The state of Illinois has priced a $1.3 billion tax-exempt bond issue. The state has ratings of A3 Moody’s and A- Standard and Poor’s. For more than one year, we have not owned the state of Illinois general-obligation bonds due to a negative outlook for both ratings. Our reasoning was that we were not being paid adequately in terms of yield given our risk limits and the volatility of the risk. That does not mean we thought the state of Illinois would default. That did mean we felt investors were not being compensated. Here is the link to last year’s commentary on Illinois: http://www.cumber.com/commentary.aspx?file=043012.asp.
The state continues to face a number of challenges. They include woeful pension shortfalls, a legislature that has been slow to recognize and fix problems, bad cash management, and using IOUs to pay vendors. However, the state did raise its income tax rates two years ago and may do so again. The state of Illinois has a large and diverse economy, and the legislature is making some incremental progress on pensions. This state has a long way to go.
In a market where we judge risk in terms of yield and compensation, the state of Illinois priced a deal today: $1.3 billion of tax-exempt bonds. We will not repeat the entire scale here, but with many maturities having yields over 5 percent, we felt we finally were being paid for the incremental risk of owning the state. The math is simple. A 5.25 percent tax-free yield equates to a 9.27 percent taxable equivalent yield at the highest tax levels (43.3 percent with combined federal income tax and 3.8 percent Obamacare tax). With trailing inflation at 1.4 percent, an investor is receiving a 7.87 percent taxable-equivalent REAL yield(after inflation) on an AA bond (by virtue of Assured Guaranty insurance).
It is deals like these that generally mark a topping-out point in any market back-off. And since the deal was priced, the tax-free market has rallied vigorously – confirming our view.