Grading on the Illinois scale: a flawed budget beats no budget
CHICAGO – With the ink still drying on Illinois’ fiscal 2019 budget, Gov. Bruce Rauner defended the $38.5 billion package as a “balanced” bipartisan compromise that moves the state in the right direction despite its flaws.
Municipal bond analysts offered a tougher assessment after their initial relief that the state passed a budget at all, while secondary market traders saw the bright side, bidding up Illinois paper.
“At least the lies are bipartisan this time,” Municipal Market Analytics wrote in its weekly market commentary.
The new budget is “at least 3-4% reliant on one-time revenues and aggressive assumptions while mostly ignoring the vendor payables and long-term pension funding crises,” according to MMA.
The budget is the first full-year spending plan Rauner has signed since taking office in 2015. The state went two years without a full budget before lawmakers overrode Rauner's veto to enact the fiscal 2018 budget and tax increases to fund it.
“This is a compromise. It’s not perfect. None of us got everything we were looking for," Rauner said Monday at the budget-signing ceremony.
The harshest criticisms focus on the budget's assumption of revenue from the long-stalled sale of the state’s downtown Chicago headquarters for $240 million, $445 million in uncertain pension savings from mostly voluntary buyout programs, the one-shot of $800 million in inter-fund borrowing, and the failure to account for an estimated $300 million expense for employee back pay while there's only a narrow ending balance of $15 million.
Rauner defends the plan, saying it scales back on about $1.5 billion of new or expected spending and saves on pension contributions. The availability of additional tax collections from federal tax changes also helped “us to move forward,” Rauner said.
With the state facing a $129 billion unfunded retirement liability tab, Rauner said further pension reforms are needed. The governor also said the state's roughly $7 billion unpaid bill backlog must be addressed.
“The changes we have made clearly are not enough,” he said while offering no timeline for action.
The bipartisan spirit of cooperation and praise seen during the House and Senate budget debate last week remained on full display Monday as Rauner was flanked by GOP minority leaders with Republican and Democratic budget negotiators in the background. House Speaker Michael Madigan and Senate President John Cullerton did not attend.
Municipal market traders rewarded Illinois with a steady narrowing of spreads. “This is a credit positive for the state which risked its investment grade rating last year after failing to adopt a spending plan on time,” Bank of America Merrill Lynch said in its Municipals Weekly commentary published Monday. “We expect the rally to continue.”
Budget watchdogs zeroed in on the budget’s flaws, challenging assertions that it is balanced and chiding lawmakers for putting off needed work, while municipal analysts say it's clear the budget is designed to get lawmakers through the election cycle with the state’s low investment grade rating intact.
Only one of the three rating agencies – two of which rate the state at just one level above junk – have so far issued formal commentaries.
“Timely enactment of a fiscal 2019 budget in Illinois is consistent with the stable outlook S&P Global Ratings currently maintains on the state's credit rating” of BBB-minus, analysts wrote Tuesday. “While the emergence of a more collaborative budget process has potentially constructive credit implications, the substance of the package largely represents an extension of the status quo.”
“To be fair, the state has now passed the last major potential conflict ahead of November, at which point the (seemingly likely) election of a Democratic governor will lead to more permanent solution making,” MMA wrote. “Whether or not that actually happens, meaning whether or not incremental revenues are added to the state budget and vendor payables are not just stabilized but reduced, is now the critical focus for bondholders.”
If the state fails to raise fresh revenues in the coming year, “it may be unable to prevent noninvestment-grade ratings on its bonds,” MMA added.
“The willingness to pass it is a good sign,” said Howard Cure, director of municipal bond research at Evercore Wealth Management, LLC. “During an election year you don’t want to not have a budget. I think that was a big motivation this time around. The market is happy there is a budget in place and this budget hasn’t done a lot of harm,” Cure said.
While Cure said market participants weren’t necessarily expecting the state to make much headway on structural issues, the budget only buys so much time. That means the price rally could turn against the state if confronted with negative headlines like a souring economy or unexpected costs.
Cure said Moody’s Investors Service put the state on notice in a report issued last week as lawmakers were voting on the budget warning that action would soon be needed to rein in mounting pension, retiree healthcare and debt service costs to prevent further rating cuts.
“When the 2019 budget process unfolded, I saw it taking two paths -- a repeat of what happened before where the two sides used the upcoming elections to take hardened stances or precisely because of the upcoming elections, they pass a care-taker budget which doesn’t make too many waves,” said John Humphrey, head of credit research at Gurtin Municipal Bond Management. “An early read is that it tends toward the latter.”
Humphrey said the firm has only begun digging into the budget’s details. Without a path to tackle the backlog he’s looking for cracks that could result in a further building in delinquent bills given “there is some fragility to the budget.”
“Spreads on Illinois GO bonds have dropped a lot during the past week,” said Municipal Market Data strategist Daniel Berger.
The state’s spread to the MMD top-rated benchmark on its 10-year began the month at 202 basis points. After peaking for the month on May 16 at 208 bp it slowly fell, landing at 190 bp just ahead of the budget passage last week.
On May 31 after the final vote was cast, spreads narrowed to 165 bp, a new recent low, according to MMD data.
Spreads have fluctuated over the last year. The 10-year began 2017 around a 235 bp spread and hit an all-time peak of 335 bp on June 8 after an adverse court ruling on Medicaid. It hovered between 273 and 292 bp in mid-2017 as the state threatened to head into a third year without budget and faced a cut to junk.
After the gridlock broke last July spreads narrowed to the low 200s and hit a then low of 168 bp last October. The New Year began with spreads at about 177 bp, rising to 197 bp in March.
In the primary market, the state saw a 205 bp spread on the 10-year in its April sale, up from 170 bp last fall.
The rally is reverberating across the Illinois market with some local issuers seeing 15 to 20 basis points shaved off their spreads depending on the name, said IHS Markit’s Edward Lee. “Bonds are reacting positively to the budget passage,” Lee said.
The market has long stung Illinois-based issuers – from top-rated credits whose finances face little state exposure to struggling credits reliant on the state for aid, like its junk-rated regional state universities – with spread penalties simply for carrying an Illinois in its name.
MMD’s Berger said some tightening might be expected as other issuers in the state are “taken along for the ride” but cautioned that other factors could be contributing to the narrowing including the availability of cash with June and July reinvestment dollars in play.
Even if other issuers don’t see much tightening, having a state budget in place provides clarity in their own fiscal planning and that’s a plus, Cure said.
Jim Colby, portfolio manager and senior municipal strategist at Van Eck Global, said he saw improvements on the bid side for Illinois-based issuers but it will take a couple more trading days to gauge whether it will hold.
The chances are better if buyside analysts decide after dissecting the budget that “it at least stems the tide of red ink and non-payment of vendors,” Colby said. “It remains to be seen what is the appropriate value” for issuers’ paper in the state.
Another buyside analyst who was still digging into the budget’s details before offering an assessment said at first blush it appears “to give lawmakers cover going into the election cycle and appears to just kick-the-can on pensions so it will be interesting to see what rating agencies say.”
Rauner’s opponent in November's governor's race went on the attack Monday.
“After his 736-day budget crisis, Bruce Rauner has been relegated to signing his name, as the General Assembly works to clean up his mess,” said J.B. Pritzker campaign spokeswoman Jordan Abudayyeh.
After the election, governance will take center stage.
“While I won’t speculate as to who will win the election in November, the outcome could have credit implications,” Humphrey said. “If Gov. Rauner wins, what does that second term look like and how does his relationship with the legislature work? If Pritzker wins, we will have another governor with no practical political experience govern at a critical time when more than minor policy decisions will be needed.”