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Muni Bond Talk

Is Illinois Built On A House of Lincoln Logs?

The State of Illinois is now at the bottom of the pack of fifty states. With a general-obligation rating lowered to A2, it is now the lowest-rated by Moody’s of all the states.

Illinois’ woes have been well documented. The state has a severe backlog of unpaid bills, both to vendors and to Medicaid, totaling $8 billion+. Many vendors are being paid with IOUs. The state’s pension fund system is reported by Bloomberg to be the lowest-funded state pension system in the US, with assets equaling only a little over 44% of projected obligations. These unfunded pension obligations total over $80 billion. The state covered its payments to the pension fund in 2010 and 2011 through borrowing.

The stress in the state can be seen in some widening in the value of the state’s bonds. In the taxable bond market, its general-obligation bonds (5.10s of 2033, with over $7 billion issued in 2003) have recently widened out to +250 basis points over US Treasury bonds, compared to roughly +220 a few weeks ago. To put this in perspective, these pension obligation bonds came to market in June of 2003 at a spread to US Treasuries of 72 basis points. Tax-exempt bonds have seen similar widening in the past few weeks.

The consternation over the state’s finances can also be witnessed in the market for credit default swaps, where 10-year credit default swaps (“CDSs”) for Illinois have widened this month from 240 basis points to 275 – a rise of 35 basis points. To be fair, all municipal-credit default swaps have widened this month, as concern over Europe has put some of the flight-from-risk trade back into the Treasury market. But compare this to California, a state rated A- by S&P, which saw its 10-year CDSs rise from 206 basis points to 235 – a rise of only 29 basis points.

So what has Illinois done to stem the tide? Last year the Illinois state legislature raised the state’s top income tax rate from 3% to 5%. That has provided additional funds, but not enough to reduce the drag created by pension costs and the reduction of federal funding to the state. The governor has introduced a plan that looks to increase employee contributions to pensions, limiting cost-of-living increases and extending retirement ages.

Clearly, more needs to be done across the whole spectrum of revenue raising as well as cost reduction. Illinois is planning to bring a $1.8 billion general-obligation deal this week (April 30th, 2012). The price talk on the deal is 175 to 200 basis points over the AAA scale (Municipal Market Data). This compares to a smaller $500-million-dollar deal in March of this year, which came at a spread of 150 basis points over MMD. Thus the markets are now saying things are going to get worse before they get better.

Aside from the state itself, who is getting hurt? Answer: all the local-governmental units within the State of Illinois that issue bonds. From the University of Chicago, to the City of Peoria, to Lincoln’s home of Springfield, to smaller towns and villages, all are paying higher debt-service costs because of the poor financial management at the state level.

At some point these issuers, sick of paying these additional interest costs, will take up the famous line from the movie Network, when Peter Finch shouts from the window, “I’m mad as hell, and I’m not going to take this anymore!” And call for real change.

Thanks to our friends at Cumberland Advisors

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