CHICAGO – Municipal market buyers aren't waiting for the rating agencies -- they're already trading Illinois GOs at junk bond levels.
While rating agency analysts mull whether to drop Illinois to a speculative grade as it veers toward a third fiscal year without a budget, the market spoke Thursday by sending secondary trade spreads on Illinois general obligation paper into the high-yield sphere.
Buyers settled down on Friday and Illinois paper rebounded with longer bonds seeing a stronger recovery and shorter to mid-range maturities still about 35 basis points over where they were before an adverse court ruling late Wednesday.
Spreads to the Municipal Market Data top-rated benchmark rose on average about 50 to 75 basis points on Thursday. The spread on a 2024 maturity hit a high of 377 basis points as spreads on some maturities widened by as much as 100 basis points. The 5-year ended at a 360 bp spread and 10-year ended at a 335 bp spread.
On Friday, spreads recovered to varying degrees with the 5-year closing at a spread of 300 bp and the 10-year closing at a 305 bp spread.
“Yesterday's collapse of Illinois GO's has seen a healthy rebound,” MMD said in its market close. “Illinois GO's past the 20-year range were trading +290/+300bps yesterday but saw bonds clear the market at +255/+260bps today. However, in the short maturity range Illinois markets still fall shy of recouping the hefty losses of yesterday,” MMD said in its market close. Earlier in the week ahead of the ruling, the 5-year was at a 265 bp spread and the 10-year was at a 270 bp spread. The 20-year had mostly recovered.
The reaction came as the market digested a court ruling that requires the cash-strapped state government that is $15 billion behind on its bills to more quickly pay down $2 billion in delinquent Medicaid bills. The ruling pressures the state’s ability to meet other “core” priority obligations like pension payments, payroll, and debt service.
A downgrade to below investment grade, which “looks extremely likely at this point within the next three weeks,” could have a similar or worse impact, said John Miller, co-head of fixed income at Nuveen Asset Management, in comments made during and after an investors’ panel discussion at The Bond Buyer’s Midwest Municipal Market conference Thursday.
“A downgrade and the media attention around the first ever state to be rated below investment grade presumably is more than that,” he said of the spread widening.
While the ruling on its face didn’t seem that adverse, instructing the state comptroller and lawyers for Medicaid recipients to negotiate a resolution, it underscores concerns about the prioritization of obligations that some investors and analysts fear could eventually interfere with debt service.
If the state and Medicaid recipients don’t come to an agreement by a June 20 deadline the market may view that as a perhaps “a catalyst for a downgrade,” Miller said.
The Thursday spike may provide a “hint of what could happen to Illinois GO bond prices when they actually are downgraded because if there is this much spread widening” based on the ruling there could be another 50 to 100 bp movement based on a downgrade, Miller said.
SPREADS
The Thursday jump in spreads made the 20 to 30 basis point widening after two rating agencies dropped the state’s ratings by one notch to the lowest investment grade level of Baa3/BBB-minus on June 1 look like a minor blip.
“Illinois GO bonds got hit very hard,” said Daniel Berger at MMD. A GO due in 2019 traded at 3.99%, a 314 bp spread, while a 2024 bond traded as cheap as 5.17%, topping out at a 377 bp spread. A 2028 bond traded as cheap as 5.36%, a 343 spread. “Some of this trading was off over 100 bps” from Wednesday, Berger said.
A spread of 335 basis points represents a junk level based on the Barclays high yield index. Miller said when stripping out Puerto Rico from the index because as a distressed credit it skewers the averages, the average yield considered junk falls to a 255 bp spread.
The court ruling was not released until Wednesday evening so the market opened Thursday to the headlines.
IHS Markit said it observed a handful of trades landing as a 305 to 345 basis point spread compared to comparable trades a day earlier in the 270 bp spread range, said Chris Taddoni, a vice president in municipal evaluated pricing services for the firm.
Illinois’ 10-year began March at a 213bp spread, jumping to 220 bp in early April and rose to 231 bp by the end of April. It continued inching up through May hitting 240bp on May 31 and then 258 on June 1, according to MMD data. The spread was at 162 basis points in late September.
JUNK
“Illinois is very interesting to us and that’s not a good thing for the state’s finances that a high-yield fund is looking at spreads of plus 300….and thinking about it,” said Bill Black, senior portfolio manager at City National Rochdale. “We are looking at it very carefully and I think it’s going to be a very big event -- the potential downgrade.”
Bill Grady, senior portfolio managers at Allstate, stopped short of calling investors “panic-stricken” but said some are taking the view that “I’ve had enough, just getting out.”
“There are buyers at these new levels,” Grady said of the Thursday trades that all found purchasers.
Whether that’s the case if, or as several panelists said, when the state loses its investment grade is a question market participants are pondering and they know the answer.
“I’ve become recently a little more concerned that Illinois could have more impact on the muni market as a whole” than future Puerto Rico decisions, Miller said.
That’s because Puerto Rico prices reflect its downgrades, defaults, bankruptcy-like filing, and initial court rulings so the next big news over recovery rates could have less of an impact than the first ever event of a sovereign state falling to a speculative grade.
The “Illinois GO is a more normal muni bond” and “hits closer to home from a general municipal bond perspective,” Miller said. The state’s $26 billion of GOs and billions more of debt linked of the state’s credit are held by investment grade funds.
“Not everyone has to sell” the roughly $35 billion in debt that could be affected but “a lot will probably want to sell,” Miller said. “That’s a lot of supply” relative to the $90 billion of assets under management in high-yield accounts. “That’s what we are trying to figure out….how many people care to buy at what price point.”
CONTAGION
Recent primary market offerings provide clear evidence of the “contagion” effect Illinois’ finances are having on Illinois issuers, Grady said.
Chicago’s $400 million wastewater and $200 million water revenue deals that sold Tuesday and Wednesday, respectively, were well-received and repriced to lower yields but the single A to double-A rated paper still landed a yields about 100 basis points off the triple-A benchmark.
“That should not be indicative” of a solidly rated water/wastewater utility, Grady said.
The firm’s home town of Northbrook, Illinois saw its triple-A paper rated bonds sold earlier in the week land 30 to 40 basis points off the benchmark “just because it’s in Illinois,” Grady said.
Some of the penalty is due to questions all portfolio managers face about how much Illinois-based paper they hold, Miller said.
As the “Illinois GO widens out, this punishment or taint that the market is applying….is growing and that’s concerning,” Miller said. During a recent legislative hearing, Miller estimated the penalty costs local units of governments $930 million in added annual interest costs.
The recent downgrades left the state’s appropriation-supported debt at junk.
S&P dropped the state to BBB-minus and made clear another hit is coming if the state enters a new fiscal year July 1 without a sound budget plan. Moody’s Investors Service lowered the state to Baa3 and assigned a negative outlook.
Fitch Ratings rates the state BBB and has said it will act on a credit watch placement with a downgrade expected if no budget agreement is reached. No signs were evident Friday that a budget agreement was at hand or serious negotiations were even occurring.
