CHICAGO – Two downgrades Thursday brought Illinois closer to becoming the first state with a junk bond rating.
Illinois’ general obligation bonds likely will sink to a speculative grade if the state heads into a third fiscal year July 1 without resolving its budget stalemate, S&P Global Ratings warned Thursday in a report downgrading the state one notch to BBB-minus, the lowest investment-grade rung.
Moody's Investors Service also on Thursday dropped the state to Baa3 from Baa2. It's the first time it has rated a state government below Baa2, the rating agency said.
"The rating actions largely reflect the severe deterioration of Illinois' fiscal condition, a byproduct of its stalemated budget negotiations, now approaching the start of a third fiscal year," S&P analyst Gabriel Petek wrote.
S&P placed the Illinois ratings on CreditWatch with negative implications. Moody's assigned a negative outlook.
A fall to junk would mark a first for a state with sovereign powers that afford it sweeping flexibility to manage spending and revenues. Illinois’ ability to leverage those powers has been halted by deep divisions between Gov. Bruce Rauner, a first-term Republican, and the legislature’s Democratic majorities.
“In our view, the unrelenting political brinkmanship now poses a threat to the timely payment of the state's core priority payments,” Petek wrote.
S&P’s downgrade came less than 12 hours after the General Assembly adjourned its spring session late Wednesday without agreement on a plan to stabilize a dismal balance sheet. S&P lowered the state’s $26 billion of GOs by one level to BBB-minus.
A month remains before the next fiscal year begins, but that's not enough time for Moody's.
"During the past year of fruitless negotiations and partisan wrangling, fundamental credit challenges have intensified enough to warrant a downgrade, regardless of whether a fiscal compromise is reached in an extended session," Moody's wrote. "As the regular legislative session elapsed, political barriers to progress appeared to harden, indicating both the severity of the state's challenges and the political difficulty of advocating their solutions."
“This is a telegraphed punch,” said Brian Battle, director of trading in Chicago at Performance Trust Capital Partners. “The state is on notice that something structural has to be done” on long-term planning, expense cuts, and tax increases.
In addition to dropping $26 billion of GOs to BBB-minus, S&P dropped the state's appropriation debt, which includes bonds issued by the Illinois Sports Facilities Authority and the Metropolitan Pier and Exposition Authority, one notch to the below-investment grade-level of BB-plus. The sports agency has $430 million of debt and Met Pier has $2.6 billion. Chicago’s motor fuel bonds were dropped to BB-plus. Moral obligation backed debt fell one notch to BB-minus, along with a Transportation Infrastructure FInance and Innovation Act loan.
S&P dropped sales tax-backed Build Illinois bonds, previously AAA, three notches to AA-minus.
Moody's dropped the Build Illinois bonds to Baa3 from Baa2; it had already capped the credit at the state's GO rating. Moody's dropped the Met Pier debt to junk Ba1 from Baa3 and sent the state's Civic Center program bonds to Ba1. The Moody's actions impact a total of $31.5 billion in debt.
“I think this sends a clear signal that the rating agencies have completely lost patience with the state and it sends a clear signal that rating downgrades will accelerate because the problem is getting bigger at a faster rate,” Battle said.
S&P’s concerns run deep. “Illinois is now at risk of entering a negative credit spiral, where downgraded credit ratings would trigger contingent demands on state liquidity, further exacerbating its fiscal distress,” Petek wrote.
The state is strained by a deficit that is expected to grow to $7 billion in the next fiscal year, a $14.5 billion bill backlog, and rising contributions needed to address $126.5 billion of unfunded pension obligations.
S&P said it anticipates resolving the CreditWatch by the start of the new fiscal year July 1. “If lawmakers fail to reach agreement on a budget with provisions designed to reduce the state's structural deficit, it's likely we will again lower the ratings,” S&P said. In S&P’s history of state ratings, only California and Massachusetts have been rated at the BBB level. No state until now has been rated at the BBB-minus level.
Fitch Ratings, which has its BBB rating on negative watch
The Rauner administration blamed House Speaker Michael Madigan, D-Chicago.
“Madigan’s majority owns this downgrade because they didn’t even attempt to pass a balanced budget, get our pension liability under control, and other changes that would put Illinois on better financial footing,” said spokeswoman Eleni Demertzis.
CONSEQUENCES
If the state lands in junk, it will lose buyers limited to investment grade holdings, driving up borrowing costs. A fresh round of negative headlines might drive some away sooner “as fewer and fewer people believe the state has the willingness and ability to pay” its debts, Battle said.
The state’s 10-year paper has been trading recently at the 245 basis point to 250 basis point spread to the Municipal Market Data’s top-rated benchmark, levels that already incorporated a downgrade.
Illinois-based credits face higher penalties too. Nuveen’s John Miller recently estimated the penalties for being based in Illinois have already cost local units of governments $930 million in added annual interest. The penalties range from 25 to 30 basis points to 150 basis points depending on the credit.
Illinois is now facing an increase in floating-rate costs tied to $600 million of paper. Under terms of the state’s two-year direct placement entered last November to replace expiring letters of credit its payment spread rises to 3.45% from 2.95% if one of its ratings dropped to Baa3/BBB-minus.
If one of its ratings falls to junk the fee increases to 5.45%. If at least two drop the state to junk, the spread rises to 645 basis points. If any of its ratings fall to Ba2/BB, the spread jumps to 745 bp.
A fall into speculative grade territory would trigger termination events on some state swaps. Termination is not triggered on the largest swap until a fall to BB. The swaps were negatively valued at $108 million as of March 31.
