State, city budget woes help investors find yields
BY DAVID ROEDER Staff Reporter August 30, 2013 7:28PM
Updated: October 2, 2013 6:37AM
If the municipal bond market were a diner, it would have signs inviting you to feast on the government debt of Illinois and Chicago.
“Buy Illinois at 6 percent,” one sign might say. Or, “Let the politicians serve you a heaping yield.”
Prices for bonds issued by the state and city have declined in recent weeks as reductions in their credit ratings have shaken the market’s confidence. Sellers unloaded municipal debt, a sector that usually appeals to conservative and income-seeking investors, after Detroit’s bankruptcy filing in July.
Some wondered if Illinois and Chicago would be in a similar fix. Lawmakers have squabbled all summer about public pension deficits while making little headway. The dispute suggested little political will to improve public finances and scared off more bond buyers.
But when bond prices fall, the interest rates they pay rise, leading to enticing offers for investors who want a return on something that’s still reasonably secure.
Market data show that general obligation bonds issued by Illinois and Chicago are offering some of the highest yields available for tax-free income.
“The yields are tempting, the income is favorable but the trends in this market are not favorable,” said John Miller, co-head of fixed income at the bond firm Nuveen Investments Inc.
Municipal bonds, called “munis” in the trade, have become a tougher sell. Investors have pulled 13 percent of muni fund assets since May, according to Lipper reports. Besides the trouble in Detroit, anxiety grew about the Federal Reserve orchestrating increases in interest rates, which would make fixed-income investments less attractive.
Miller said prices for Illinois and Chicago general obligation debt have fallen more than the overall market. General obligation means they are backed by that government’s full taxing power and not by a single revenue source. It’s usually seen as a guarantee of payment, almost as iron-clad as what’s offered by U.S. Treasuries.
Chicago general obligation debt is promising a yield that’s about 170 basis points, or 1.7 percentage points, more than other cities’ highly-rated bonds, Miller said. Illinois is worth a premium of about 150 basis points over other state bonds, he said.
Examples of bond offers last week, according to Fidelity Investments, include Chicago bonds maturing 20 years from now reaching yields of 5.9 percent. An Illinois general obligation bond maturing in 2033 traded at a 6 percent yield, and other long-term debt from the state had yields of 5.8 percent.
Those are among the highest tax-free yields available. General obligation munis earn money that’s free of federal taxes, but usually not state taxes.
Depending on someone’s tax bracket, the yields can have a taxable equivalent of more than 9 percent, nearly unheard of with today’s low interest rates.
Still, some fund managers and institutions that do most of the business in munis are steering clear, said Aaron Izenstark, chief investment officer at Iron Financial LLC. The Northbrook-based firm has about $2 billion under management.
“It’ll take time for some people to buy” anything out of Illinois, he said. “Enough people have been burned so many times in the market that they’ll take something with a zero yield to keep their money safe.”
Moody’s Investors Service Inc. and Fitch Ratings Inc. have lowered the grades they assign to certain local debt and applied negative credit outlooks to both the state and the city, suggesting more rate reductions ahead.
“I think buying munis in Illinois is a contrarian move and a good move in terms of the yields,” Miller said. He said Nuveen has trimmed some of its holdings in Illinois bonds but has kept them in the portfolio. For most investors, the diversity of a bond fund is better than buying munis directly, he said.
John Sinsheimer, director of capital markets for the state, agreed that the Illinois pension situation has affected demand for the state’s bonds. “Some institutions are not buying Illinois paper,” he said.
Nevertheless, the state accumulated $9 billion in orders for $1.3 billion in general obligation bonds in June, the last time it went to market. Sinsheimer said another bond issue is possible in October or November but might be put off. “The market is in a bit of turmoil right now,” he said.
Moody’s has publicly taken Illinois to task for “political paralysis” when it comes to unfunded pension liabilities, which are estimated at around $100 billion. If the state doesn’t change its pension laws and help Chicago, the city will have to lift its pension contribution to $1.2 billion in 2015 from $467 million in 2014, Moody’s reported.
Yet others have argued that the pension problem poses little risk to bondholders. Illinois defaulted on its debt once — in 1842 — and no state has done it since 1933.
“So the entire asset class has an 80-year record of consistent performance,” wrote Marc Joffe, principal consultant for Public Sector Credit Solutions, in a column for Bloomberg News.
The record beats the AAA-rated mortgage-backed securities or collateralized-debt obligations that melted down in the financial crisis, Joffe said.