Illinois Is in Deep Trouble: What Investors Need to Know
June 29 2017 - 05:59AM
Dow Jones News
By Heather Gillers
Illinois is locked in a political stalemate, and in danger of
becoming the first U.S. state to have its debt downgraded to junk
status. S&P Global Inc. threatened to take that action if Gov.
Bruce Rauner and Democratic Speaker of the House Michael Madigan
can't agree on a package of spending and taxes by the start of the
next fiscal year on Saturday. Below is a breakdown of what this
unprecedented event would mean for everyone from individual
investors to large Wall Street money managers.
Who owns Illinois's debt?
Much of Illinois's $25 billion in outstanding general obligation
debt is held by individual investors seeking a stable source of
income, according to analysts' estimates. But Wall Street is also
exposed via mutual funds, hedge funds and insurers that purchased
the state's bonds. Money management giant Vanguard Group has $1.2
billion spread across seven mutual funds. It is the biggest holder
among all mutual-fund firms that had a total of $4.5 billion in
Illinois bonds as of the first quarter of 2017, according to
research firm Morningstar.
What would a downgrade do to those investments?
Not much, say analysts. They predict prices would drop only a
few cents in the event of a junk downgrade. Currently the state's
general obligation bonds are trading at nearly 100 cents on the
dollar. Junk bonds don't usually trade at par, but state general
obligation debt is considered safer because states have broad power
to tax and lack the legal ability to declare bankruptcy.
Will investors still get paid?
A junk rating won't affect the state's ability to pay
bondholders. State officials have said those payments are their No.
1 priority.
What does a 'junk' rating mean, anyway?
Ratings firms rank debt according to how safe an investment they
believe it is. The 12 safest tiers are considered "investment
grade," meaning investors have what S&P terms "adequate"
protection against the risk of default. Below that, bonds are
considered junk, or "speculative grade," meaning they face "large
uncertainties" or "major exposure to adverse conditions," according
to S&P. Investors who buy junk may earn greater profits if the
bonds perform well but they also face greater danger of losses.
Are mutual funds even allowed to own junk municipal bonds?
Most mutual funds have rules limiting their investment in
junk-rated debt, but when bonds drop below investment grade they
may not be required to sell them. At Vanguard, mutual funds are
allowed to hold a "modest allocation" of junk bonds, a spokesman
said. Vanguard's municipal bond team, a spokesman said, is
"comfortable with the risk/reward" of investing in Illinois
bonds.
How are investors expected to react to a downgrade?
Bonds are still likely to change hands as holders spooked by the
state's deteriorating credit sell and high-yield investors take
advantage of the opportunity to buy. Mutual funds have already sold
more than $2 billion in Illinois general obligation bonds since the
end of 2016, according to Morningstar, and buyers have been taking
advantage of temporary dips. Howard Cure, director of municipal
bond research at Evercore Wealth Management, said some of his
clients might buy more Illinois bonds if prices drop further.
How would a downgrade affect Illinois?
The most immediate impact would likely be a rise in borrowing
costs, making it more expensive to raise money for new projects.
Analysts predict investors could demand an additional half-percent
to a percent in interest, meaning the state would pay an additional
$5 million to $10 million for every $1 billion it borrows. Illinois
already pays a premium. When it last sold tax-exempt debt in
November 2016, the state paid yields of 4.4% for 20-year bonds. In
contrast, 20-year bonds issued by the state of Wisconsin around the
same time yielded 2.8%.
Is Illinois on its way to becoming the next Puerto Rico?
Analysts say no, noting that Illinois's problems are largely
political. Unlike Puerto Rico, which is in the midst of a
court-supervised restructuring, Illinois has a strong underlying
economy and annual revenues that are about 10 times its yearly debt
service payments. Puerto Rico, on the other hand, has endured more
than a decade of economic distress. "There's no risk of Illinois
losing market access," said Matt Fabian, a partner at Municipal
Market Analytics.
Will a junk downgrade spill over affect other states and
cities?
It could. New Jersey and Connecticut, among the lowest-rated
states after Illinois, may face more scrutiny from investors,
analysts said. Both are wrestling with budget problems and mounting
liabilities. But New Jersey and Connecticut still have a long way
to go to match Illinois's ratings dilemma. They are rated several
notches higher by S&P and Moody's Investors Service.
Do you have more questions about the potential for an Illinois
downgrade? We will do our best to answer them. Please add them in
the comments below.
Write to Heather Gillers at heather.gillers@wsj.com
(END) Dow Jones Newswires
June 29, 2017 05:44 ET (09:44 GMT)
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