- In July, Illinois narrowly avoided a bond downgrade.
- I saw an opportunity, despite the market’s negative view.
- Three key reasons led us to expect a positive outcome.
Illinois dominated municipal bond market headlines early this summer, as the state faced a potential downgrade to speculative grade by all three rating agencies amid fiscal woes. Nevertheless, our muni team saw the potential for a political solution despite the noise, and opportunistically invested in the state’s general obligation bonds (GO) in several of our municipal bond funds where they were appropriate holdings.
Due to market trepidation resulting from a looming budget deadline and other negative news, spreads to the AAA muni yield curve on Illinois GOs began moving significantly in May. Long bonds ultimately widened from a spread of 210 basis points to 290 basis points. For reasons explained below, we saw the market overreaction as an investment opportunity. When positive news hit, spreads tightened to 200 basis points, increasing the value of these bonds.
Saved by a Buzzer-Beater
Illinois had not enacted a budget since Governor Bruce Rauner took office in early 2015. With an impending budget deadline, Standard and Poor’s and Moody’s downgraded the state’s GOs in late June. A week later, Illinois lost a lawsuit brought by a group of managed care organizations over its failure to pay what it owed in a timely manner.
On July 1, the state was on the verge of entering a third fiscal year without a budget, imperiling its credit rating yet again. The legitimate threat of a downgrade to junk status shook markets.
Then, late in the day on June 30, the first signs of a budget materialized. Over the following week, Illinois lawmakers passed a budget along with a highly contested income tax increase (from 3.75% to 4.95%) and even overrode Governor Rauner’s veto to force through the legislation. Bonds rallied into this historic milestone.
How Were Capital Group’s Muni Funds Positioned?
Capital Group’s municipal bond analysts and portfolio managers held a favorable view of Illinois going into the period of volatility. Despite a grisly long-term fundamental backdrop (nearly $15 billion in payables on a revenue base of $32 billion and one of the worst-funded pension systems in the U.S.), we saw three key reasons to invest in the state’s bonds at historically wide spreads:
1. Sovereign power: States have taxation power, can push payments to local governments and are ineligible for bankruptcy.
2. Ability to pay: Tax rates in Illinois are relatively low at 3.75%, 5.25% and 6.25% for income, corporate and sales taxes, respectively. Sales tax could also be expanded.
3. Strong security provisions within the GO construct: This includes features significantly stronger than the typical GOs, like setting aside a portion of future debt payments in a segregated account and strong legal rules protecting bondholders.
Despite this huge milestone, Illinois is not out of the woods. I expect continued volatility in the bonds’ spreads in the near- and medium-term. I also expect between $3 billion and $6 billion of tax-exempt GO issuance by the end of the year to cover a portion of the state’s payables. This could put technical pressure on bond values.
Later this year, Illinois politics will be in full swing as the gubernatorial election heats up for November 2018. Amid this, Governor Rauner and House Speaker Michael Madigan will have to hash out another budget next May, which could increase volatility.
Although our research identified an opportunity here, investments don’t always work out. In the case of Illinois, there are bound to be more twists and turns in its credit story.