27 October 2020

Weekly Municipal Monitor—Illinois Accesses Market

By Robert E. Amodeo, Thea Okin

Municipals Posted Negative Returns as Yields Moved Higher With Treasuries

Municipal yields moved higher as Treasuries retreated. AAA municipal yields increased 2 bps across intermediate and long maturities, trailing Treasuries higher. The Bloomberg Barclays Municipal Index returned -0.07%, while the HY Muni Index returned -0.10%. This week we take a look at Illinois in light of its $850 million transaction.

Municipal Mutual Fund Inflows Continue Amid Near-Record Issuance

Fund Flows: During the week ending October 21, municipal mutual funds recorded a third consecutive week of net inflows of $604 million, according to Lipper. Long-term funds recorded $97 million of outflows, intermediate funds recorded $61 million of inflows and high-yield funds recorded $21 million of inflows. Municipal mutual fund net inflows YTD total $25 billion.

Supply: The muni market recorded $19.5 billion of new-issue volume last week, up 4% from the prior week and marking the highest level of new issuance since 2017. Issuance of $397 billion YTD remains over 30% above last year’s pace, driven by taxable issuance which is over 3x last year’s level. We anticipate another elevated week of issuance this week, with approximately $16 billion of scheduled new-issue volume. The largest deals include $1.8 billion Los Angeles Community College District and $1.1 billion Los Angeles Unified School District transactions.

This Week in Munis: Illinois Accesses Market

Last week the State of Illinois (rated Baa3/BBB-/BBB- by Moody’s, S&P and Fitch) priced $850 million of general obligation bonds across tax-exempt and taxable transactions in its first transaction since accessing the Fed’s municipal liquidity facility. Tax-exempts priced at 4.40% in 2045, while taxables priced at 3.24% in 2025.

Illinois has well-documented structural budgetary and pension issues that will undoubtedly be further stressed by the current pandemic. Earlier in the year, the state projected a budgetary shortfall of $6.2 billion, over $134 billion of pension liabilities and an unpaid bill backlog exceeding $6.4 billion. The fiscal 2021 budget balance depends on a revision to the tax code that would introduce a progressive tax structure, already passed by the legislature and awaiting constitutional ratification. The budget also depends on $5 billion of federal funds, either from direct stimulus or borrowing through the Fed’s municipal liquidity facility.

The state forecasts base revenues to decline 6%, or $2.4 billion, from 2019. However, monthly comptroller reports suggest tax collections are exceeding this pace, despite the current conditions.

Western Asset has long viewed revenue-backed bonds favorably over general obligation securities, as we believe the former can help investors benefit on a risk-adjusted basis. The COVID-19 pandemic has contributed to spread-widening in the Illinois debt complex, which—considering potential better-than-anticipated revenue collections—could adequately compensate investors for outstanding risks. While we believe the state has the ability to manage through its challenges, it is not likely to be a smooth road due to the political climate. A progressive tax structure for the state is a sound first step to address these challenges and improve the state’s credit profile.

Exhibit 1: Illinois Spread to AAA and High-Yield Municipals
Explore Illinois Spread to AAA and High-Yield Municipals.
Blue Line: State of Illinois 20-Year BVAL less AAA Callable Curve. Grey Line: State of Illinois 20Y BVAL less High Yield Municipal Yield to Worst.
Source: Bloomberg. As of 23 Oct 20. Select the image to expand the view.
Exhibit 2: Municipal Bond Yields and Index Returns
Explore Municipal Bond Yields and Index Returns.
Sources: (A) Muni yields: Thomson Reuters MMD; Treasury Yields: Bloomberg. As of 23 Oct 20.
(B) Bloomberg. As of 23 Oct 20. Select the image to expand the view.
Exhibit 3: Tax-Exempt and Taxable Municipal Valuations
Explore Tax-Exempt and Taxable Municipal Valuations.
Sources: (A) Bloomberg, Western Asset. AAA, AA, A, BBB Corporate Indices. After-tax yield assumes a top effective tax rate of 40.8%. As of 23 Oct 20.
(B) Bloomberg, Western Asset; Taxable Muni Index Corporate comparable used is the long corporate (ex. BBB) to better align credit quality and duration. As of 23 Oct 20. Select the image to expand the view.