Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Are These Illinois Vendor IOUs a good idea?

The Wall Street Journal published an article on December 11th, 2010 about State of Illinois’ move to pitch plans to large investment banks and hedge funds in order to finance its obligation to vendors. The article can be found at the following link:
In short, the State owes about $4.5 billion to vendors of different sizes, many of which depend on state contracts for their survival. Yet like many other states, Illinois faces tax shortfalls and increasing pension obligations and does not have the cash to pay the vendors on time. Therefore, the State attempts to raise cash from the capital market to meet its vendor obligations. According to the illustrations on WSJ, for every month the State falls behind its vendor payment beyond 60 days, investors will collect 1% penalty. Since the State is currently 5 months behind its vendor payments the investors will expect to collect 3% initially and get 1% penalty for every additional month until the State pays back the money. State officials expect to pay back investors in 6 months, although there is no guarantee of that.
I don’t have additional information with regard to how the discussion between Illinois and the potential investors have progressed and other intricate details. However, I would like to present my opinion about whether this will be a good idea for investors. Please note that this opinion is developed based on very limited information. For this article, I will refer to the debt described above as the Vendor IOUs.
The investors in these Vendor IOUs are exposed to two main risks:
1)      The State may default on the Vendor IOUs. The State’s ability to pay principal and interests on the Vendor IOUs will be supported by its ability to tax. Therefore, in terms of credit quality, this should be similar to a General Obligation debt. The State of Illinois’ general obligation bonds are currently rated A+/A1 by S&P/Moody’s and we can assume that the credit quality of these Vendor IOUs to be at least investment grade. The more important point is, unlike cities and counties, by Constitution, a State cannot declare bankruptcy and therefore by law must pay back its obligations sooner or later.  
2)      The payback of Vendor IOUs may take longer than expected. This risk can be mitigated partially by Illinois’ proposed funding structure. According to the plan illustrated in the WSJ article, upon issuance of Vendor IOU, only 90% of the proceeds will be paid to vendors and the remaining 10% will be put into an escrow account. If the State has not repaid the investors after one year, funds in the escrow can be used to pay interest on the Vendor IOUs. This provides a little more security for the investors, although the majority of the principal will still be exposed.
From a Returns perspective, Assume the State takes about 6-12 months to pay back Vendor IOU, investors may be rewarded with 9-15% annualized return. In addition, municipal debt are federally tax exempt, assume a 25% marginal tax rate, the Vendor IOUs will offer an equivalent taxable return of 12-20%. As of end of December 2010, 1 year Treasury bill yields about 29bps, the Vendor IOUs can potentially provide a huge risk premium over Treasury. That is very impressive for an investment grade rated debt.
In addition, for investors concerned about a rise in general interest rate level, the Vendor IOUs may offer a place to temporarily park money with attractive returns and low reinvestment risks. The Vendor IOUs are short term in nature (less than 12 months) but the monthly step-up in interest rate can more than keep pace with a potential rise in general interest rate level. If the general interest rate level actually rises in 12 months and the State pays back the principal within that period, investors can reinvest the proceeds into higher earning assets.
Overall, in my opinion, the Vendor IOUs offer quite attractive reward for risks involved with investing in such obligations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.