CHICAGO — Illinois’ $500 million bond sale next week will offer a fresh view into the market’s appetite for yield versus risk as investors digest a barrage of negative fiscal news about the state, from pension reform stuck in the political muck to a warning that coffers are running precariously low.

Comptroller Judy Baar Topinka on Monday warned of a $9 billion bill backlog and a $1 billion shortfall in funds needed for social and human services.

The state’s rocky fiscal foundation was also underscored by its release last week of three-year budget projections that raise questions over whether Illinois can afford to let its 2011 tax increase partially expire in fiscal 2015.

The state’s pension crisis, illustrated by $95 billion of unfunded liabilities, and cash-flow problems creating the massive bill backlog, are cited by rating agencies as two core strains on Illinois finances. The 2011 income tax hike provided a temporary salve that eased pressure on the operating budget but its looming partial expiration adds to the specter of further credit deterioration.

Fitch Ratings earlier this month put the state’s single-A rating on negative watch, warning that continued inaction by lawmakers to shore up the pension system over the next six months would drive a downgrade.

The flurry of negative news comes as the state plans to enter the market with a competitive sale of general obligation bonds next week to raise funds for its ongoing $31 billion capital program, and as lawmakers are expected to resume efforts to tackle pension reforms.

The state pays a steeper interest rate penalty in the primary market than other states or similarly rated credits. It pays 50 basis points to 200 basis points over the triple-A MMD scale depending on maturities and the security. Spreads tightened in secondary market trading last year as Illinois benefitted from a quest for yield that keeps demand up, compressing spreads throughout the municipal market.

“The state continues to trade pretty well even in front of this coming deal as investors continue to look for yield in an environment where there is not a lot of yield,” said Michael Pietronico, chief executive officer at Miller Tabak Asset Management.

While some conservative investors won’t buy Illinois paper, those looking for yield see the state’s strong GO statutes that make repayment a priority as a key selling point. The market believes pension reforms will eventually happen “no matter how painfully long they might take” and investors “would be surprised if the state were not to make the income tax increase permanent or at least extend it,” Pietronico said.

The latest bad news came Monday from Topinka, whose office manages the state’s books. She warned of the rising backlog and said Illinois is $1 billion short of appropriated funds needed to cover expenses.

“We know today that many of our programs and agencies will run out of authorized funding months before the end of the fiscal year,” Topinka said. “We need to end the denial and address those budget shortfalls before they jeopardize critical services that our residents depend on.”

She recommended that either state agencies set aside reserves to address the shortfall or lawmakers act to increase appropriations. If the latter option is taken, she urged the General Assembly to identify a revenue source to cover the additional spending.

Several key Democratic legislators said they intend to introduce legislation that would authorize short-term borrowing to pay down bills. Past proposals from lawmakers or Gov. Pat Quinn ranging from $4 billion to nearly $9 billion have failed to generate sufficient support to win passage.

The other significant news came last week from Office of Management and Budget acting director Jerry Stermer in three-year budget projections required under a 2010 law.

The projections show the state faces deep cuts and will make little headway in paying down its bill backlog after the current fiscal year due to the strain of rising pension payments and a drop in income tax collections in fiscal 2015.

The state anticipates personal income tax collections will drop to $14.3 billion in fiscal 2015 from $15.7 billion in fiscal 2014. They will take a steeper fall to $12.2 billion in fiscal 2016. Corporate income taxes would also fall from $2.9 billion expected in the next fiscal budget to $2.1 billion in fiscal 2015 and $1.7 billion in fiscal 2016. The general fund budget, estimated at $35 billion in fiscal 2014, would fall to $30.5 billion in fiscal 2016.

The declines come as the individual income-tax rate that was raised to 5% from 3% in January 2011 will drop to 3.75 %, and the corporate income tax rate that was raised from 4.8% to 7% will fall to $5.25 % midway through fiscal 2015.

The state is on pace to close out the current fiscal year with an $8.3 billion bill backlog. It drops to $7.4 billion in the next fiscal year and remains there through fiscal 2016, based on the current revenue picture. Tax growth of $600 million expected next year will be more than consumed by a $945 million increase in the state’s pension payment, to $5.1 billion.

“Illinois faces tremendous fiscal challenges in the coming three years,” the OMB report reads. “The challenge in the years ahead is management of the state’s accumulated bills in the face of continuously increasing pension contributions and the statutory reductions” of income tax rates. Steep cuts of 5.7% and 13.6% will be needed in fiscal 2015 and 2016, respectively.

“The urgency of the crisis is being reinforced by the state’s own projections,” said Richard Ciccarone, chief research officer at McDonnell Investment Management LLC.

Illinois may continue to enjoy market access but its penalties could worsen should less favorable market conditions arise and the state hasn’t acted to turn the fiscal tide. “A pension fix is the lynchpin,” Ciccarone said. “But the idea of a temporary tax is also being discredited by the numbers.”

Deputy budget director Abdon Pallasch said the projections underscore “that the pain gets more severe the longer we go without pension reform.” Asked whether Quinn would eventually push to make permanent or extend the tax hike, he would say only: “We continue to focus to pension reform.”

Stermer has said that given the likely legal challenge unions will mount to any pension reforms, the state would not incorporate potential annual contribution savings into its next few budgets, further adding to the pressure on the general fund. The governor must unveil his fiscal 2014 budget by Feb. 20, although he has asked the General Assembly to allow him to delay the budget until March 6.

Earlier this month, after lawmakers adjourned their veto session without adopting pension reform, Fitch put the state’s A rating assigned to $26.2 billion of GO debt on negative watch. The state’s pensions are just 40.4% funded. If downgraded, Illinois would join California at the A-minus level. Puerto Rico is rated BBB-plus. All other states are rated in the double-A category.

Lawmakers could not settle on a plan despite mounting pressure from Quinn, civic and business groups, and the public to chop the obligations. Various proposals would cut benefits, raise contribution rates and retirement age, and some support shifting the costs of suburban and downstate teacher pensions now paid by the state to local districts.

Moody’s Investors Service assigns a negative outlook to Illinois’ A2 general obligation rating as does Standard & Poor’s, which rates the state A.

Illinois will take competitive bids on $500 million of GOs on Jan. 30 in its first GO sale since last fall.

Public Resources Advisory Group is advising the state and Mayer Brown LLP and Burke Burns & Pinelli Ltd. are bond counsel on the 25-year bonds, according to state director of capital markets John Sinsheimer.

The rating agencies have not yet issued reports on the new sale, but state finance officials recently discussed the deal with analysts, Sinsheimer said. They also discussed the state’s new three-year budget projections.

Illinois won’t be conducting any special investor outreach or roadshow since it’s a competitive sale. “I think the banks understand the state’s strong general obligation pledge. The municipal calendar has been fairly light and so we would expect that the banks are seeking inventory for their desks and would hope that translates into attractive bids,” Sinsheimer said.

The state last sold GOs in a small $50 million competitive issue last September. While secondary trading prices provide an indication of the market’s perception of state paper, the new sale will provide a fresh data point for the state along with investors. “We will be looking closely at the results to gage where spreads come in to give us an idea of where we stand with the market,” Sinsheimer said.

In an April refunding, the state paid a yield 65 basis points over the triple-A MMD on its shortest maturity, while the final maturity in 2025 came in at 171 basis points over MMD.

The threat of further credit downgrades did “not shake our advice to add to state of Illinois positions for incremental income and safety,” Municipal Market Advisors said in its weekly outlook report issued last week. “State law well protects payments to bondholders, meaning the risk of payment default likely has not meaningfully changed despite the pension system’s troubles.”

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