CHICAGO – Rating agencies delivered a mixed bag of news for Illinois Friday as the state’s failure to overhaul its pension system prompted a downgrade from Standard & Poor’s while Moody’s Investors Service affirmed its rating.

The rating updates come ahead of the state’s competitive sale of $500 million of general obligation bonds on Wednesday.

On Friday, Standard & Poor’s lowered its rating on Illinois’s $26 billion of GO debt one notch to A-minus from A and warned of possible further action by assigning a negative outlook. The action puts the state’s rating on par with that of California, S&P’s lowest-rated state, although S&P assigns California a positive outlook.

Moody’s affirmed Illinois’ A2 rating and negative outlook saying it reflects the state’s current profile, stressed by unfunded pension obligations of $95 billion, escalating pension payments, and an expected $8 billion bill backlog at the close of this fiscal year June 30.

“Illinois’ A2 general obligation rating and negative outlook are consistent with our view that the state’s pension funding pressures are likely to persist and perhaps worsen in the near term,” Moody’s wrote. Moody’s downgraded the state in January 2012 and in December revised its outlook to negative from stable. California and Illinois are the only states rated by Moody’s in the single-A category though Moody’s rates California higher at A1.

Fitch Ratings earlier this month put Illinois’s rating of A on negative watch warning that the credit faces further deterioration if action is not taken over the next six months on pension reforms. If downgraded, Illinois would join California at the A-minus level. All other states are rated in the double-A category, Fitch noted.

Standard & Poor’s has long warned of a possible multiple notch downgrade if the state didn’t act to shore up its pensions and ease the strain of growing payments on the balance sheet. Political bickering derailed several proposals over the course of 2012 and no agreement could be reached during a veto session earlier this month during which Gov. Pat Quinn, local governments, and business and civic groups had hoped action would be taken.

“The downgrade reflects what we view as the state’s weakened pension funded ratios and lack of action on reform measures intended to improve funding levels and diminish cost pressures associated with annual contributions,” Standard & Poor’s wrote. The state pension system’s funded ratio fell to 40.4% at the close of fiscal 2012 from 43.4% a year earlier and is expected to drop further to 39% in fiscal 2013. Payments will rise by nearly $1 billion in the next fiscal year budget which is to be unveiled in February or early March.

Lawmakers, after convening in a new session, recently re-filed reform legislation but it’s unclear how soon or if lawmakers can resolve their differences and pass a plan.

Quinn noted the urgency during an appearance Friday.

“We’ve got to all work together in a bipartisan way to get this challenge of pension reform behind us,” Quinn said. “That’s really the message the credit rating agencies are screaming at the top of their voice. I’ve heard it, and I think the members of the legislature need to hear it as well.”

Various proposals would cut benefits, increase employee contributions, and gradually shift responsibility from the state to districts the cost of funding local school teachers’ pensions. Republicans oppose the teacher cost-shift. Democratic Senate leaders want a backup plan in the legislation asking employees to shift to a plan with reduced benefits in order to preserve their retiree healthcare benefits in the event the first plan is ruled unconstitutional.

Any reforms likely face a legal challenge by unions given the strong protections afforded to pension benefits in the state constitution, a fact noted by Moody’s and Standard & Poor’s in their reports.

“We believe that legislative consensus on reform will be difficult to achieve given the poor track record in the past two years,” Standard & Poor’s wrote. “If there is meaningful legislative action on reform, we believe that there could be implementation risk based on the potential for legal challenges, and it could be several years before reform translates into improved funded ratios and budget relief.”

Pension pressures are especially acute as a partial expiration of the 2011 income tax hike looms midway through fiscal 2015. Investors believe the state will eventually act to make the increase permanent or extend it. The state will see revenues fall by $2 billion to $4 billion in fiscal years 2015 and 2016 and it expects the bill backlog will remain at about $7.4 billion in the coming fiscal years.

The state’s challenges also include a moderately high debt load to fund an ongoing $31 billion capital program and from borrowing in fiscal 2010 and 2011 to fund pension payments.

The state benefits from improving tax revenues that are exceeding projections in the current fiscal year, a deep and diverse economy, above average income levels, almost unlimited ability to raise revenues, and statutes that give top priority to GO debt service. Analysts also praise recent efforts to improve the state’s structural balance.

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