CHICAGO - Illinois, turning to the corporate investment-grade market to raise funds tohelp balance its budget and to restructure a portion of its unfunded pension liability,will launch an unprecedented $6 billion taxable general obligation pension salebeginning today and culminating in a final pricing Thursday.
Bear, Stearns & Co. and UBS PaineWebber Inc. are co-book-running managers. ABN AmroFinancial Services Inc., Citgroup Global Markets Inc., and Goldman, Sachs & Co are co-senior mangers, with a group of 11 other firms as co-managers.
Though the front page of the deal's preliminary official statement cites a size of $4billion, finance officials anticipate pushing the amount up to $6 billion or even higher- although they may also go the other way and pull some maturities back if they thepricing levels. The state is authorized to sell a total of $10 billion.
"That gives you an indication that we think the demand is pretty good and interest ratesare good," said Lawrence Morris of Mesirow Financial Inc., one of the state's financialadvisers. "We have a high-grade credit, and it's reasonably rare to have someone sellthis many bonds this long."
The deal has piqued the interest of a broad market, both domestically andinternationally, with buyers looking at the state's issue to provide a yield above U.S.Treasuries without the risks that accompany corporate credits. "There is a fair amountof interest," Charles Mires, senior managing director at Allstate Investments, said ofthe overall market.
Mires said that he himself is looking at the deal. "The fact that it diversifies riskaway from corporate risks makes it interesting," he said, adding that in the end, thedecision to buy will depend on the deal's prices as compared to "other alternatives."
Though finance officials working on the deal cautioned that the structure could change,it now calls for $600 million of bonds maturing serially from 2008 to 2015, term bondsfor $375 million maturing in 2018, one for $700 million maturing in 2023, and a $4billion one maturing in 2033.
Market participants said the long bonds would receive the most attention, while somesaid the smaller size of the earlier maturities might deter some buyers looking for bulkto maintain liquidity in secondary market trading. State finance officials believe,based on early marketing efforts, that there is plenty of interest among buyers for thewhole range of maturities.
In an effort to widen its potential list of buyers, the state will market as much as 30%to buyers overseas, where underwriters believe investors are eager to diversify U.S.holdings by adding the debt of a sovereign state.
Moody's Investors Service last week assigned a corporate scale rating of Aaa to theglobal piece of the overall offering. "The rating reflects the very highcreditworthiness of the state's obligation on these bonds in terms of expected defaultrisk and loss severity," the agency stated in a release.
Moody's rates the state's traditional GOs Aa3, while Fitch Ratings gives it a AA - bothreflecting recent downgrades. Standard & Poor's gives it a AA with a negative outlook.
The state will use roughly $2 billion of proceeds to cover payments it owes its pensionsystem in fiscal years 2003 and 2004. The use of bond proceeds helped the statesubstantially trim an estimated $5 billion deficit off the $52.4 billion fiscal 2004budget lawmakers approved over the weekend. Pension managers will invest the rest torestructure a portion of the state's $36 billion unfunded pension liability.
The transaction - which has been more than a few months in the making - is unprecedentedin that it comes from a highly rated issuer, yet because interest earnings are subjectto taxation, it will sell in the corporate investment-grade market competing alongsidethe nation's top private companies.
The pension deal is one that the administration of freshman Gov. Rod Blagojevichconsidered as U.S. Treasury yields shrank to near record lows earlier this year andembraced in an attempt to deal with two inherited crises - the deficit and the unfundedpension liability.
In addition to providing immediate relief, the deal will bring the state's pensionsystems to 63% funded compared to their current 54%. The overall savings are achieved bytrading in an 8% interest rate on the liability for the one that will be paid on thebonds.
The state's bonds will price directly off Treasury yields. Market participants said thestate could expect to pay a range of 70 to 80 basis points above Treasuries on itslongest term bond, slightly less on the shorter maturities. The overseas piece will bepriced off the London Interbank Offered Rate.
The timing of the transaction favors the state more than it did just a few months ago,when officials simply hoped that Treasury yields would hold. They have since fallen. Thestate now stands to save several hundred million dollars more over initial savingsprojections.
In trading early yesterday, the benchmark 10-year note stood at 3.44% and the 30-yearbond at 4.42%. Treasury prices had risen in recent days, pushing yields up following therelease of economic data on Friday and a Federal Reserve speech yesterday.
