Illinois budget alone doesn't threaten investment-grade status
Illinois’ adoption of a fiscal 2021 budget that relies on potential borrowing to make up for a deep tax hit due to the COVID-19 pandemic alone won’t trigger a rating cut, rating agency analysts said in interviews this week.
The budget authorizes up to $5 billion of borrowing through the Federal Reserve’s short-term lending program, that the state would tap in the absence of a new federal relief package, in order to match revenues with expenses. If the state does borrow, it hopes to repay with future federal funding. Gov. J.B. Pritzker has acknowledged that deep cuts lay ahead in the absence of such funding.
“There is inherently some risk in a financial plan that relies on non-recurring resources,” like borrowing from the federal government, “but the budget allows the state flexibility to deal with this crisis and it doesn’t commit the state to any particular path … the budget is more like a framework,” said Ted Hampton, lead Illinois analyst at Moody’s Investors Service.
“We will have to wait and see how the fiscal year plays out,” Hampton said. “When we revised the outlook to negative we knew the state was facing a severe revenue loss that makes meeting long-term obligations much harder, and that hasn’t change” so the adopted budget by itself “does not worsen the state’s credit” from the current level.
If the state opts to tap the federal borrowing, Hampton said, the rating agency would have to consider the terms and impact on long-term liabilities in a rating review.
“Any borrowing where you are talking about current expenses being repaid by future revenues” adds to structural “misalignment” and “risks,” said Geoffrey Buswick, S&P Global Ratings' lead Illinois analyst, but the rating agency, for now, considers the budget package as having “more of a static” impact on the rating.
The state does have the ability to cut spending if the federal government relief being sought doesn’t come to fruition. “There are risks, but they have tools that haven’t been used,” Buswick said. S&P views the state’s commitment to fund the statutory pension contribution as a positive.
S&P warned in a report Monday that while “additional direct federal aid is possible, the amount, timing, and potential restrictions on use are unclear at this point, and so budgeting potential use introduces risk” and the “proposed borrowing simply shifts the repayment to future budget years, and the hope for additional aid is a precarious assumption.”
The state's options to address the virus-related issues are “limited, compared to those of other states,” S&P said in the report, noting the state faced political gridlock through multiple fiscal years, built a significant bill backlog, delayed action on its now $137 billion pension tab, and did not contribute to a rainy day fund while other states did.
“When we downgraded the rating and put a negative outlook on the credit back in April that action reflected our view that this downturn would likely lead Illinois to implement all kinds of non-structural budget management measures that would be difficult to unwind," said Fitch Ratings lead Illinois analyst Eric Kim.
Kim expects the state to revisit the budget package as it becomes clearer later in the year whether the federal government will come through with aid to cover revenue losses or frees up existing aid earmarked for expenses.
"It's our view that this budget is more of a placeholder," Kim said. "Should we get to the fall and additional aid hasn't materialized and none appears to be forthcoming, the state would have to take another look at the budget and its revenues and expenses. The outcome of the constitutional amendment vote is another influencing factor.”
At that time, Kim said the rating agency "will have to assess how the revenue picture looks" and “any sizeable borrowing and decision by voters on the income tax will lead us to review the credit."
Over the last two months, the state saw three negative rating actions. Fitch cut the state’s rating one notch to BBB-minus and assigned a negative outlook. Moody’s and S&P already rate the state at the lowest investment-grade level of Baa3 and BBB-minus, respectively, but revised the outlook to negative from stable.
The assessment of the budget — passed by lawmakers late last month during a marathon session of the legislature after a months-long absence due to Pritzker’s Stay-At-Home order — is limited to the near-term and the state’s bill backlog, pension status, and potential borrowing remain under close scrutiny.
The state expects revenues of $36.5 billion — down more than $4 billion from estimates earlier this year — but lawmakers approved more than $39 billion in operating expenses that include the full statutory pension contribution of $8.6 billion and a $1.9 billion group health insurance payment.
The state must also repay two debt measures used to clear out a COVID-19 2020 revenue hole, including $1.2 billion in note borrowing completed this week through the Federal Reserve’s short-term lending program and $400 million of loans held by the state treasurer. The state also owes $1.8 billion in debt service and owes another $425 million in statutory transfers.
To cover all $43 billion of general fund expenses, the state will borrow up to $5 billion through the Fed program and will tap $300 million from balances in non-general fund accounts by raising the authority to $1.5 billion from $1.2 billion and taking up to two years to repay. Another $1.2 billion would come from one of two sources.
The first is previously authorized debt to pay down the state’s backlog that stood Thursday at nearly $6.9 billion. The second is the roughly $1.2 billion in new income tax revenue expected if voters approve a constitutional amendment on November’s ballot allowing the state to move to a progressive income tax rate structure from the current flat one. If approved, the state would raise rates on top earners.
“While the federal loans have been widely discussed, the additional borrowing has escaped notice because it was authorized in 2019 as a way to reduce the state’s backlog of unpaid bills and did not require action during this legislative session,” the Chicago Civic Federation noted in its review of the budget package published this week.
Illinois spreads continued to improve over the last week from peak levels, which market participants said reflected a more stable market and the expectation the state will hold on to its investment grade ratings for now. The state’s one-year bond was at a 325 basis point spread and bonds six years and out at a 355 bp spread to the Municipal Market Data’s AAA benchmark Thursday. That’s improved from 365/387 earlier this week and a peak last month of 400/425 bps.
The final budget is up from the revised 2020 budget of $40.6 billion, and holds most spending steady. The budget does not fund the scheduled $350 million increase in education funding that districts were counting on, instead holding it to 2020 levels. It does not include the 5% to 10% cut to the level of income tax revenue it shares with local governments that it had in past years, but it does continue a 5% cut implemented several years ago in sales taxes that are distributed to transit districts, according to the Civic Federation.
The budget allocates to local governments $250 million of the state’s roughly $3.5 billion share of a $4.9 billion allocation of aid in the Coronavirus Aid, Relief, and Economic Security Act signed March 27 to cover COVID-19 expenses. That allocation is for those governments that don’t qualify for the direct aid of $1.4 billion.
Another potential burden to add to the COVID-19-driven fiscal strains on the state is whether ongoing demonstrations over the killing of George Floyd while in Minneapolis police custody poses additional policy or rebuilding cost burdens. It could eventually be viewed as a risk factor depending on policy changes and costs to restore properties damaged during the sometimes violent protests in Chicago and elsewhere. “It has to be viewed as a risk” to watch closely, Buswick said. “Policy decisions could come with credit implications.”
Moody’s recently issued a commentary noting the widespread civil unrest occurring as states and cities continue to respond to the coronavirus pandemic and the related economic shutdown and that short-term credit could be impacted by public safety expenses and reduction in tax revenue due to disruption in commercial activity and property destruction. But longer-term credit impacts depend on whether the unrest subsides or becomes a recurring pattern, which could accelerate demographic trends, such as workers and businesses relocating from cities.