Why an influential muni strategist is bullish on Illinois bonds

Illinois' bonds are underappreciated, Wells Fargo Head of Municipal Markets Strategy Vikram Rai said Monday as he released a report on the state titled, "Why Illinois Beckons."

"All the negative news was drowning out all the positive news and the positive developments about Illinois' improving story," Rai said during Monday's municipal market weekly call, noting that Illinois, the sixth largest U.S. state by population, has a larger gross domestic product than Saudi Arabia.

While Rai acknowledged that the biggest credit challenge Illinois faces involves its long-term liability burden, he argued in the call and in the report that the state is on the upswing.

The state's A-minus level ratings are a big improvement over the BBB-minus status they carried as recently as 2021, but still trail other states.

"The upcoming elections, they will have very little bearing on Illinois' credit in the medium term," Rai said. "And the main story for Illinois has been a general improvement in credit fundamentals. ? Things have changed since Gov. Pritzker took over, and under his leadership, the state has made great strides fiscally. We have had balanced budgets, elimination of the bill backlog, improving balances in the budget stabilization fund? and [the state has] reached $1 trillion in GDP."

Gov. JB Pritzker, a Democrat who took office in 2019, succeeded Republican Bruce Rauner, bringing an end to deep animosity between the governor's office and Democratic-controlled legislature that left the state without an enacted budget for two years as unpaid bills piled up.

The Wells Fargo (WFC) report lists three reasons for optimism about Illinois' credit.

One is the structural supply demand imbalance, "such that even a marginal allocation to municipals will lead to municipals remaining well supported."

The second is that an upward sloping curve "will also catalyze leverage" and revitalize tender option bond-type structures, which would send more cash flowing into longer-dated municipals and should strengthen demand for state GOs.

And third is the stable broader outlook for municipal credit.

"While many municipal entities did tap into their strong reserves this year for one-time projects, they typically also maintained 'rainy day fund' reserves available in case of revenue slowing or unexpected operating needs," the report adds.

Rai noted on the call that Illinois has built up its rainy day fund to $2.19 billion.

"Could the rainy day fund withstand another budget impasse? No, absolutely not," he said. "But it's just a step in the right direction, and the expectation is that the balance will reach $2.36 billion by the end of fiscal year 2025."

The report also delved into Illinois taxables: pension obligation bonds and Build America Bonds. While POBs tend to trade cheaper than the issuer's GO debt, it said, most POBs are pari-passu with the GO debt. That is true of Illinois POBs; but the state's POBs are liquid, "which makes them popular with taxable investors," the report noted.

"Going forward, we could see these POB spreads tighten further to near straight GO levels, which would be justifiable given it is pari-passu with GO paper and the chances of fiscal distress for the state have diminished substantially," it added.

As for BABs, the report said the uptick in extraordinary redemption provision calls means "in some sense, there is a floor on spreads for BABs with ERP calls, and this is true for Illinois BABs as well in the current interest rate environment."

Overall, demand for taxable Illinois bonds will depend on the relative value in the corporate market, the report noted.

Illinois' GO bonds are rated A-minus with a stable outlook by Fitch Ratings, A3 with a positive outlook by Moody's Ratings and A-minus with a stable outlook by S&P Global Ratings. KBRA assigns a long-term rating of AA-plus to the state's Build Illinois Bonds. The outlook is stable.

In general, Rai argued that while the Chicago metro area makes up nearly two-thirds of the state's GDP, the knock-on effects of Chicago's budgetary challenges on Illinois' credit are likely to be minimal. They remain constructive on the state's credit regardless of Chicago's situation, he said.

"Not that I'm negative on Chicago, but that's a topic for another [day]," he added.