Municipal Bond Outlook for Chicago, Illinois | Lord Abbett
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Fixed-Income Insights

The city of Chicago and the state of Illinois may have alleviated some near term risk with their proposed budgets, but will need to identify new sources of revenue in the long-run. 

(This article is from the fourth-quarter 2019 edition of The Muni Quarterly.)

The City of Chicago and the State of Illinois continue to capture the attention of municipal bond investors. While the City and the State are known for having outsized unfunded pensions, they’re also recognized for their large and diverse tax bases, and are home to the headquarters of numerous Fortune 500 companies. Both credits suffered as years of political brinksmanship resulted in fiscal structural imbalance. Now, with a Governor and State legislature more in alignment, the State should be better positioned to manage finances more effectively and have a collaborative relationship with the City. Both entities produced budgets this year that relied more on recurring solutions, rather than “one-time fixes.” Although this has alleviated near-term risk, both the City and State will be required to identify new revenues to ensure long term structural balance.

City of Chicago
There were no surprises when the Mayor of Chicago presented the proposed 2020 budget on October 23. Many viewed the budget proposal as more of a stop-gap measure, rather than one that solves for structural balance. Chicago faces $30 billion of unfunded pension liabilities and its required payments to the retirement system will continue to grow significantly in years to come. Therefore, sizable new revenue sources will need to be identified over the next several years, such as increased property taxes, along with significant expense cuts.

Unlike in past budget proposals, the Mayor chose not to recommend issuing pension obligation bonds or a bond refinancing structure which extends the overall term of the outstanding debt (also known as “scoop and toss”). What’s more, the City employed more recurring revenue solutions than in the past, and did not raise property taxes for a second consecutive year, or rely significantly on one-shots. However, several budget measures will need to be approved by State Legislature in the fall session. These include a graduated real estate transfer tax and a revamped casino tax structure to make a Chicago casino viable. Other new revenues will include new taxes on ride-share services, restaurants and parking. The largest component of closing the gap will come from the refinancing of $1.3 billion of general obligation (GO) bonds with higher rated sales tax securitized bonds. This is expected to generate $200 million of savings, but will need City Council approval. 

The rating agencies viewed the budget as adequate (no rating change is expected), but they will be watching to see if the State approves the new revenue measures or will be able to make midterm expense cuts if they are not realized. Given the challenges the City faces in solving for structural balance in the immediate term, and the more supportive State Legislature and Governor, as compared to the prior administration, this approach appears to have some merits but will be tested by the economy over the next year. It will provide the City with some time to incorporate more permanent revenue enhancement and employ meaningful expense cuts.

State of Illinois
For the second year in a row, the Illinois legislature passed the fiscal 2020 budget in June 2019, on time and with little dissension. This was especially good news, as it wasn’t too long ago that the State had been unable to pass a budget for a two-year period (July 2015 until August 2017). During that period, the State’s credit deteriorated more because of political disagreement rather than economic distress. With a Republican Governor and a legislature controlled by Democrats, there was unwillingness by both sides to compromise. Financial operations remained out of balance, as the expiration of temporary tax hikes was not met with a commensurate decrease in expenses. The State spent far in excess of tax revenues, which resulted in a rapidly escalating liquidity crisis, as payables to vendors escalated. In addition, no progress had been made in funding its pension debts. In August 2017, the Governor finally agreed to the reinstatement of higher tax rates and the budget passed.

Fast forward to the current fiscal year, and there is a new Governor, a Democrat, who delivered on pushing his $40.6 billion “bridge budget” through the legislature, pretty much getting everything he wanted. The budget relies heavily on new revenues to pay for higher expenses, and increased borrowing to pay down a backlog of past-due bills and future pension liabilities. Included are tax increases on gasoline, cigarettes, parking, and vehicle registration. However, most significantly, the Governor succeeded in landing a question on the 2020 ballot to amend the Illinois constitution to try to change its tax structure from a flat rate to his preferred graduated income tax plan. Under the proposal, the top rate will be 7.9%. The November 2020 ballot initiative will require 60% passage, and according to the Governor’s estimates, would raise $3.4 billion. The Governor contends that 97% of taxpayers will pay no more than they do now because those earning less than $250,000 would pay, at most, the current 4.95% rate that applies to the flat tax.

This proposal will address the near-term budget gaps facing Illinois. However, it still has significant challenges; including a $6.6 billion bill backlog and $133 billion in unfunded pension liabilities. The budget outlines plans to reduce the sizable unfunded pension obligation. This includes dedicating $200 million of new revenue from a proposed graduated income tax, issuing pension obligation bonds (POBs), and extending the buyout programs. Voter approval of the graduated tax plan will be a critical component of any effort to solve the structurally unbalanced budget. The State’s GO bond ratings are just slightly in investment grade territory (Baa3/BBB-/BBB), so any downgrades would be very impactful. All three rating agencies agree that the fiscal 2020 budget signals near-term credit stability but that further progress is needed toward structural balance.

Like Chicago, mitigating some of the fiscal stress is the fact that the long-term economic prospects for the State are relatively good. The economy is well-balanced across employment sectors and is home to the nation’s third- largest city, Chicago. The economy is the fifth largest in the United States and 18th largest worldwide, and 36 Fortune 500 companies are headquartered in Illinois. In addition, as a state, Illinois has a high degree of flexibility to raise revenues and defer disbursements.

The City of Chicago and State of Illinois bonds will remain in the headlines for the municipal bond market and we will continue to follow them closely going forward.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

THE MUNI QUARTERLY

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The Fourth Quarter 2019 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.

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