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Aug. 6 (Bloomberg) -- Illinois is back in the doghouse among investors in the $3.7 trillion municipal-bond market.
The extra yield investors demand to own 10-year Illinois bonds rather than AAA munis has surged 0.55 percentage point since May to 1.64 percentage points, data compiled by Bloomberg show. The gap grew after lawmakers on May 31 passed a budget with a $2 billion hole. Then last month, the state Supreme Court ruled that government retirees’ health-insurance premiums were shielded from cuts, and Standard & Poor’s changed its outlook on Illinois to negative.
Though Illinois is rated six steps below AAA, it trades at near-junk yield levels. That’s still not attractive enough for James Dearborn at Columbia Management Investment Advisers and Patrick Morrissey at Great Lakes Advisors. A potential political shakeup from gubernatorial elections in November, considered a toss-up, and questions over the constitutionality of the state’s pension overhaul have bond buyers betting prices will keep falling.
“There’s the risk that spreads could widen out and you could own the bonds at a cheaper level if a downgrade were to take place, which is not out of the question,” said Dearborn, head of munis in Boston at Columbia Management, which oversees about $30 billion in local debt.
Illinois’s borrowing costs fell during the first five months of 2014 after lawmakers broke through decades of gridlock to pass a measure addressing pension systems that were 40.4 percent funded as of 2012, the weakest among states. The state issued debt four times after the December fix, including an offering in April with the smallest yield penalty since 2009.
Now bond investors are less enthusiastic about Illinois, which has the lowest credit rating among U.S. states. It’s graded A- by S&P, and a comparable A3 by Moody’s Investors Service.
Ten-year revenue bonds rated BBB, two steps above speculative grade, yield 3.43 percent, while debt from Illinois with the same maturity yields 3.94 percent, Bloomberg data show. The difference is the largest since January, signaling that investors view the state as relatively riskier.
“It’s cheap, but the question is if it will get cheaper -- the root of the problem isn’t really changing,” said Morrissey, who helps manage about $3.8 billion as director of fixed income at Great Lakes Advisors in Chicago.
The penalty may have little immediate consequence. Illinois has no plans to borrow for the rest of 2014, Abdon Pallasch, the state’s assistant budget director, said in an e-mail.
The yields reflect the potential for events to go against the state in coming months, Dearborn said.
The Illinois Supreme Court ruling that said the state’s constitution prevents reductions in government retirees’ health- insurance premiums rang alarm bells about the legality of the 2013 law designed to eliminate a $100 billion pension shortfall. That benefit-cutting measure is being challenged by public- employee unions with similar arguments about constitutional protections.
At the same time, temporary increases in personal and corporate income-tax rates are scheduled to roll back at year- end, costing an estimated $4 billion annually. Democratic Governor Pat Quinn has unsuccessfully lobbied lawmakers to extend them.
Republicans have criticized the tax boosts approved by Democratic lawmakers in 2011. Yet the Republican nominee for governor, private-equity executive Bruce Rauner, has backed away from earlier opposition to higher levies.
Rauner last month called for a four-year phase-out of the income-tax increases and an extension of the state sales tax to cover services such as attorney fees and other transactions that currently aren’t taxed.
“The state is facing real fiscal issues,” said Amanda Kass, budget director and pension specialist at the Chicago- based Center for Tax and Budget Accountability. “But there are real opportunities here to address the state’s structural deficit.”
Not all investors are shunning the state. With muni yields close to generational lows, investors are shifting into riskier securities such as those from charter schools and senior-living communities. Those bonds are among the most likely to default, according to data from Municipal Market Advisors.
Illinois offers “a better risk-reward trade-off than other parts of the market,” said Lyle Fitterer, who helps oversee $34 billion of munis at Wells Capital Management in Menomonee Falls, Wisconsin. “You’d rather own a charter school than the state of Illinois? You have to take a step back and ask if that makes sense.”
Fitterer said Wells Capital sold some Illinois general obligations during the rally earlier this year. The company is buying them back with the expectation that after the election lawmakers will renew the higher income-tax rate.
The 2011 personal-income-tax increase to 5 percent from 3 percent was the largest in state history. The choice for lawmakers as they crafted a budget for the fiscal year that started July 1 was to extend the levy or cut spending to offset lost revenue. The votes weren’t there to do either.
As a result, the $35.7 billion budget approved by the General Assembly doesn’t cover operations. In the meantime, the state will stiff vendors, borrow and delay employee payments. Legislative leaders have said they’ll address those tax and spending decisions after November elections.
Until then, bondholders could be in for a rocky road, Dearborn said.
“Things could really break against them,” he said. “Even though they’re cheap today, they could get much wider.”