* Illinois to sell GO bonds despite rising interest rates
* Deal spreads seen at up to 200 basis points over MMD scale
* Investors unhappy with lack of solution for state pensions
By Karen Pierog
CHICAGO, June 24 (Reuters) - Illinois' biggest bond sale so far this year will hit the U.S. municipal market on Wednesday amid rising interest rates and concerns the state's already low credit ratings could erode further as lawmakers struggle to come up with a fix for a huge public pension problem.
Credit worries coincide with a steep price drop in the $3.7 trillion municipal bond market that has lifted yields on bonds due in 10 and 30 years to levels not seen since 2011 in expectations the U.S. Federal Reserve will soon pull back on its expansionary monetary policy.
As a result, Illinois' $1.3 billion tax-exempt general obligation bond sale could result in some eye-popping yields.
In Illinois' latest effort to fix the worst-funded state pension system, lawmakers agreed in a special session last week to set up a conference committee to come up with a plan. A July 9 deadline has been set to act on the plan for dealing with the nearly $100 billion unfunded pension liability.
Dan Solender, head of muni investments at Lord Abbett & Co, said early price talk for the bond deal has yields in the 20, 25-year range at 175 basis points over Municipal Market Data's benchmark triple-A scale. Another price drop on Monday would translate into rates on the long end of the deal approaching 5.80 percent or more, he added.
That would be well above yields that topped out at 5.52 percent for debt due in 2038 in a $350 million taxable GO bond issue Illinois sold in April.
"It's a combination of a tough market situation and (the state) not solving their problems," Solender said.
The fact that Illinois has failed to fulfill promises to reform its pensions could push spreads over the MMD scale closer to 200 basis points and place the 25-year yield at just over 6 percent, said Tom Spalding, a senior vice president at Nuveen Investments.
The volatile market has led some issuers, including Georgia, to pull deals from this week's sale calendar. But Illinois is forging ahead with its issue, which will fund infrastructure projects including the rebuilding of a major elevated train transit line in Chicago, said John Sinsheimer, the state's capital markets director.
"We've got critical projects underway that simply can't be shut down," he said.
Sinsheimer also said that bond insurance is under consideration for the deal. But Spalding said that may only work to draw retail buyers.
"With any large institutional buyer, I don't think insurance would sway them a whole lot," he said, adding that high yields in the deal could attract buyers that would normally invest in taxable debt.
The yield on top-rated, tax-free 10-year munis ended Monday on MMD's scale at 2.80 percent - 72 basis points higher than the beginning of June. The yield on triple-A-rated 30-year munis rose to 4.13 percent - an 89 basis-point climb since June 3.
Illinois' inability to rein in pension costs and its huge backlog of unpaid, overdue bills have led to a series of downgrades by credit rating agencies that have left it with the lowest GO ratings among U.S. states. And those ratings at the bottom of the A scale also carry negative outlooks, meaning there is potential for the ratings to fall to the triple-B level, which is unusual for a state.
Investors have already been demanding hefty yields for Illinois' debt. The state's so-called credit spread over MMD's scale was 145 basis points for 10-year bonds in the latest week. That is the second highest spread behind Puerto Rico among large muni debt issuers tracked by MMD, a unit of Thomson Reuters.
Illinois' deal, scheduled for pricing on Wednesday through Wells Fargo Securities, Siebert Brandford Shank & Co, and Stifel, is structured with serial maturities from 2014 through 2038 and a term bond, according to the preliminary official statement.
State officials have been holding meetings with prospective investors in several east and west coast cities, as well as Chicago, ahead of the sale.