"The decline in the Treasury bond rates since the authorization passed has resulted in asignificant advantage to the state and effectively reduced the rates the funds will haveto earn to make this revenue neutral," said Ronald Picur, a state budget consultant.
The deal's maturity schedule was set to mirror the pension payments owed down the lineto make up for a lack of past funding and investment declines. Because debt service doesnot begin until 2008, the state will have a few years' breathing room. With the debtback-loaded, the state is also able to maintain a more level overall debt serviceschedule. If the investment earnings do achieve a level at least 200 basis points overthe bonds' interest rates, the restructuring will be "revenue neutral" with regard tothe state budget.
Illinois may tout the benefits of the deal, but there are critics, too. The deal hascontributed to two rating agencies' decisions to knock the state's credit. It hasspurred critics of pension bonds to warn of the risk associated with arbitrage plays,because the deal only works in the long run if the invested proceeds meet earningsexpectations. Also, the state would be more than doubling its GO debt if it sells theentire $10 billion over the next year. Because the upcoming deal is back-loaded, somecritics contend the state will limit its flexibility to issue debt in the future.
The state and its financial team have marketed the deal through several investor roadshows and have traveled to Dublin, Frankfurt, and London to talk to internationalinvestors. The book-runners began approaching the investors on Friday, according tomarket participants, and today will formally begin "building the book" for the deal. Theprocess involves establishing the spread on the bonds to Treasuries. Late tomorrow orThursday the book will be closed.
In sizing the deal, the state faced several conflicting dynamics. If the market appearedwilling to absorb the whole $10 billion, officials were inclined to move forward withthe full authorization. At the same time, if the state holds back, it may achieve evenbetter prices once the bonds have a secondary market trading history. The risk is thatTreasury yields will rise.
The state may not need to worry as much about holding back some of the deal and riskingan increase in yields, because the General Assembly this past weekend was expected tohave approved the use of derivatives. If the state fears interest rates will soon rise,it could quickly execute a contract for an interest rate swap and price the bonds later.
On the local front, the deal was the most sought-after transaction by financialadvisers, broker-dealers, and law firms in recent memory, and firms used all their cloutto win a spot. At stake is a $3.50 per $1,000 bond in fees for underwriters alone, asset by the lowest qualified bidder that participated in the competitive selectionprocess.
The initial selection of firms prompted charges of favoritism, especially in cases wherea firm's ties would not provide a public-relations embarrassment. Lehman Brothers waskicked off the deal after a gossip column item stating that one of its bankers hadhosted a small fundraiser for the governor during his tenure as a congressman and thatit recently hired a close ally of Blagojevich, John Wyma, as a consultant. However, eachof the other main players on the deal carry clout, either in the form of politicallyconnected consultants or through affiliations with close allies tied to the governor orhis staff.
Bear Stearns' selection as a book-runner also raised jealous eyebrows. The state hadearly on stressed, in its selection of the top-tier firms, their experience in thecorporate-grade market. Bear Stearns doesn't even crack the top 10, while other firms inlower positions, such as Merrill and Goldman, do. Other firms with a local presence thatapplied and were not picked, such as Banc of America Securities and J.P. MorganSecurities Inc., also rank higher.
Market sources have said the local perception is that it was the ties of Chicago-basedsenior managing director P. Nicholas Hurtgen and former Bear Stearns official Peter Foxto Tommy Thompson that helped win the firm the lead spot. Both were close to Thompsonduring his years as governor of Wisconsin. Thompson is now secretary of Health and HumanService and controls the purse strings to Medicare and Medicaid reimbursements. A localgossip columnist recently reported that Blagojevich, a Democrat, and Thompson, aRepublican, had dinner together in Chicago.
Bear Stearns declined to comment on the suggestion. State officials said they tried toinclude a broad range of firms in the deal.
"Rankings are one thing, but the nature of a municipal credit being sold in a taxablemarket also counts," Morris said referring to Bear Stearns' status as one the topmunicipal underwriters. "The ideas are more important than just how many bonds yousold."
Internally, some underwriters in lower-tier positions on the deal fear they will get toosmall a piece of the transaction. Many local investment bankers are used to issuers heredesignating chunks of bonds for co-managers - a move that provides bankers with someguarantee that they will be able to fill orders.
Market sources also said that even within Bear Stearns there have been conflictsinvolving the public finance group led by Daniel Keating having to fend off an attemptby the corporate group to lead the deal.
