Moody's Investors Service affirmed its Baa3 rating and stable outlook on Illinois general obligation bonds Tuesday afternoon.
The formal action underscores the views of several municipal bond market observers that the budget does just enough to keep the state from a calamitous downgrade to speculative grade — but nowhere near enough to start talking upgrade.
“In the past year, the state has avoided material worsening of its credit vulnerabilities and marginally built on strengths” as “buoyant tax revenues encouraged policymakers to refrain from proposed cuts to pension contributions, and the legislature authorized some new revenue sources, as well as a referendum to potentially adopt progressive income taxes to further increase revenue-raising capacity,” Moody's lead Illinois analyst Ted Hampton wrote.
“The accomplishments of the 2019 legislative session indicate improvement in political willingness. However, pension contribution requirements remain on track to outpace organic revenue growth, which will subject the state to persistent fiscal pressure, barring further politically difficult decisions on tax increases or essential service cuts,” Hampton warned.
The final fiscal 2020 budget that passed over the weekend relies less on revenue one-shots then Gov. J.B. Pritzker initially proposed, bolstering the state’s case to hold on to its barely investment grade ratings and retain healthier spreads, at least for the time being, market participants say.
“Raising revenue is always good from a credit perspective especially from diverse sources,” said Brian Battle, director of trading at Performance Trust Capital Partners. He cited the increased revenues that will come from a cigarette tax, a Medicaid tax, expanded gambling, and other sources with the potential for more revenue should voters approve a shift to a graduated income tax rate next year. “The market perspective is that this will assuage the rating agencies.”
The long-run horizon is much cloudier. “It’s all short-term," he said.
"What they didn’t do is address the long-term problems like the pension deficit and higher taxes can also be corrosive to macro-economic growth,” Battle added.
“The fiscal 2020 budget signals near-term credit stability and buys the state more time to address out-year gaps,” S&P Global Ratings lead Illinois analyst Carol Spain said when asked for a comment on the budget approved by lawmakers before they ended their spring overtime session last weekend.
“The state will need further progress toward sustainable structural balance, paying down its bill backlog, and addressing its pension liabilities to maintain an investment-grade rating,” Spain said.
S&P rates Illinois’ general obligation debt at the lowest investment grade level of BBB-minus with a stable outlook.
In addition to a $40 billion general fund budget, lawmakers also approved a six-year, $45 billion capital program. The General Assembly raised the general obligation and sales-tax backed bond cap levels by about $23 billion with most going to fund the program. Pritzker supports both.
“The state’s capital plan addresses much needed infrastructure improvements, but will substantially increase the state’s debt burden. The new revenues that will support increased debt service will relieve some state operating pressure, but Illinois’ large liabilities will continue to weigh on its credit profile,” Spain said.
Fitch Ratings, which has the state one notch higher at BBB but assigns a negative outlook, is still assessing the budget plan, how it achieves cash balance, and where it leaves the state’s structural imbalance, but a $1.5 billion April revenue windfall definitely helped, said lead analyst Eric Kim.
“It was incredibly beneficial for fiscal 2019 and fiscal 2020 by alleviating some pretty significant near-term pressures,” Kim said. The windfall, like those seen by other states, is largely due to non-income factors stemming from the federal tax changes so may not be sustainable.
For Illinois, it wiped out a fiscal 2019 deficit and drove a revision for fiscal 2020 estimates. The state responded by canceling plans to help balance the next budget by re-amortizing the current pension funding schedule to shave more than $1 billion off fiscal 2020 contributions. It also allowed the state to shed its reliance on license fees from the legalization of recreational cannabis and the implantation of sports betting in the 2020 spending plan.
“The question we need to fully understand is ‘What is the sustainability for this revenue?’” Kim said.
The rating agency intends to soon resolve its negative outlook. While Kim won’t disclose if analysts are leaning one way or another he reiterated past comments that its focus will be on structural balance. “What we said in the past is that a downgrade could occur if the state does anything to exacerbate” its imbalance, Kim said.
While the state’s long term ills, led by its $133.7 billion of unfunded pension liabilities, remain a drag on its ratings, Municipal Market Analytics sees passage of an on-time budget as an accomplishment after the political gridlock that marked the tenure of Pritzker’s predecessor Bruce Rauner, who lost his November re-election bid.
“The budget still relies on optimistic revenue projections, doesn’t do anything for pensions, sells $1.2B more bonds to refinance vendor payables, ultimately depends on voter approval of tax reform, and begs detailed further study to detect non-recurring savings,” MMA wrote in its weekly outlook column. “But Illinois has a functioning budget process again: a key takeaway that justifies recent spread tightening.”
Illinois' 10-year GO paper began May at a 178 basis point spread to the Municipal Market Data top benchmark and ended at a 139 bp spread.
The tightening has been attributed to market demand for higher yielding paper combined with passage of a resolution asking voters to approve next year a shift to progressive income tax rates. Pritzker is banking on it raising more than $3 billion annually.
“Will this continue? It is hard to handicap the public support for this new tax structure but early polls have been favorable. As long as there is evidence that the IL income tax structure may change spreads should tighten,” MMD-Refinitiv’s analyst team wrote in its Municipally Speaking column Monday when no further spread movement was yet observed.
Battle cast a warning over the state’s looming uptick in debt issuance should market conditions change because many traders believe it’s primarily the dearth of supply that’s driven the state’s spread narrowing.
“There’s 20% fewer bonds and higher yielding credits are being bid up,” he said. “If those trends reverse it’s going to get expensive, fast” for the state to issue in the primary.
The Moody's affirmation at Baa3 affects Build Illinois sales tax revenue bonds as well as GOs; about $30.2 billion of outstanding debt is affected. Moody's also affirmed at Ba1 about $3 billion of debt issued by the Metropolitan Pier and Exposition Authority and by the state under its Civic Center program.
