Illinois Able to Issue AAA Rated Bonds Despite BBB General Obligation Bond Ratings

The state of Illinois issued bonds last week backed by state tax revenues, and despite having its general obligation bonds rated in the BBB category and facing ongoing budget problems, it was able to garner a AAA rating for the new bond issue….well, at least one AAA rating. The state issued its Build Illinois sales tax revenue bonds, which were rated AAA with a negative outlook by Standard and Poor’s, and AA+ with a stable outlook by Fitch. The state did not seek a rating for the bonds from Moody’s.

While both rating agencies acknowledged Illinois’ fiscal problems and its lowest GO debt rating of any U.S. state, the Build Illinois debt program has achieved high ratings because of its exceptionally high debt service coverage levels, as well as its bondholder protections. The bonds are backed by statewide sales tax revenues, and current pledged tax revenues provide about 26x coverage over maximum annual debt service. Future leverage is limited, as pledged tax revenues must provide at least 10.2x coverage on all debt if new bonds are issued. At that level, we would generally expect the bonds to be rated AAA by all rating agencies. We believe that the negative outlook by S&P and the lower rating by Fitch provide implicit recognition of Illinois’ fiscal issues, despite the strength of the Build Illinois credit.

Again, we have noted the absence of a Moody’s rating on the bonds. While Moody’s has a Baa2 negative rating on the state’s GO debt, close to the BBB+ negative ratings by both S&P and Fitch, Moody’s methodology for rating the Build Illinois debt differs from S&P and Fitch. In many cases each of the rating agencies may cap the rating of bonds backed by a dedicated tax, such as a sales tax (like the Build Illinois bonds), at the rating of a state’s general obligation bonds. In this instance, Moody’s would have restricted the rating of the sales tax bonds at Baa2, eight notches below S&P’s rating, despite the exceptional coverage levels and bondholder protections. In fact, the state has some Build Illinois sales tax bonds outstanding that are rated Baa2 because they were originally rated by Moody’s and were subsequently downgraded each time the state GO bonds were downgraded. Moody’s has not been invited to rate new Build Illinois sales tax bonds since they started downgrading the bonds in line with the state GO downgrades.

While we understand Moody’s rating methodology, and believe there should be some ratings and pricing penalty on the Build Illinois bonds, we also believe the bonds have coverage levels and bondholder protection provisions at a level that would warrant a rating higher than Baa2. The tax-exempt Build Illinois bonds with a 10-year maturity priced last week at an attractive level of +48 basis points over the AAA benchmark yield. The state also issued taxable Build Illinois bonds, and the yield for 10-year maturities was priced at +105 basis points. We participated in this deal as we felt the ratings divergence created an opportunity to own a solid credit at levels consistent with not so solid credits.

Source:  Bond Buyer, Fitch Ratings, Moody’s Investor Service, S&P Global Ratings