CHICAGO – Illinois’ fiscal reckoning arrives Friday, both state leaders and market participants warn.

Negotiations continue on a budget package but there’s no clear path to ending a two-year-old budget stalemate ahead of the close of fiscal 2017 at 11:59 p.m. House Speaker Michael Madigan will call a Democratic plan up for a vote Friday, but its requires some GOP votes and Republicans and Democrats remain on odds on some key items.

Gov. Bruce Rauner said he will keep lawmakers in Springfield, so they can work through the weekend. If a solution isn’t reached, many believe S&P Global Ratings will move quickly to cut the state’s rating to junk, a stigma no state has ever worn.

Illinois State Comptroller Susana Mendoza
“The state’s unprecedented fiscal crisis is quickly taking a dangerous turn,” Illinois Comptroller Susana Mendoza said. Illinois Comptroller's Office

Also Friday, U.S. District Court Judge Joan Lefkow may decide how much more the state needs to pay Medicaid providers to chip away at a $3 billion bill backlog and bring the state into compliance with consent decrees.

The plaintiffs want the court to order the state to pay about $1.1 billion monthly for at least the next four months. State comptroller Susana Mendoza has warned the state can’t afford to pay much more than the $150 million a month it has offered.

“The state’s unprecedented fiscal crisis is quickly taking a dangerous turn,” Mendoza said in a You Tube video this week citing the budget deadline and possible court ruling. A budget agreement is needed to avoid “disaster,” she said, and without such an agreement a court order that requires a big hike in Medicaid payments “will create a critical breaking point,” she said.

“Those two things together will magnify the effect of the crisis, depending on how the judge rules,” said Brian Battle, director of trading at Performance Trust Capital Partners.

While both stand to rattle investors and impact state bond holdings and their value, the court decision may hold a greater immediate impact on spreads.

“The state’s bonds are trading at a yield that implies a junk rating, everyone is putting a high probability that the state won’t have a budget,” Battle said. “I don’t think Judge Lefkow’s decision is priced into the market yet.”

MARKET

Multiple market participants believe that while some selling will occur it’s unlikely that holders will move in masse to shed Illinois $26 billion of general obligation paper if S&P drops the state to junk.

“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 warned when it downgraded the state to BBB-minus on June 1. Fitch Ratings is expected by the end of July to act on the state’s BBB rating. Moody’s Investors Service assigns a Baa3 and negative outlook.

A significant sell off isn’t expected because the investment perimeters of many institutional buyers allow them to hold some amount of speculative grade paper even if they can’t buy it going forward. Many are expected to stand pat based on their belief that Illinois bonds are still attractive with low default risks. Many are betting on the value improving once the political logjam lifts given Illinois’ economic strengths.

“The problem is no one alive has ever traded a non-investment grade state GO so it’s hard to know exactly what the bonds will look like,” said Matt Fabian, partner at Municipal Market Analytics. “What is the real risk in holding an Illinois bond? Liquidity and price change.”

If the state’s paper remains liquid, that could hold spreads from too dramatic of a widening. Liquidity is a greater concern than default -- which typically becomes more heightened at a speculative grade level – because investors still generally believe the state’s GO Bond Act protections protect debt service.

“There could be some knee-jerk reaction," Battle said, but most holders adverse to headline and credit risks have already shed Illinois paper.

John Miller, co-head of fixed income at Nuveen Asset Management, said earlier this month the market reaction to the court’s Medicaid decision earlier this month ordering negotiations on Medicaid payments may provide a hint of what could happen to Illinois GO bond prices after a downgrade.

Spreads widened between 50 to 100 basis points to the Municipal Market Data’s top-rated benchmark.

Miller and others predict a possible 50 to 100 bp widening. The state’s 10-year has been trading at a 270 to 290 basis point spread, down from the 335 bp spread it hit the day after the court ruling.

The state paid a true interest cost of 4.2449% on its last GO sale in November. The 10-year in the $480 million issue landed at a 200 basis point spread to the AAA benchmark.

Illinois bonds are held by a diverse range of buyers with the majority still held being retail accounts with insurance companies, mutual funds, other institutional buyers, and some hedge funds holding the remainder. Some shift is expected from traditional investors to crossover investors looking to buy at a discount with the hope of a quick gain that would occur if a budget deal is reached.

Going forward the state will face a narrower audience on future sales.

For high-yield accounts the prospect of the state falling to junk is appealing. Distressed funds are “salivating,” Battle said of the high yield/low default risk Illinois’ junked paper will offer.

Invesco Municipal Funds doesn’t think there will be a budget agreement and “it is highly likely 2 of 3 agencies downgrade Illinois into junk status in 2017 which will cause their debt to exit investment grade rated indexes,” Mark Paris, chief investment officer, said in a report earlier this month.

High yield accounts hold assets of $90 billion.

CONTAGION

The state’s fall from investment grade will reverberate across the state with the “contagion” effect impacting borrowers across the credit spectrum and portfolio managers will face questions over how much Illinois-based paper they hold, market participants said.

Nuveen has put the annual costs paid by local governments in Illinois because of the state budget woes at $930 million with the penalty ranging from 25 basis points for a top-rated borrower to 250 bp for a double-B issuer.

Market participants have differing opinions on a broader fallout. Some believe other struggling states like New Jersey and Connecticut could see their spreads widen if Illinois leads the state GO sector into junk territory. But Invesco's Paris said in the report earlier this month that the issues affecting Illinois are very specific to the political climate of the state, and not a harbinger of the future for other states.

A year ago, the prospect of a state government falling to junk seemed unlikely given their broad powers to cut spending, raise revenue, and pass along their own pain to local governments. Market participants say the perception of a state rating floor has crumbled as the Illinois impasse dragged on and its unpaid bill backlog climbed to $15 billion.

Rating agencies began to make clear in downgrades last year and in commentaries earlier this year that Illinois’ strong GO statutes and sovereign status would only go far in protecting its investment grade status.

At this point, Battle and Fabian said, the greater jolt to the market could occur if the state reaches a budget agreement. “It would be the first meaningful sign of progress” and could help trim spreads around 50 basis points, give or take some, Fabian said.

DEFAULT AND LIQUIDITY

Mendoza has sought to send a clear message to the financial markets that “debt service will not be delayed or diminished.”

A core strength of the state GO is the irrevocable and continuing appropriation for debt service payment, the early set aside of debt service in monthly allotments, the ability for holders to legally compel the state to pay, and the ability to tap various accounts holding more than $10 billion.

Market participants, however, worry that such a prioritization over other stakeholders starved for their aid or vendor payments is not politically sustainable or could be threatened by court actions.

"We placed the ratings on CreditWatch with negative implications because, in our view, the unrelenting political brinkmanship now poses a threat to the timely payment of the state's core priority payments,” S&P analyst Gabriel Petek wrote in the June 1 report.

Court documents filed this week in the Medicaid case warn that the state could face a shortfall of $700 million in covering core priority obligations in August if the court grants the plaintiffs request.

“Core priority” expenses include $226 million in monthly debt service, $593 million in pension payments, $160 million in Medicaid payments, $370 million for payroll, and $270 million in state aid to school districts.

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