A simple outlook change packs a market punch for Illinois
The upward outlook tick on one of Illinois’ ratings carries a bigger bang in the market than it would for other states, given its low investment grade standing and investor concerns about trading volatility that moves in tandem with headlines.
Fitch Ratings on Wednesday raised its outlook to stable from negative on the state’s BBB issuer rating and affirmed it, action that follows the rating agency’s digestion of the results of first-year Gov. J.B. Pritzker’s first legislative session that saw the on-time passage of a $40 billion fiscal 2020 budget.
“The outlook change is really due to what they were able to do in the past few months on their own and what they were able to benefit from,” Fitch’s lead Illinois analyst, Eric Kim, said in an interview Thursday, referring to both a $1.5 billion April tax windfall that reflected revenue gains in other states too and is largely attributed to 2017 federal tax changes.
“A big piece was the revenue surge that allowed them to make fiscal decisions that stabilized their credit profile and enabled them to address a substantial fiscal 2019 budget gap,” Kim said. “It also established a higher revenue projection for 2020 that allowed the state to avoid measures we had expressed concerns about,” like a pension funding schedule reamortization that would have provided near-term budget relief.
“There are definitely looming challenges,” Kim cautioned.
Moody’s Investors Service and S&P Global Ratings rate the state one notch lower at the Baa3 and BBB-minus, respectively, just one notch above a speculative grade. Both assign a stable outlook.
“Illinois is already much stronger than we were a year ago, and it’s refreshing that Fitch is recognizing the good news and progress we’ve made so far. We know we have a long way to go, but we are committed to improving our long term fiscal stability and building an economy that works for everyone,” Dan Hynes, a deputy governor, said in a statement.
“I think it’s a positive for the name and a pretty big deal and more relevant because of the rating level,” said Douglas Benton, portfolio manager at Cavanal Hill Investment Management. “It’s one thing on a double-A credit but in triple-B land it’s something else” with greater meaning because “we are all looking at the next step” for the rating.
For investors, the outlook shift signals more predictability for the bonds’ value and it’s a relief for the market even if it’s not reflected in state bond prices, said Matt Fabian, partner at Municipal Market Analytics.
“For a state credit, the direction of the credit is more important than the absolute level. No investor thinks Illinois is going to default but if it keeps getting downgraded, that generates negative headlines and so the value of the bonds is less predictable and more volatile,” Fabian said. “So while it may not impact the pricing it’s a tremendous reassurance or confirmation to the market that Illinois has moved back into the universe of other state bonds and at least for now put the volatility behind it.”
Whether a simple outlook change and its positive headlines will influence trading spreads remains to be seen. The state’s spreads dropped during May from around 178 basis points above the Municipal Market Data benchmark at the start of the month to about 140 bps by the end as the state benefited from both positive budget headlines and demand for higher yielding paper.
The price gains have nearly been wiped out in the aftermath of a lawsuit jointly filed early last month by a hedge fund and head of a conservative-leaning policy organization challenging the legality of $14.3 billion of outstanding GO bonds from issues in 2003 and 2017. Spreads this week on the 10-year and longer maturities were at a 175 bp spread.
IHS Markit strategist Edward Lee said one sizable trade on a 2026 maturity narrowed by four basis points to 174 bps Thursday from a previous trade.
MMD-Refinitiv municipal strategist Dan Berger said he had not observed any notable spread movement Thursday.
The litigation has no immediate bearing on the state’s rating, Fitch said in the new report. A hearing on the petitioners’ request to move forward as a taxpayer action is pending with a hearing set for Aug. 15. The state is fighting the action.
“As with all state debt, the 2003 and 2017 bonds were approved by the attorney general at the time and bond counsel. Fitch does not consider the filing of this litigation to be a material credit factor but will monitor developments in the case and assess any implications for Illinois' credit profile,” Fitch said.
The rating report provides a road map to eventually win an upgrade and pitfalls that could trigger a downgrade.
The cornerstone of Pritzker’s long-term plan is a constitutional amendment to allow a progressive income tax system instead of the current flat-rate mandate. The governor backs a structure that raises more than $3 billion annually by hiking rates on higher income taxpayers.
“We are absolutely focused on what happens around the 2020 ballot and whether or not it passes, how the state responds, and how, if it passes, they utilize the additional revenue,” Kim said.
The move to a graduated structure could raise substantial revenue, but it faces a long and uncertain path before implementation, Fitch warns. The credit implications of the November 2020 vote on the income tax amendment depend on whether Illinois uses any increased revenue to address structural budget challenges, or if the state can adequately adjust its budget to work towards structural balance if the amendment fails.
A downgrade could result if the state adds to its structural budget pressures in a way that boosts its liabilities or its $6 billion backlog of overdue bills.
A deferral of pension payments or other measures that add to the state’s unfunded tab without other offsetting factors could also drive a downgrade. Fitch noted that Pritzker had proposed just such a measure in the re-amortization and it’s unclear whether the state may resurrect the idea in the future.
An upgrade may be a long way off. “Upward rating momentum is unlikely until the state more comprehensively addresses its accumulated liabilities including the accounts payable balance,” Fitch wrote.
The state's elevated long-term liability position remains a key credit challenge. The state’s long-term liabilities that include debt, pension and other post-employment benefits total about $200 billion or about 29% of state income, well above the 6% median for states. Illinois has $28 billion of GO debt, $38 billion of OPEBs, and a $133.7 billion of unfunded pension burden.
Governance also remains a concern despite the more cooperative atmosphere that was seen this year under the new Democratic governor who enjoys Democratic legislative majorities.
The political divide between the majority and former Gov. Bruce Rauner, a Republican, led a two-year budget impasse.
“Despite progress in the most recent legislative session, the track record for the political environment in the state, and its hampering of prudent fiscal policy, remains a negative rating consideration,” Fitch wrote.