CHICAGO — With its ratings still on the verge of junk, Illinois plans $6 billion of general obligation borrowing over the next two weeks, offerings expected to lure investors with unusually rich yields for a sovereign state credit.
“In an era of low rates and tight spreads, Illinois is going to offer general obligation-backed, sub-sovereign paper at yields that certainly represent its rating, and that should be very attractive,” said Brian Battle, director of trading at Performance Trust Capital Partners in Chicago.
The lack of supply to meet demand could help tamp down the yield penalty on the state, though it's difficult to say where spreads will land given the state’s battered credit and the size of the transactions, Battle added.
The state will kick off a total of $6.75 billion of planned fixed-rate, tax-exempt GO borrowing, including $6 billion to pay down a backlog of bills that currently stands at $15.4 billion, on Tuesday when it competitively bids $1.5 billion of bonds.
The state returns the week of Oct. 23 with $4.5 billion in a negotiated sale. A deal for $750 million is planned in December to fund fiscal 2018 capital projects. The $4.5 billion is the state’s largest single transaction since its $10 billion pension GO borrowing in 2003.
An investor roadshow was planned Friday and additional individual meetings will be held in the coming days.
The $1.5 billion is divided into three series, each for $500 million, with maturities in 2018, 2019 and 2029. The $4.5 billion being sold the following week will offer $500 million tranches that mature between 2020 and 2028.
The $6 billion authorization inserted in the state’s $36.1 billion fiscal 2018 budget package set a final maturity of 12 years and requires level annual principal repayment.
Proceeds of the $6 billion – along with federal leveraging of Medicaid payments – should lower the backlog to $7.5 billion by the end of fiscal 2018, according to the offering statement.
That level is in line with backlogs between 2010 and 2015. It dropped to $5 billion in 2015 as revenue from a temporary income tax increase was collected. Comptroller Susana Mendoza has authority to allocate the proceeds to any unpaid vouchers incurred prior to July 1.
PFM Financial Advisors and Public Resources Advisory Group are advising the state. Chapman and Cutler LLP and Burke Burns & Pinelli Ltd. are bond counsel. Six firms are senior managers on the $4.5 billion.
Market participants say it’s hard to nail down where spreads might land as the state squeezes $6 billion into a 12 year repayment scheme. The 10-year is currently trading around a 168 basis point spread to the Municipal Market Data’s top-rated benchmark.
“The spread is lower than it has been for quite a while, however it is still the highest among the 50 states,” said MMD’s Dan Berger.
Illinois paid a 200 basis point spread on the 10-year in its last GO sale for $480 million in November 2016. It saw spreads of 193 basis points on a $1.3 billion GO refunding in an October, 2016 sale and 185 basis point spread on a $550 million June, 2016 sale.
Spreads have fluctuated depending on fiscal developments. The spread in basis points on the 10-year began the year around 235, dropped to 215 in the spring and then steadily rose as the budget impasse dragged on and the state inched closer a junk rating.
The 10-year spread hit an all-time peak of 335 on June 8 after an adverse court ruling on Medicaid payments. The spreads rebounded and hovered between 273 and 292 basis points until July after the budget passed when they dropped to about 200.
“The one and two year maturities in the competitive sale will be attractive to banks who need short term paper,” said one Chicago-based public finance banker who isn't working on the transactions.
“The size of the deal is its main attraction, especially because many investors have found themselves under-allocated to Illinois now that it's moved a half step back from the abyss,” said Matt Fabian, partner at Municipal Market Analytics.
Several market participants said once completed, the deals’ spreads stand to influence overall market pricing.
Ahead of the sale, rating agencies affirmed Illinois’ GO ratings. They had had previously factored in the $6 billion in borrowing in reports published after the July budget passage.
The state is most at risk of a cut to junk by Moody’s Investors Service, as its rates the state at the lowest investment grade level of Baa3 with a negative outlook. S&P Global Ratings also has the state at the lowest investment grade of BBB-minus with a stable outlook. Fitch Ratings rates the state one notch higher at BBB, but assigns a negative outlook.
STATE PITCH
The state’s finance team faces a political balancing act in promoting the deal against the backdrop of divisions between Gov. Bruce Rauner, a Republican, and the Democratic controlled General Assembly. The $6 billion authorization was inserted in a budget package that took effect only after the legislature overrode the governor’s vetoes.
An investor presentation highlights that “the state’s credit fundamentals are improving.”
“Recent positive developments by the state include passage of the fy 2018 budget, passage of the Senate bill 1947 which provided for evidence based method of allocating funds among the state’s school districts” along with “a permanent increase in personal and corporate income tax rates resulting in over $4 billion in additional revenue,” capital markets director Kelly Hutchinson told investors.
Investment risks listed in the offering statement include the administration’s estimate of a $1.5 billion deficit fiscal 2018 deficit, an inability to assure a secondary market for the bonds, risks related to the state’s swaps, and massive unfunded pension obligations.
It also includes a warning the bill backlog “may continue to increase unless balanced budget are enacted in the future.”
The state’s swaps tied to $600 million of floating-rate paper were negatively valued at $111 million at the close of fiscal 2017 June 30. The state has $126 billion of unfunded pension liabilities in a system just 39% funded. The state was scheduled to contribute $8.8 billion this year but changes in the budget that include a smoothing of actuarial changes has lowered that amount to $7.9 billion.
Budget director Scott Harry said the state collected $29.4 billion in revenue last year but spent $34 billion, leaving a $4.6 billion gap. He warned of the looming $1.5 billion gap in the current budget – which was also the subject of a press release released late Thursday. “The state can provide no assurances as to how, when or in what form this might be addressed,” reads the offering statement.
The deficit this year stems from lower revenue estimates, the fact the budget only accounted for debt service on $3 billion of borrowing, and delays in when savings will be achieved from the establishment of a tier 3 pension plan.
The finance team highlights the state GO Bond Act’s “strong constitutional and statutory provisions,” which include monthly set asides, a continuing appropriation, the ability to legally compel the state to pay debt service from any legally available funds in various accounts that hold about $11.6 billion. Monthly debt service payments will total $250 million after the deals.
“The state’s recent budget impasse highlights the importance of these protections,” Hutchinson said.
RATINGS
The state’s rating remain precarious despite the breathing room that came with the end of the budget impasse.
S&P analyst Gabriel Petek said the BBB-minus “reflects our view of the state's nearly depleted budget reserves and generally weakened financial condition that intensified into liquidity stress during the state's two-year budget impasse.”
“The stable outlook reflects that, with passage of its fiscal 2018 budget, the likelihood that Illinois will experience a liquidity crisis in the coming months has fallen markedly and therefore so have the odds of its rating falling to below investment grade,” S&P added.
All three rating agencies warn that the state must guard against allowing its bill backlog to rise again, after it’s paid down by the borrowing. They are watching to see how the state deals with the gap in the current budget.
“The rating will be lowered if the state returns to a pattern of deferring payments for near-term budget balancing and materially increases the accounts payable balance,” Fitch wrote. “Specific risks include spending above the level assumed in the budget, a significantly slower growth revenue environment, and re-emergence of political stalemate that negatively affects fiscal operations.”
Moody’s said its negative outlook stems from “expectations of continued pension liability growth and pension funding pressures; the fact that the state's budget remains imbalanced, despite the enactment of substantial tax increases; and the state's heightened vulnerability to national economic downturns or other external factors.”
