Buyside expects little from November's Illinois election

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CHICAGO — Muni investors aren’t banking on November's Illinois election to cure the state’s deep fiscal wounds.

That was the assessment offered by several local buyside representatives who participated in a panel discussion at The Bond Buyer’s Midwest Municipal Market Conference here Thursday.

The incumbent governor, Bruce Rauner, a Republican and political novice when he launched his first campaign in 2014, is facing another wealthy businessman and first-time candidate, Democrat J.B. Pritzker.

“There’s so much dysfunction in Illinois in general that I don’t know if who wins makes a difference,” said Bill Grady, senior portfolio manager at Northbrook, Illinois-based Allstate.

If Rauner prevails, questions will arise over whether the state will return to the gridlock that left it without a budget for two years.

If Pritzker wins and Democrats keep control of the legislature, partisan gridlock may be absent but it's far from clear that he could achieve concrete fiscal gains.

“Investors might cheer a Pritzker victory just from the narrow framework that maybe there is some more cooperation in the government, but if it’s all tax, then you have a problem,” said John Miller, co-head of fixed income at Chicago-based Nuveen Asset Management.

“You got the cooperation, but on what policies … if it’s tilted toward all taxes, all new taxes, trying to create a synthetic progressive income tax,” and there are no expenditure cuts or pension reforms to balance out the taxes, “then the honeymoon would end pretty quickly” for investors, he said.

If Rauner is re-elected, Miller said he has “hard time seeing the spirit of cooperation breaking out” but he thinks Rauner wouldn't – or couldn’t – “unwind” the recent income tax increase that offers some protection against a return to a sea of red ink.

“The state has the revenue," he said. "You don’t have to go back and increase personal income tax revenues to get next year’s budget.”

The state’s secondary spreads are down since Rauner signed a budget June 4, the first full-year budget he has signed during his three and ahalf years in office.

Illinois’ long bonds have traded recently at a low spread of 155 basis points to the Municipal Market Data benchmark, Miller said, describing it as a “volatile spread trend” for a GO. That’s down sharply from a high of 300 bp as the state threatened to enter fiscal 2018 without a budget (a budget was enacted over Rauner's veto), and under the 200bp spread at the end of 2017 and the 185 bp where the state’s most recent issue landed, Miller said. The triple-B spread is about 80 bp over the AAA, and the state is close to the 195 bp spread expected for a speculative-grade credit.

This year's spending plan is widely viewed as flawed, structured to get the state through the November election without political damage to either party. It relies on uncertain pension savings and on one-shots and doesn’t account for some costs like a $400 million bill for overdue step pay increases while leaving a $129 billion pension tab and $7 billion to $8 billion bill backlog to tackle another day.

Rating agencies for the time being are leaving the state at the barely investment grade level of Baa3 with a negative outlook from Moody’s Investors Service, BBB-minus with a stable outlook from S&P Global Ratings, and BBB with a negative outlook from Fitch Ratings.

Is “Illinois is close to getting out of the woods? No. Are they making progress? Yes,” Grady said.

“I think the election gives them a little window and they may get a hall pass from rating agencies” to prove they “can make some progress,” Grady said of the potential for more rating deterioration that could make Illinois the first-ever junk-rated state government.

“Illinois has at least a year, maybe longer, to continue to stabilize in the current ratings area, but longer term it’s still a wait-and-see approach in terms of reform policies,” Miller said.

The best bet for the state is to grow its economy out of the mess and its biggest fiscal risk may be a recession, given the state’s weakened ability to manage through one, Miller said.

Pritzker has not said what he would do to rein in the state’s most burdensome challenge – its pension obligations – except to say pensions must be honored. Rauner supports a Senate Democratic plan that asks employees to accept a cost of living adjustment cut in exchange for other perks. Unions have threatened a legal battle.

Grady interprets Pritzker’s stance as one that suggests “he going to try to fix it from the revenue side.”

Miller said he’s not confident either candidate would pursue the constitutional amendment many believe is needed to allow the state to make future benefit changes. Such a move also could face a legal challenge.

Pritzker wants to see a constitutional amendment on the 2020 ballot allowing the state to shift to a graduated income tax from a flat tax rate In the meantime, he would seek an “artificial” or “synthetic” graduated tax by raising the overall rate while increasing various tax credits and exemptions that benefit lower-income and middle-class filers. Rauner and Republican lawmakers are staunch critics of such a move and want various policy and contract changes they believe would grow the economy.

The state got a fresh warning Friday on the budget’s weak spots from Fitch in a report highlighting the risks of a the state labor board’s recent ruling that as much as $400 million in step raises – which are based on experience and had been withheld since 2015 during contract negotiations – must be paid.

The decision highlights “the implementation risks in a budget reliant on one-time items and policy measures with uncertain fiscal benefits,” Fitch said.

“Given the potential that budget performance will fall short of expectations, Fitch anticipates the governor and legislature may need to revisit the 2019 plan as soon as this fall,” analysts wrote. It’s not yet clear whether the full $400 million must be paid in fiscal 2019. The budget did not include any funding for the raises although lawmakers knew the expense loomed.

“Fitch remains concerned that several elements of the enacted fiscal 2019 budget may be delayed beyond the fiscal year or could fall short of estimates,” analysts wrote. “While the state avoided immediate political stalemate, the on-time budget fails to make material progress in addressing the state's sizable accounts payable backlog.”

The budget relies on achieving $450 million of savings from pension changes including two buyout programs, $800 million in interfund borrowings, which must be repaid over two years, counts on about $250 million to $300 million from the sale of its downtown Chicago headquarters, and projects just a narrow balance of $14 million.

The benefits of higher tax collections from internet sales allowed by the U.S. Supreme Court’s Thursday Wayfair v. South Dakota decision are already factored into the new budget.

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