Illinois’ credit distress is making investors wonder about New Jersey, according to Citi analysts.
"Investors are transfixed by the developments related to Illinois credit and many have questioned us regarding New Jersey and related credits," Citi said Friday in its Municipal Weekly report. "This is mostly because New Jersey also suffers from a deeply underfunded pension and seems to be in the crosshairs of the rating agencies."
New Jersey debt is rated A3 by Moody’s, A-minus by S&P and Fitch and A by Kroll Bond Rating Agency, which cite negative pressure from growing pension liabilities.
New Jersey appropriation debt "has attractive risk-reward metrics," the Citi analysts write. "But, not all of our clients agree with our view and some have deep reservations regarding the creditworthiness of this debt. We have to admit that at least some of their reservations are not baseless."
The report noted that should Illinois face another downgrade it would mark first time in modern era a state’s general obligation bonds reach junk territory. A budget stalemate that is about to hit the two-year mark spurred recent Illinois downgrades to BBB-minus from S&P Global Ratings and Baa3 from Moody’s Investors Service. Fitch Ratings has Illinois at BBB.
“Ironically, the credit negative developments around Illinois debt could have a knock-on effect on New Jersey debt,” Citi analysts Vikram Rai, Jack Muller and Loretta Bu wrote in their June 16 analysis. “To quote Star Trek, once one goes ‘where no man has gone before,’ it does make it easier for the next man (or woman) to follow. By that we mean that if rating agencies take the seemingly extreme step of cutting a state GO to below [investment grade] rating, it will set an unhealthy precedent for other states with similar problems.”
Citi notes that Moody’s forecasts New Jersey's $116 billion adjusted net pension liability will amount to 292% of its own-source revenues in the 2017 fiscal year, up from 227% for 2015. Citi analysts also highlighted that as of June 2016 all five of New Jersey’s active pension funds projected insolvency under governmental accounting rules since benefit payments far exceed contributions. The state’s pension fund assets dipped by more than $8 billion in aggregate in 2016, according to Moody’s.
“If, as projected by rating agencies, pension assets are depleted completely, the state will have to fund a very large pension expense (more than $4.5 billion annually) from its operating budget,” wrote Rai, Muller and Bu. “We expect that the rating agencies will steadily downgrade the state’s GO and appropriated debt as they price in such a scenario.”
New Jersey has incurred 11 rating downgrades since Gov. Chris Christie took office in 2010 driven in large part to pensions, which were at the worst funding level in the U.S. for the 2015 fiscal year at only 37%, according to Pew Charitable Trusts.
The Citi analysts wrote that clients have expressed concern that severe fiscal stress could drive New Jersey not to appropriate debt service for its appropriation-backed debt.
"We trust that lawmakers will not consider such an irresponsible step," the Citi analysts wrote.
"We believe that appropriation risk is minimal, especially over the next 3 years," they wrote.
"We do believe that these bonds have attractive risk-reward metrics for a number of reasons," citing among them the 100 to 110 basis point spread pickup between New Jersey appropriated debt and the New Jersey GO curve, despite only a one-notch rating differential.
Christie, a Republican, has pushed a plan in his final year of office that would dedicate the state’s lottery revenue toward the pension system over a 30-year period. State Treasurer Ford Scudder told a Senate Budget Committee last week that the roughly $1 billion of New Jersey Lottery proceeds now utilized for social service and education programs would immediately boost the pension fund’s value by $13.5 billion and increase its funded ratio from 45% to 59%.
“The contribution of the lottery enterprise will significantly reduce pressure on the State budget from ever-increasing pension costs, the chief fiscal burden of the State,” said New Jersey Treasury spokesman Willem Rijksen. “The 30-year commitment of a steady stream of funding will immediately reduce the system’s unfunded liability and elevate its funded ratio while reducing the general fund obligation.”