LIQUIDITY
Alarms are being sounded by investors and analysts over the state’s liquidity pressures, strained by the $4 billion annual drop in revenue that began on Jan. 1, 2015 when an income tax hike partially expired.
About 90% of state spending continues based on continuing appropriations and legal orders. Debt service, along with pension payments, payroll, school district aid and other high priority obligations consumes more than $2 billion monthly.
A federal judge next week could add Medicaid payments to that list, which state lawyers have warned would jeopardize the timely payment of the other obligations.
“Failure to reach a consensus before the current legislative session adjourns on May 31 would signal deepening political paralysis, heightening the risk of creditor-adverse actions. The state could resort to borrowing from debt service funds, depleting available non-operating cash or, eventually, prioritizing core operating needs over debt service,” Moody’s warned in a report earlier this year.
Bondholders are supported by statutes that allow the state to pay debt service from all legally available funds. The state can dip into non-general fund accounts that held $10.8 billion as of Jan. 31. The state also sets aside debt service monthly well ahead of due dates.
Even for those with an appropriation, payments are months behind due to the backlog. The administration’s five-year forecast warns of a $34 billion backlog in 2020 and $47 billion in 2022.
LEGISLATURE
When the session opened in January, lawmakers were under pressure to reach agreement because a six-month stopgap appropriation approved in June of last year had expired. The expiration has left social service providers and public universities starved for cash. K-12 education had received a full year appropriation.
Senate President John Cullerton, D-Chicago, and Minority Leader Christine Radogno, R-Lemont, crafted a package of bills aimed at ending the stalemate and laying the groundwork for agreement on a fiscal 2018 budget with tax hikes.
It sought to meet some of Rauner’s demands for “structural” reforms on issues like worker’s compensation, local government consolidation, procurement reforms, and pension changes in exchange for his support for tax hikes. It also authorized $7 billion in borrowing to pay down the backlog, overhauled education funding formulas, funded government through June 30, and expanded gambling.
After fits and starts, Republicans signed on to some measures but said others did not go far enough. Many were sent over to the House and some won approval. The education overhaul, which the GOP called a bailout for Chicago Public Schools, faces a veto.
Senate Democrats last month signed off on a $37.3 billion budget with more than $5 billion in tax hikes and $3 billion in cuts. It was crafted through bipartisan talks but Republicans ultimately pulled their support without agreement on what’s become Rauner’s chief demand – an at least four-year local government property tax freeze. Worker’s compensation changes also fell short.
The Senate rolled back some cuts, passed it, and sent it to the House.
After talks with the Senate, House Democrats ultimately decided Wednesday to forgo a vote. They disliked some of the cuts, the retroactive nature of the income tax hike to Jan. 1, and feared voting for tax increases without GOP support would provide campaign fodder.
Madigan announced the decision in a statement saying no consensus had been reached and public hearings by a House budget working group would begin June 8. “House Democrats will continue our efforts to address this challenge, end this destructive impasse and close the Rauner budget deficit,” said Madigan.
At the heart of the divide is Rauner’s position that his policy and governance proposals are needed to ensure economic growth while Democrats consider them to pro-business and harmful to the middle-class.
Rauner, Radogno, and House Minority Leader Jim Durkin, R-Western Springs, responded with a news conference attacking Madigan and his fellow Democrats.
“Today, we’ve seen a complete dereliction of duty by the majority in the General Assembly,” Rauner said.
The path to an agreement remains clouded especially given the rising rhetoric and partisan attacks. Rauner has not said if he would call a special session forcing lawmakers to remain in Springfield during talks.
The state could again settle on some form of a temporary spending plan specifically aimed at providing school districts with the aid some say is needed to open in the fall.
After May 31, a three-fifths majority is required to pass legislation if it is to take effect immediately. It’s the same threshold for a veto override to succeed. Senate Democrats enjoy such a narrow supermajority while House Democrats hold a simple majority.
Some believe the prospects for a break in the logjam before the 2018 election cycle is dimming. Rauner is seeking re-election and a handful of Democrats have announced their candidacies. Cullerton warned against such a delay in resolving the crisis during a Chicago City Club address because “by then, we’ll have been downgraded to junk status and no one will lend us money. The new governor will have that hung around his or her neck.”
Madigan’s office fired back at Rauner for placing blame on the speaker for the downgrades saying it “shows complete incompetence of staff. Madigan has never issued a single bond More handiwork from a group that helped create the worldwide depression that set a course for Illinois and many others.”
State comptroller Susana Mendoza, whose office manages bill payment, warned in a statement: “We’re about to reach the breaking point at which court-ordered payments will exceed the state’s revenues. Illinois’ sick, elderly, young, and most vulnerable are paying the price. This crisis is untenable, unconscionable, and unnecessary. It’s time that the governor stop campaigning and take responsibility for his failures and fulfill his constitutional mandate to introduce a balanced budget,” said Mendoza, a Democrat.
Among some of the most actively traded issues on Thursday, the state’s 2003 pension obligation 5.1% taxable bonds of 2033 were trading at a low price of $87.817 cents on the dollar, or a high yield of 6.321%, in 36 trades worth $87.39 million, according to the Municipal Securities Rulemaking Board’s EMMA website. In contrast, the 5.1% taxables of 2033 on Wednesday were trading at a low price of $89.96 cents on the dollar, or a high yield of 6.091%, in 22 trades worth $15.27 million.
-Chip Barnett contributed to this story
