CHICAGO – Fitch Ratings made clear Tuesday the clock is ticking for Illinois to resolve its record-long budget impasse if it wants to avoid another credit hit, but added that the deadline extends past the General Assembly’s scheduled May 31 adjournment.
Fitch published a brief report entitled “May 31 Not the Deadline for Illinois’ Budget” explaining its position as the session nears its formal end.
Come June, legislation passed during a special session must receive three-fifths majorities to take effect immediately. Democrats hold such a supermajority in the Senate while they hold only a simple majority in the House. That means any legislation vetoed by Gov. Bruce Rauner, a Republican, would require some GOP support for an override to succeed.
“Fitch does not view Illinois' voting requirements as the main obstacle to passing a budget,” lead Illinois analyst Karen Krop wrote. “Illinois' budget crisis and related deterioration in credit quality is the result of a political impasse between the governor and the legislature.”
It remains unclear whether continuing Senate negotiations on a sweeping package of tax increases, reforms, and borrowing, as well as talks on a separate fiscal 2018 budget, will result in an eventual deal.
“It seems clear that a budget will not be enacted until a compromise is reached,” Fitch wrote. “As a result, Fitch does not view the super-majority voting requirement that will arise after May 31st as the greater hurdle to enacting a balanced budget by the start of the fiscal year.”
Fitch last acted on the state’s rating on Feb. 1 dropping it to BBB while maintaining its placement on Rating Watch Negative. It said at the time that the watch would be resolved within six months “based on an assessment of the state's fiscal trajectory as it starts fiscal 2018.”
“Failure to enact a balanced budget for fiscal 2018 would result in a further downgrade. The timing of that review is unchanged,” the new report says.
Illinois is the weakest rated state at the Baa2/BBB level. Fitch, Moody’s Investors Service, and S&P Global Ratings have all warned that further credit erosion looms without a resolution that helps stabilize the state’s budget crisis.
The state is grappling with a $5 billion deficit, $14 billion bill backlog, and $126.5 billion of unfunded pension obligations and has been without a full budget since July 2015.
With Illinois’ 10-year spreads now at more than 200 basis points to the MMD’s top-rated benchmark, the municipal market has already factored in at least a one-notch downgrade in its views, traders say, and it’s widely believed that a drop into junk territory – unprecedented for a state – is possible.
The state’s current prices offer buying opportunities, Vikram Rai, CFA at Citi Research, wrote in the group’s municipal weekly published Monday.
“Illinois bonds have cheapened over the political stalemate period and we see some opportunities for an investor with some risk appetite,” Citi wrote.
Illinois’ 10- and 20-year paper is trading about 150 basis points cheap to the BBB curve.
“In spread terms, long dated GOs seem attractive even if we assume that the bonds get downgraded one more notch,” the report says.
Also, the Illinois spread curve is inverted with the 5 – 7 year GOs especially attractive with a spread pick-up of almost 160 basis points. That’s unusual as the market typically views it so unlikely that a state would default on its GOs that yield and spreads curves are naturally upward sloping. Citi attributes the flattening to a “segmentation of the buyer base” with short term buyers focused on higher grade credits.
“We strongly encourage investors to take advantage of the cheapness of the front and intermediate IL GOs,” Citi wrote.
Citi said many of its clients seem to believe a one-notch downgrade looms and it just might “galvanize the state’s lawmakers into action and pressure them into passing a budget.”
Citi doesn’t think a multi-notch downgrade looms but does offer some caution, noting Moody’s comments that there is no floor for US state ratings, despite states' inherent credit strengths and typically very high ratings.
Based on prior examples with Illinois, a rally could occur after a downgrade. “While Illinois GO yields could richen slightly even after a downgrade, they could witness a sharp rally across the curve if Illinois lawmakers pass a budget which would stave off a downgrade,” Citi said.
Negative headlines pose a threat that could “inhibit demand for its bonds and possibly cause a further shrinkage of its buyer base,” Citi said. “It is the simplicity of Illinois’s story that gives us pause. We say this because the state has strong fundamentals and possesses the ability to tax-and-grow its way out of its fiscal and operational troubles. But, it hasn’t been able to do so due to the lack of collective political will.”
