 basis points, Rai said.
Rai said he doesn’t expect copycat lawsuits given the judge’s decision and doesn’t see a downgrade in store for the state.
