Illinois Prepares to Borrow After Moving Off Precipice of Junk

(Bloomberg) -- Illinois is poised to reap lower borrowing costs as it returns to the municipal-bond market for the first time since pulling back from the brink of becoming the first junk-rated U.S. state.

Illinois is offering $920 million of general-obligation refunding bonds for yields ranging from 3.05 percent to 4.41 percent, according to three people familiar with the terms who declined to be named as the pricing isn’t final. The preliminary yields are about 30 basis points lower than the state’s deal in April, according to data compiled by Bloomberg. Proceeds from the negotiated offering will also pay termination payments to banks to cancel interest-rate swap agreements and eliminate Illinois’s derivative exposure, bond documents show.

Bondholders and rating companies have praised Illinois’s progress. Spreads on the worst-rated state’s 30-year bonds over benchmark debt tightened to the lowest since March 2015 after Moody’s Investors Service lifted its outlook to stable from negative last month. It’s the first time Illinois has been at that level since December 2012, according to Moody’s.

The so-called Illinois penalty, or extra yield that investors have long demanded to own the state’s debt, has receded from the high of nearly 3 percentage points in June 2017. The premium was 1.4 percentage points on Monday.

“They’ve shown some progress with a successful budget,” said Gabe Diederich, portfolio manager for Wells Fargo Asset Management, which oversees $39 billion of state and local bonds, including Illinois debt. “At the same time, I think the yield penalty is certainly not going to evaporate with this deal given some of the continued work that lies ahead for the state.”

Illinois’s fiscal woes are far from over. The budget, while enacted before the July 1 start of the 2019 fiscal year, has a $1.2 billion structural gap, and the state is struggling with $137 billion of unfunded pension liabilities, according to bond documents.

Debt Swaps

The deal will “de-risk” Illinois’s portfolio by refinancing $600 million of variable-rate debt from 2003 into fixed-rate, according to S&P Global Ratings, which rates the deal BBB-. Proceeds will also terminate interest rate swaps that Illinois originally entered into to hedge risk associated with the variable-rate bonds, S&P said.

The variable-rate debt was backed by six letters of credit that were going to expire in November 2016, and Illinois refunded that with proceeds from bonds sold to four banks under direct purchase agreements. Those agreement are set to expire in November, according to S&P. As of Aug. 1, the termination payments were estimated at $74 million, bond documents show.

There’s “clear market recognition” of the budget progress, said Neene Jenkins, a vice president and municipal analyst at AllianceBernstein, which oversees $42 billion of state and local bonds, including Illinois debt.

"I recognize both the tremendous amount of progress the state has made relative to last year and the challenges that still face the state moving forward,” said Jenkins, who is looking at the deal. “They have a lot of work to do.”

The effects of the record two-year impasse that wrecked havoc on Illinois’s finances haven’t disappeared. That political stalemate drove unpaid bills to a record $16.7 billion. That backlog is now about $7.8 billion, reduced because the state borrowed $6 billion in November to pay it down.

“We are optimistic because the state is in a better fiscal position today with enactment of a full-year budget,” Elizabeth Tomev, a spokeswoman for the governor’s office, said in an email. “The ratings agencies have acknowledged our efforts to address our pension burden and are encouraged by the budget’s passage into law.”

Slim Calendar

Wednesday’s bond sale comes amid a much smaller issuance calendar compared to last week. U.S. state and local governments are scheduled to sell about $4 billion of debt this week, compared with about $12 billion last week. Illinois’s offering is the largest long-term deal this week, according to data compiled by Bloomberg. Texas is scheduled to sell $7.2 billion in short-term notes on Wednesday.

The offering comes amid ongoing demand for high-yield paper in a low-rate environment. Investors added $244.2 million to high-yield municipal funds in the week ended Aug. 15, according to Lipper US Fund Flows data. Those funds have seen inflows in nine of the past 10 weeks.

“They still pay a penalty because of their history and because of the uncertainty going forward,” said Daniel Solender, head of municipal investments at Lord Abbett & Co., which manages $20 billion of state and local debt, including Illinois bonds. “They’re definitely headed in a better direction, but there’s still a lot of things that need to happen for the situation to materially improve.”

To contact the reporter on this story: Elizabeth Campbell in Chicago at ecampbell14@bloomberg.net

To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, Michael B. Marois, William Selway

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