Illinois to sell $6B of bonds to a skeptical market

Illinois budget

Investor skepticism that Illinois can climb out of a deep fiscal hole will loom over the state's $6 billion sale of tax-exempt bonds into the U.S. municipal market set to start next week.

The fifth-largest U.S. state will have to demonstrate that it is willing and able to address long-term issues, including a $130 billion unfunded pension liability, said Hugh McGuirk, who heads T. Rowe Price’s municipal bond team.

"I think people are skeptical and Illinois has to show the market that they really mean it," he said.

The state will offer three $500 million general obligation bond series with maturities in 2018, 2019 and 2029 in competitive bidding on Tuesday. During the week of Oct. 23, a team of underwriters will price $4.5 billion of GO bonds maturing in 2020 through 2028.

Illinois compounded an already shaky financial situation by going an unprecedented two fiscal years without a complete budget because of a feud between its Republican governor and Democrat-controlled legislature.

The impasse ballooned the state's unpaid bill pile to a record $16 billion and left a huge pension liability largely unaddressed.

Illinois, the lowest-rated U.S. state, avoided becoming the first to be downgraded to junk after its legislature enacted a $36 billion fiscal 2018 budget and $5 billion income tax increase in July over Governor Bruce Rauner's vetoes.

The budget package authorized the bond sale to raise money to shrink the pile of bills from vendors and service providers accruing late payment penalties of as much as 12 percent annually.

"The question will be is the bill backlog going to start rising again after the dust settles after that financing because the state is caught in this mode of running deficits and deferring bills," said Ted Hampton, an analyst at Moody's Investors Service, which rated the bonds one step above junk at Baa3 with a negative outlook.

Bond proceeds, federal matching Medicaid funds and other measures are expected to reduce outstanding bills to $7.5 billion when the fiscal year ends on June 30. A report released late on Thursday by Rauner's office cited a $1.5 billion gap in the current budget that could grow in coming years.

"Without changes to the current trajectory of the state’s finances, the projected deficit for fiscal 2019 is $2.15 billion and the bill backlog could grow to an estimated $13.7 billion by the end of fiscal 2023," the report said.

LOOMING ELECTION

With Rauner and most state lawmakers facing reelection in November 2018, the political environment may deter positive momentum on the fiscal front. The political stakes will be high going into the election with Rauner battling Democrats as well as some fellow Republicans he recently alienated by signing an abortion funding bill, said University of Illinois political science professor Christopher Mooney.

"It's quite possible we don't get a budget for (fiscal 2019)," he said.

The risk that Illinois' fiscal progress could stall has pushed some investors to the sidelines.

"Until they ensure long-term sustainability of their credit worthiness and pay their vendors, we won’t be buying their longer-dated debt as it will continue to be subject to headline risk and credit risk," said Barry Hoaire, co-head of fixed income at Bel Air Investment Advisors.

The muni market has eased its penalty for Illinois bonds following the budget and tax hike. Spreads over Municipal Market Data's benchmark triple-A yield scale narrowed considerably after reaching record highs in June.

The state's 12-year bond spread is 163 basis points over the scale, down from 325 basis points in June, according to MMD, a Thomson Reuters unit.

Illinois bonds are yielding much more than states like Connecticut and Pennsylvania that are struggling with budget issues. Bonds due in 12 years from those two states were yielding 2.97 percent and 2.72 percent respectively, versus Illinois' 3.78 percent.

(Reporting By Karen Pierog; Editing by Daniel Bases and Meredith Mazzilli)