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Woebegone Illinois Sells

CHICAGO — As Illinois prepares to offer investors $1.3 billion of general obligation bonds, the pressure on its credit ratings escalated this week with one agency downgrading the state and two warning that further action looms if lawmakers again turn to one-time measures to balance the budget.

The state will take competitive bids tomorrow on $250 million of GOs that mature March 31, 2011. Standard & Poor’s assigned an SP-1 rating and Fitch Ratings its F1, both one notch lower than their top short-term marks, leaving no room for a further downgrade, which would make the paper ineligible for money market funds to hold.

The downgrades stand to increase interest rates on the remaining $1 billion of mostly taxable GO Build America Bonds that will sell in two deals on April 6 and April 20. Several market participants said additional yield would attract sufficient interest, but the credit attention could erode the interest of some buyers.

“We will probably take a pass on it because we don’t like the underlying credit,” said Chris Ryon, managing director at Thornburg Investment Management, which stopped buying Illinois GOs a year ago.

Several market participants said growing international appeal for BABs even from struggling states — as seen in California’s sale last week — could help limit the impact.

Fitch downgraded the state’s $23.4 billion of GO bonds on Monday one notch to A-minus due to its deteriorating fiscal position. Fitch last downgraded the state by two notches to A last July due to the scope of its fiscal mess and its failure to enact solutions with long-term effects in the previous legislative session.

The agency left a negative watch on the credit this week as it awaits the results of the current session and whether Illinois will turn to one-time measures, like delaying bill payments and deficit borrowing, or enact more lasting solutions. The state currently faces a two-year $13 billion deficit and has a backlog of $5 billion in bills.

Fitch was pessimistic on the prospects for sound action in the current session.

“The downgrade at this time … reflects the increasing likelihood that sufficient solutions will not be implemented in the FY 2011 budget,” analysts wrote. “The state is facing a growing budget deficit, soaring accounts payables, and a significant structural gap for which solutions have been difficult to identify and implement.”

Only California is rated lower by Fitch, at BBB. Fitch did note that Illinois’ GO credit would rise to A-plus once its recalibration of municipal credits is completed.

Richard Ciccarone, head of municipal research at McDonnell Investment Management, said the warnings could help prompt legislative action, but with lawmakers facing re-election in November, the odds are split. “Unfortunately sometimes it takes crisis to raise the political will to make tough changes, but with the election it’s going to be difficult,” he said.

Standard & Poor’s on Friday affirmed Illinois’ A-plus rating, but moved to place the rating on negative watch. “The CreditWatch reflects the state’s growing budget gap, ongoing liquidity pressure, and the lack of recurring solutions under consideration for fiscal 2011 and beyond,” analyst Robin Prunty said, adding that analysts are waiting to see if the government enacts revenue increases. Only California, at A-minus, is rated lower.

Moody’s Investors Service affirmed its A2 GO rating and negative outlook. Again, only California is rated lower at Baa1. Moody’s did not rate the short-term debt. State and local government GO ratings will rise between one and three notches, when Moody’s recalibrates its ratings scale. Credits at the A2 level like Illinois will on average rise about two notches.

A spokeswoman for the state finance team said officials “are disappointed and disagree with Fitch’s action.”

In a statement Friday following Standard & Poor’s action, Illinois budget director David Vaught said the negative watch “underscores the urgency for solutions and emphasizes the need for continued action to achieve fiscal balance by cutting costs, receiving assistance from the federal government, managing our debt, and securing revenue increases.”

Gov. Pat Quinn’s proposed $52 billion fiscal 2011 budget includes $2.4 billion in cuts and $4.7 billion in deficit borrowing, and leaves nearly $6 billion in bills unpaid. A 1% income tax hike could generate up to $3 billion that would help reduce the amount of unpaid bills and restore $1.3 billion in proposed education cuts.

The state’s three bond sales include tomorrow’s $250 million GO issue. The financing is aimed at both paying down a backlog of overdue Medicaid bills and at leveraging an additional $400 million in federal matching dollars.

The arrest of former Gov. Rod Blagojevich, the financial crisis, and Moody’s decision to strip Illinois’ of its top short-term marks in December 2008 resulted in scant interest in the state’s short-term cash-flow certificates. Several market participants said funds see little reward for credit risks, but broker-dealers that have relationships with the state will work hard to market the paper with their buyers.

Illinois on April 6 will take competitive bids on $356 million of new-money GOs, including $300 million of taxable BABs and $56 million of non-BAB taxable GOs. The bonds will mature serially between 2011 and 2035 with a make-whole call provision. Proceeds will finance school construction grants included in the capital budget approved last year by lawmakers.

Illinois will then enter the market April 20 with an additional $700 million of 25-year GO BABs. William Blair & Co. is senior manager. Proceeds will finance transportation, transit, commuter, and high-speed rail projects.

Officials hoped to defer negative action last week with the passage of pension reform legislation. The reforms — which affect future employees — are estimated to save at least $300 million in fiscal 2011, and more than $100 billion through 2045. The state closed fiscal 2009 with a $62.4 billion unfunded liability in its four retirement funds, a 51% funded ratio.

Standard & Poor’s Prunty said: “The weak funding levels have been an ongoing issue so any actions taken to begin to manage that liability certainly is a positive development, but I think the budget is a much more immediate issue.”

Fitch’s action also moves the ratings of state appropriation-backed debt to BBB-plus and negative watch, including some issued by the Illinois Sports Facilities ­Authority and Chicago’s motor fuel-tax revenue bonds. Standard & Poor’s said its action also affects the ratings on some bonds issued through conduit agencies that carry the state’s moral obligation pledge.

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