UPDATE 2-Illinois pension woes drive up costs in $1.3 bln bond sale
* Governor says bonds to cost state extra $130 mln
* Fund manager calls deal "ridiculously cheap"
* $1.3 bln deal attracts over $9 bln in orders
(Adds details of bond sale, adds investor comments)
CHICAGO, June 26 (Reuters) - The state of Illinois was forced to slash the price on $1.3 billion of bonds on Wednesday in order to entice investors to swallow the deal, the latest evidence of the penalty the market is inflicting on the state for its inability to resolve a long-running pension crisis.
The hefty interest rate premium will saddle state taxpayers with an additional $130 million of debt finance costs over the next 25 years, Illinois Governor Pat Quinn said in a statement that scolded lawmakers for failing to strike a pension deal earlier this month.
The state will pay as much as 5.65 percent for the longest-dated bonds in the deal compared with 3.83 percent for top-rated municipal issuers.
Illinois, which has the lowest credit ratings of all the states, pays some of the highest interest rates among a select group of large municipal issuers, with a credit spread over a benchmark yield scale that is the second-widest after Puerto Rico's.
Tax-exempt bonds due in 25 years in the Illinois deal yielded 5.65 percent or 182 basis points over Municipal Market Data's triple-A benchmark scale at Wednesday's market close compared with a spread of 138 basis points the state's bonds were yielding over Tuesday's scale.
The deal's top yield in 2038 also surpassed the 5.52 percent yield fetched by taxable 25-year GO bonds in a $350 million bond issue Illinois sold in April.
The 4.46 percent yield on uninsured 10-year bonds resulted in a spread over MMD's scale of 185 basis points versus 145 basis points on Tuesday.
MARKET REVERSES DIRECTION
Citing critical infrastructure projects that needed funding and could not be stopped, the state forged ahead with the deal's pricing despite a recent muni market downturn that drove yields up to levels not seen since 2011. However, the market reversed direction on Wednesday with prices heading higher, pushing yields down by as much as 22 basis points on MMD's scale.
Quinn's office said downgrades of Illinois credit ratings, including two earlier this month that were due to a lack of a pension fix, will cost the state more money to pay off the bond issue over its 25-year life compared with prices on debt sold Wednesday by other muni issuers not hit by similar downgrades.
"Today's bond sale ensures that the work continues on much-needed improvements to roads, bridges and other infrastructure projects across Illinois," Quinn said in a statement. "But legislative inertia has a price, and today the price for taxpayers was an extra $130 million."
The deal attracted more than $9 billion in orders from 145 investors and resulted in an average interest rate of 5.042 percent, according to Quinn's budget office.
The sale was the state's first for GO bonds since it ended its spring legislative session on May 31 without a fix to its nearly $100 billion unfunded public pension liability. The lack of action on pensions led to downgrades of Illinois, already the lowest-rated state, by Moody's Investors Service and Fitch Ratings.
A legislative conference committee is now tasked with coming up with a plan to repair the nation's worst-funded state pension system that Illinois lawmakers can consider by a July 9 deadline.
Tim McGregor, director of municipal fixed income at Northern Trust, said a big run-up in yields in the $3.7 trillion muni market since late last week along with Illinois' pension problem combined to pump up yields in the deal, attracting both traditional and nontraditional buyers of tax-free debt.
"The yields are obviously getting a lot of people's attention," he said.
John Mousseau, director of fixed income at Cumberland Advisors, called the bonds' pricing "ridiculously cheap," particularly for a state GO bond issue.
"There is no question in my mind that at this level you are being paid to own the credit," he said, referring to headline risk from the state's ongoing financial problems.
He added that Cumberland ordered some of the bonds for clients.
Illinois' deal included bonds insured by Assured Guaranty Municipal Corp in four maturities. The spread for insured bonds maturing in 10 years was 144 basis points over the MMD scale.
Illinois' bonds were initially priced with even higher yields that were lowered as much as 20 basis points on the long end of the deal in a repricing.
(Editing by Tiziana Barghini, Kenneth Barry, Bob Burgdorfer and Matthew Lewis)