* State failed to fix bloated public pensions
* Illinois faces the highest yield spreads
* Backlog of unpaid bills
By Karen Pierog
CHICAGO, Jan 30 (Reuters) - Illinois yanked a $500 million general obligation bond issue slated for Wednesday because of credit concerns that could boost its borrowing costs, in the latest financial blow to the state, which has failed to fix its bloated public pensions.
Investment banks that planned to bid on the debt indicated investors would demand higher yields on the 25-year bonds, said John Sinsheimer, Illinois' capital markets director.
"We were getting indications of higher spreads than we were anticipating," said Sinsheimer, who declined to discuss specific spread levels. "We felt it was prudent to pull the deal for the time being."
Illinois is already faced with the highest spreads - 137 basis points in the latest week - over Municipal Market Data's benchmark triple-A scale among states and cities tracked by MMD, a unit of Thomson Reuters. By contrast, the spread for California, another low-rated, high-debt issuance state, was only 48 basis points in the week ended Jan. 25.
The nation's fifth most populous state faces an array of financial problems including the most underfunded state pension system in the nation and a backlog of billions of dollars in unpaid bills. Politicians have failed to act as the crisis mounted, prompting credit agencies to cut the state's debt ratings and to warn of further downgrades.
On Friday, Standard & Poor's Ratings Services cut Illinois to A-minus with a negative outlook, while Fitch Ratings earlier this month warned it could downgrade the state's A rating within the next six months. In December, Moody's Investors Service revised the outlook on the state's A2 rating to negative.
Illinois' ratings with S&P and Moody's are at the lowest level among states they rate.
The bond sale would have been the first by Illinois since the latest round of credit warnings and since the Democrat-controlled legislature once again failed to reach a consensus on any measure to tackle a $96.8 billion unfunded pension liability during a lame-duck session that ended Jan. 8.
A new date for the Illinois bond sale could depend on when Democratic Governor Pat Quinn unveils his proposed fiscal 2014 budget in February or March, Sinsheimer said.
Tom Cross, Republican leader of the Illinois House, called the bond sale postponement "a clear indication that officials were concerned that we might pay too much in interest, in large part due to our awful credit rating."
"Our failure to pass meaningful pension reform, to pay down our large backlog of bills and to live within our means is contributing to this uncertainty in the markets for us," he said in a statement.
Democrats hold a majority of seats in the Illinois legislature.
Tim McGregor, director of municipal fixed income at Northern Trust, said the state probably would have had little difficulty selling the bonds on Wednesday "with a little bit of yield" given low supplies of debt in the $3.7 trillion municipal market and yield-hungry investors. He added that if Illinois wants to attract lower rates in the market, it needs to fix its finances, particularly pensions.
"Spreads won't tighten just because they want them to tighten," he said, adding the state needs to impress the market by tackling pension reforms.
Lawmakers have promised to discuss pension reforms in early February.