CHICAGO – Illinois’ weakened fiscal condition and battered ratings translate in steep borrowing penalties for taxpayers but won’t lead to a default any time soon, an academic research paper argues.

The state earlier this month suffered a fresh round of downgrades from two rating agencies after the legislature failed to agree on a plan to overhaul  a pension system saddled with $95 billion of unfunded liabilities. The negative headlines and worries over the state’s solvency have attracted national attention, eroding market perception and driving up the state’s borrowing rates.

The state’s $1.3 billion general obligation deal that priced Wednesday paid a yield of 4.46% on a 10-year maturity, compared with a 2.81% rate on 10-year top-rated paper on the Municipal Market Data scale.

The independent study was authored by Marc Joffe, principal consultant with Public Sector Credit Solutions, which analyzes government bond credit risk. The paper seeks to assess whether those higher interest rates properly compensate bondholders for the added risk of holding Illinois general obligation paper.

“There’s no question Illinois’ bonds are risker than those of a triple-A rated state, but how much more risky are they,” he asked.

The research paper, commissioned, funded, and published Wednesday by The Mercatus Center at George Mason University, concludes that  Illinois is unlikely to face insolvency and possible default over the next three decades. The perception that the state is teetering on insolvency is driven in part by the pace of its credit deterioration which has pushed up already steep interest rate penalties.

“While Illinois’s fiscal policies are likely to have negative effects on future state residents and implications for other public policies, they are not sufficiently dangerous to worry bondholders,” the report concludes.

After recent downgrades, Illinois is the lowest rated state by Moody’s Investors Service and Standard & Poor at A3 and A-minus, respectively. Both assign a negative outlook. Illinois carries the same rating of A-minus as California from Fitch Ratings, though California has a positive outlook and Illinois a negative one.

As a result of the poor market perception, “Illinois taxpayers pay tens of millions of dollars in additional interest charges—costs that could be avoided if the state were perceived to be a safe investment,” the report said.

Using his research model, Joffe compares Illinois’ default risk against the state’s top-rated neighbor to the east, Indiana, which has a reputation as being fiscally well-managed. The paper is titled “Modeling State Credit Risks in Illinois and Indiana.”

Joffe, a former rating agency analyst who worked in structured finance, acknowledged the strong statutory protections afforded repayment of Illinois GOs. His analysis assumes there’s a point at which politicians are willing to risk default..

Joffe reviewed the history and theory of state credit performance to establish a threshold at which default could be predicted. That mark was set at where the aggregate of a state’s interest and pension costs reach 30% of total revenues. The ratio was at 10% in Illinois when all Illinois GO and special obligation debt of $30 billion is counted based on fiscal 2011 figures and 4% in Indiana.

Neither state is on pace to hit the 30% mark in the coming years. Although Illinois could approach that threshold further in the future, policy actions such as pension reform could lower the ratio.

After setting the default threshold, the report took into consideration the long term strains on Illinois’ solvency and funding needs including the state’s existing debt burden, pensions, other post-employment benefits, education, and health care.

In setting the default mark, the author looked to past state defaults, which have been rare since World War II. Illinois and Indiana did default in the 1840s after Illinois borrowed heavily to finance construction of a canal connecting the Illinois River to Lake Michigan and to capitalize two banks. Illinois emerged from default in 1857 and was debt-free in 1880. Indiana defaulted in the 1840s.

For modeling purposes, the report looked at the only state default on interest payments to individual bondholders in the last 140 years as a result of a financial crisis. It involved Arkansas’s default on interest payments in 1933 at a time when its interest costs accounted for 30% of its revenues.

In putting state pension payments in Illinois on par with debt interest payments and counting them towards the 30% threshold, the author considered the increased protections afforded pension benefits in the state’s 1970 constitution that afford contractural rights against impairing or diminishing pension benefits.

While providing reassurance for bondholders and questioning the level of rating actions, the report doesn’t let the state off the hook for its “poor fiscal policies.” Unfunded liabilities have grown because of pension holidays and an inadequate annual payment scheme and the state will carry $6 billion in unpaid bills into the next fiscal year. 

A 2011 income tax hike partially expires in fiscal 2015. Most of Joffe’s models assume it will be made permanent or the revenue replaced in some other fashion. Joffe’s position is based on a 95% probability estimate he reached after conversations with local political observers.

“While raising taxes is politically distasteful, most of these officials have done it before, and it is reasonable to expect that they will do it again—given the state’s ongoing fiscal stress,” the report reads.

Joffe also uses total state revenues, not just the general fund. The all-funds budget includes some non-discretionary funds and federal funding levels. He defends the use of the higher number because of the state’s ability to borrow from other funds. The report finds a minimal potential for default beginning in 2030 in a review that looked out over 30 years, assuming no policy changes. 

The state has adopted a $35.6 billion general fund that’s included in an overall budget of $62.4 billion for fiscal 2014 beginning in July. The state will pay $6 billion in pension contributions and $2.2 billion for total debt service and to repay interfund borrowing.

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