The State of Illinois has issued $6 billion in general obligation debt over the last two weeks, the largest portion of which came last week when the state issued $4.5 billion in $500 million serial maturities from 2020 to 2028. The 10-year non-callable bonds priced at approximately +175 basis points (1.75%) over the AAA muni scale and traded down slightly after they were issued, which was consistent with other municipals on that day. The deal was not heavily oversubscribed, as has been the case with most municipal deals with higher yields this year, and the shortest maturities were left unsold. The spread level for the 10-year tenor on the new issue represented a concession of about 15 basis points versus where bonds had been trading in the secondary market prior to the deal. Spreads were much lower on some of the short maturity debt, especially the 1- and 2-year bonds that were issued two weeks ago, which priced at +70 over the AAA municipal scale. These shorter bonds have struggled to find homes with investors.
Overall, Illinois bonds have been among the top performers YTD, as spreads came crashing back in after the state finally passed a budget and staved off downgrades to below investment grade (see chart below). This performance has come with a very high degree of volatility, and is subject to reversing very quickly should the state fail to make sound fiscal decisions moving forward.
All of the ratings agencies confirmed their investment grade ratings prior to this deal, although Fitch has maintained a negative outlook for the credit (though its rating is currently one notch higher than the other two agency ratings). Moody’s also has a negative outlook, and an additional downgrade would take the state below investment grade. All three major rating services believe that Illinois’ problems are related to management (and associated budgetary and fiscal policy dysfunction), and they do not believe that the state’s current rating is driven by underlying economic fundamentals. A Fitch report, seeking to put the rating in a global context, notes that the fundamentals for the state are stronger than other comparably rated European sovereigns. In addition, Fitch points out that comparisons to Puerto Rico are at this time unfounded as the state maintains a robust economy, unlike the commonwealth in the years leading up to its bankruptcy.
Investors have spent most of this year on a hunt for yield, as evidenced by the performance of corporate bonds and lower rated municipal bonds relative to other investment grade bond market segments. While Illinois still offers a large yield premium over other BBB category municipal issuers, that premium is much smaller than it was a year ago. Furthermore, the managerial concerns have not materially improved and the state’s pension liability continues to grow, causing the fundamental picture to deteriorate at the margin. A downgrade to below investment grade remains possible and would likely drive spreads wider. This could cause a great deal of selling pressure if investors with investment grade mandates were forced to sell, and is among the reasons that we avoid this name in our portfolios.
Source: Bloomberg, Fitch