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Fixed-Income Insights

With one more downgrade, Illinois’s general obligation bonds could become the first junk-rated debt of any state since 1970. But default risk still remains low.

[Note: This article is from the July 2017 edition of The Muni Quarterly.]

Can Illinois extricate itself from crushing debt and pension obligations?

After a series of credit rating agency downgrades and credit deterioration, Illinois had the unique distinction of entering its third year without a budget, and was about to become the only U.S. state with a junk-bond rating. However, on July 7, 2017, Democrats who control the legislature and almost a dozen of Republican governor Bruce Rauner’s fellow Republicans voted to override his vetoes of a $36 billion spending plan and across-the-board tax hikes, enacting a budget for the first time since mid-2015.  This saved the state from an immediate downgrade, but action still needs to be taken to avoid facing such a move in the future.  On July 10, 2017, Illinois state treasurer Mike Frerich (a Democrat) urged Rauner to undertake a five-step plan, lest the credit agencies possibly plunge Illinois into junk-bond status, which would result in higher borrowing costs for the state.

Rauner rejected Frerich’s suggestions, so the state legislature still has much work to do, as it will face the challenge of addressing unfunded pensions, school funding, and containing outstanding bills. The legislature has been able to avert a crisis; now it needs to demonstrate a willingness to avoid further brinksmanship and forge a path toward improved credit quality, or the state’s debt could be downgraded.  

How Illinois Differs from Puerto Rico and Detroit
Prior to the budget passage, the credit quality of the state’s general obligation (GO) bonds continued to deteriorate. (See chart.) Although often compared with the other prominent examples of municipal distress, Puerto Rico and Detroit, in particular, Illinois’s woes stemmed from a lack of political will, rather than the kind of economic pressure faced by those other credits. For the past four years, there has been a standoff between Rauner and the Democratic-controlled House of Representatives, led by Speaker Michael Madigan.

 

How Illinois Slid Down the Ratings Scale
State of Illinois's general obligation bond ratings history

Source: The Institute for Illinois’s Fiscal Sustainability at The Civic Federation.

 

Even without a budget, the state was able to continue spending, which led to growing budget deficits and soaring accounts payable. All three major credit ratings agencies put Illinois’s ratings outlook on negative, and each warned that downgrades were imminent if a budget was not passed by the June 30th fiscal year-end. At current rating levels (as of July 20, 2017)—‘Baa3’ and ‘BBB-’ from Moody’s and Standard & Poor’s, and ‘BBB’ from Fitch—a one-notch downgrade by the first two agencies would result in the rating falling to below investment grade, which would be a first for a U.S. state since 1970.

From a political standpoint, the main sticking point came down to the governor’s insistence that any income tax increases to align revenue and spending had to be coupled with what he viewed as pro-growth economic measures, such as a statewide cap on local property taxes, a workers’ compensation overhaul, and public pension reforms. The deadlock led to a government that had been unwilling to balance financial operations and fund its pension debts, and led to a rapidly intensifying liquidity crisis.

Axis of Taxes  
Illinois’s road to fiscal peril was protracted, and started well before Rauner became governor. However, the expiration of the temporary income tax increase in January 2015, which had been in place since 2011, can be cited as the event that pushed the state’s budget into crisis. Without an extension, the personal income tax rate declined, to 3.75% from 5.00%, and the corporate income tax rate fell, to 5.25% from 7.00%. This resulted in an annual revenue loss of $5 billion on an ongoing basis, as lawmakers failed to agree on replacement revenues or reduce expenditures. 

As such, a structural deficit emerged that required more than $2 billion in nonrecurring measures to balance the budget for fiscal year 2016. By the end of fiscal 2016, the general fund’s deficit was approximately $3.5 billion, or 11% of expenditures. With no budget in place for fiscal year 2017, a stopgap plan was put in place that included funding for full-year kindergarten through twelfth-grade education and critical state operations, but only partial appropriations for many other programs.  For fiscal year 2017, a $6.4 billion deficit is expected, which would be equal to 17% of expected expenditures.  

Pain Managemet
The lack of a budget has resulted in a massive buildup in unpaid bills by the state. In order to manage revenue shortfalls and cash-flow pressures, claims that are not covered by court orders or consent decrees have been delayed. At the end of fiscal year 2017, payables that were overdue had reached $14.7 billion, having increased from $5.5 billion in April 2016. The payment delays weakened the state’s commitment to public higher education, as funding cuts resulted in lower enrollment, higher tuition, and employee furloughs. Further, human services providers were forced to close underfunded facilities that were used by those who were less well-off among the electorate.

Unlike the tax expirations, which may be a short-term issue, the state will be burdened with pension plans that are among the worst funded in the nation, and for a long time to come. In 2015, Moody’s reported that Illinois’s adjusted net pension liability equaled to $193 billion, or 2.9 times revenue. This was 50% higher than the next-highest state, Connecticut. Pension payments account for a significant portion of the general fund’s expenditures (22%) and are on a rising trajectory. Compounding the problem is the fact that efforts for reform have been hindered by the state’s strong constitutional protections for pensions.

Despite Growing Uncertainty, Default Risk Remains Low
Investors historically have taken comfort in the strong legal protections afforded to Illinois's GO bonds. Pursuant to the state constitution, all general fund revenues are pledged to the repayment of GO bonds, prior to the payment of all other expenditures. By statute, revenues needed to pay debt service are required to be set aside monthly and deposited into a separately held GO bond retirement and interest fund.  These monthly receipts are large enough to cover annual GO debt service by more than 10 times.

However, there was growing uncertainty as to whether the state would remain willing to fund GO debt service if liquidity continued to diminish in absence of a budget. Political pressure to fund core services could have forced legislators to suspend monthly deposits to, or borrow from, debt-service funds, and/or consider reducing annual pension contributions. None of these actions were likely, but if they had been triggered, they would likely have resulted in negative credit rating actions. (As an aside, in contrast to Illinois, Puerto Rico has taken these actions.)

Another positive for investors is the fact that the state economy is sufficiently strong and diverse to generate additional tax revenues and support additional debt. According to the U.S. Bureau of Economic Analysis, Illinois’s income per capita ranked fourteenth in the United States, and was 105% of the national average. In addition, the U.S. Census Bureau shows that 65% of Illinois's residents live in the Chicago metropolitan area (home to numerous corporate headquarters). That being said, the budget impasse has had a negative economic impact. There has been an accelerating trend of out-migration during the last three years. Among the five largest states, only Illinois had a population decline (-0.3%) in 2015. In addition, Illinois's rate of nonfarm payroll growth in 2016 ranked fortieth among the states.

Still, default risk remains low, as the state’s ability to service its debt and recover from its budget stalemate remains intact. Most of the current budget deficit can be closed through the restoration of prior income tax rates and better managing expenditures. In addition, the state’s debt burden remains manageable, and there is substantial liquidity outside of its general fund. Finally, long-term economic prospects are relatively good, as the economy is well balanced across employment sectors and is home to the nation’s third-largest city, Chicago.

However, with other states facing similar economic challenges, most notably Connecticut, Kentucky, and New Jersey, pressure for public pension reform is likely to increase. We will explore this topic in future articles.   

 

 

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THE MUNI QUARTERLY

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The July 2017 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.

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