'I would be shocked': $14 billion Illinois bond fight a longshot

(Bloomberg) — The municipal-bond market is putting long odds on a think-tank chief’s bid to have $14 billion of Illinois debt tossed out in court.

While the yields on some of the challenged state bonds jumped by more than a third of a percentage point in the weeks after the suit was filed on July 1, they’ve since reversed course amid the market’s broader rally, indicating little risk that their legal status will be cast into doubt. Taxable Illinois debt due in 2033 is now yielding 4.46%, only about 0.3 percentage point more than bonds the state issued in April that aren’t being questioned by the suit.

“You’re getting paid the extra 30 basis points to deal with this headline risk,” John Miller, co-head of fixed income at Nuveen LLC, said in an interview. His firm holds Illinois debt. “You could have this taint and outside risk, but it’s ultimately a low probability of it actually being invalidated.”

The lawsuit, filed by the head of a conservative think tank and backed by a hedge fund, has drawn widespread attention in the $3.8 trillion state and local government debt market because it could set a novel precedent for groups seeking to challenge government spending. It came after Puerto Rico’s federal overseers asked a court to void a big chunk of that bankrupt island’s debt, arguing that it was illegally issued after the government had already run up against its borrowing limits.

John Tillman, the chief executive of the Illinois Policy Institute, a conservative think tank, claims that Illinois’ bond sales for its pensions in 2003 and to cover a backlog of unpaid bills in 2017 were deficit financings that violated the state constitution, which says bonds must be issued for “specific purposes.” Illinois officials have said the borrowings were valid and criticized the case as politically motivated. Sangamon County Circuit Court Associate Judge Jack Davis is expected to issue a decision this week on whether the petition can move forward.

Spokespeople for Tillman and Warlander Asset Management, the hedge fund backing the case, declined to comment. A spokeswoman for the Illinois attorney general didn’t immediately provide a comment.

Nuveen and AllianceBernstein LP, which together own $2 billion of Illinois general-obligation bonds, filed a brief supporting the state’s argument that the debt is valid.

That appears to be the common view on Wall Street. The recent drop in the yields on the challenged Illinois bonds “likely reflects the market’s expectation that, ultimately, the suit will fail,” Bank of America Corp. analysts said in an Aug. 23 report. Invalidation of the bonds “is certainly not our base case,” according to the report.

Even if the Illinois judge allows the case to move forward, Nuveen’s Miller said he “can’t imagine that an outside plaintiff could prevent” Illinois from making its debt payments. The required three-fifths of the state’s legislators approved the debt and its purpose to pay accruing bills, Miller said.

“I would be shocked if that’s not a legitimate purpose,” Miller said.