CHICAGO – Alarms are rising about Illinois' dismal ratings and a possible fall to junk unless it resolves a nearly two-year-old budget impasse.

Market participants are increasingly contemplating the impact of the state's potential fall to junk. From the buyside's perspective, such a drop would both sting the state's reputation and drive up borrowing costs as investment grade accounts are forced to shed the state's paper and forgo further purchases.

"The state of Illinois could very well lose its investment grade rating, sooner rather than later," wrote Jim Colby, portfolio manager and senior municipal strategist at Van Eck Global, in a blog post late last week.

“It’s not a milepost you want associated with your state,” said Jim Colby, portfolio manager and senior municipal strategist at Van Eck Global.

"Nearly two years without a budget, unfunded pension obligations, and a backlog of bills do not presage an easy future for the state's finances….Illinois may not be another Detroit, or another Puerto Rico. But it has all the characteristics of a disaster waiting to happen," he added.

Colby called the image of Illinois falling to junk a "daunting" one and characterized the consequences as dire.

"It's not a milepost you want associated with your state," especially given its wealth levels, Colby said in an interview. The state's budget gridlock is politically driven by the divide between Republican governor Bruce Rauner and the Democrats who control the General Assembly.

Illinois is the lowest rated state at BBB/Baa2. All three rating agencies have issued clear warnings recently that further rating hits are likely if the state doesn't break the logjam after it enters fiscal 2018 on July 1. No state general obligation debt in recent memory has been rated junk. Illinois GOs already trade at junk spreads in the 200 basis point range.

If rating agencies send the state to speculative grade, its borrowing costs will rise even more as trusts and other accounts with investment-grade perimeters are forced to shed the debt.

Issuers from Illinois represented the fifth-largest source of municipal bonds in 2016 with $20.2 billion sold. Only California, New York, and Texas issuers had more bonds outstanding than Illinois' $172.7 billion, the report noted.

The report highlighted the impact such a scenario would have on its own municipal exchange traded funds. The greater universe of ETFs could also see possible changes in the geographic profiles.

Van Eck has three investment-grade municipal ETFs arranged to allow investment managers to cater to client needs on the yield curve. It also manages a general high-yield account that allows for allocations of up to triple-B rated credits in addition to speculative grade paper, and another fund aimed at limiting rate risks that's limited to 12 years.

Van Eck has about $78 million of Illinois issued debt allocations, not all from the state government, in its intermediate IG ETF, representing about 4% of its assets, and about $200 million, representing about 11%, in its general high yield account, Colby said.

Because the indexes that govern construction of Van Eck's municipal ETFs have Illinois exposure, a fall to junk status would likely force the firm to shift some allocations among its ETFs to the "speculative marketplace," Colby wrote. The investment grade ETFs would see a slight reduction in liquidity and may see a drop in the deliverable yield as the Illinois paper is likely the highest yielding paper in the investment-grade funds.

For the high-yield accounts, the infusion would enhance liquidity and should go down smoothly although there would be very limited impact on yields, Colby said. While the state currently has seemingly intractable political issues to resolve, portfolio managers might view the credit as one that could improve in the coming years once the issues are resolved.

Prospects for state debt repayment remain strong, but "it is becoming more difficult to hold state of Illinois and city of Chicago bonds ahead of increasingly likely rating and headline trauma," Municipal Market Analytics warned in its outlook last week.

Headlines over stalled attempts to reach a broad compromise and a standoff over pension reforms and help for Chicago Public Schools "raise the likelihood that the state will once again choose to operate without a formal budget plan in FY18—a development that could lead to a historic downgrade of the state below investment grade" and "will make long-term budget balance more difficult to secure," MMA wrote.

On Monday, state Comptroller Susanna Mendoza called on Rauner and lawmakers to immediately take action. Her pleas followed a warning last week from Moody's Investors Service that Illinois is at tipping point and needs to make progress in the coming months to avert a downgrade.

"I don't know how many direct warnings are needed before the governor and the legislature finalize a budget that provides the stability needed to get the state's finances back on track and reverse the damage that has been caused," Mendoza said in a statement.

Mendoza highlighted a similar warning from S&P Global Ratings in a special commentary in early March. Fitch Ratings in February downgraded the state and it too warned of the possibility of another hit in the coming months.

In less than two years, Illinois has suffered six downgrades, a downward spiral that leaves taxpayers saddled with increased borrowing costs, Mendoza said. The first-year Democratic comptroller, who has traded harsh words with Rauner, softened her tone in the statement but still blamed the governor for the impasse.

"With each day that he refuses to help forge a compromise, Illinois' financial situation gets worse," she said.

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