CHICAGO — Faced with the headwinds of negative credit action, Illinois is hoping to see demand from investors whose state paper holdings were paid off over the last year and recognize the state’s fiscal strides as its offers $800 million of general obligation bonds on Wednesday.

“In the last 12 months, we have paid off a significant amount of Illinois debt so we believe there’s appetite out there for the name,” director of capital markets John Sinsheimer said Monday. He’s also banking on still-scant supply and the size of the state’s offering.

Ahead of the competitive sale of $275 million of taxable and $525 million of tax-exempt GOs, Moody’s Investors Service dropped the state’s $27 billion of GOs to A2 from A1 and assigned a stable outlook. Illinois is now the lowest rated state by Moody’s. Fitch Ratings affirmed the state’s A credit and stable outlook while Standard & Poor’s affirmed it’s A-plus rating and negative outlook.

While budget and liquidity woes were eased by a temporary income-tax increase early last year that’s expected to generate $6.5 billion this year, Moody’s said the downgrade was driven by the failure to take meaningful action over the course of last year to further pay down bills or address growing unfunded pension liabilities of $82.9 billion. The pension funds ended fiscal 2011 at a 43.4% funded ratio.

Moody’s early last year affirmed the state’s rating after its approval of a tax hike backed by Gov. Pat Quinn and General Assembly Democrats. The increase staved off “any further deterioration” of the credit, said Moody’s analyst Ted Hampton.

The agency maintained a negative outlook as analysts watched to see whether lawmakers would address the pension and remaining liquidity challenges. They were disappointed as pension reforms stalled and billions in overdue bills remained.

“There’s been no concrete indication that the state government can reach a consensus on how to manage those challenges for the long term,” Hampton said.

Prior to the increase, the state paid a interest rate penalty of more than 100 basis points. Though it has not sold any debt supported by its full faith and credit since early last year, investor confidence appeared to grow as spreads narrowed in secondary trading.

In trading last week on a short-term maturity, the spread between Illinois and comparably rated securities had narrowed to about 60 basis points.

Sinsheimer said he had not yet seen any of gains eroded by the downgrade, but believes the true test of whether the state can keep and even build on the gains lies in what action is taken in the state’ upcoming legislative session.

“If working with the governor, we can produce reforms to the pension funds, Medicaid and the outstanding vouchers then I think we are OK and the spreads will come in,” he said.

The downgrade spilled over to the state’s eight public universities this week as the agency put their ratings on downgrade review due to their reliance on chronically late state aid payments. That action impacts a total of $2.4 billion of debt issued by Eastern Illinois University, Governors State University, Illinois State University, Northeastern Illinois University, Northern Illinois University, Southern Illinois University, Western Illinois and the flagship University of Illinois. The universities carry individual ratings that range from the single-A category to UI’s mid-double A rating.

The agency intends to review over the next 90 days the timing of state payments, the universities’ ability to manage operating liquidity amid the delays, and ability to offset potential reductions in funding.

State Comptroller Judy Baar Topinka, whose office pays the state’s bills and debt service, sent a message through a statement to both bondholders and lawmakers. To bondholders, she said: “I want to make clear that there is no fear of the state missing a bond payment…. I can reassure the bond community that the first payment we make each month is to our bondholders.”

“Illinois leaders have a responsibility to hear the message being sent,” Topinka said. “The only way out of this mess is to keep cutting spending, provide for a better business climate and, for once, let growth outpace spending.”

Standard & Poor’s said the state’s rating is supported by a deep and diverse economy anchored by the Chicago area and above-average income levels. Analysts praised efforts to improve the structural budget balance by raising revenues and limiting the use of non-recurring revenues.

Factors that offset strengths include the state’s unfunded pension obligations, an unfunded retiree health care liability of $28.6 billion, and a growing debt-service burden due to increased borrowing for projects and repayment of pension borrowing over the last two years.

“If Illinois does not make meaningful changes to further align revenue and spending and address its accumulated deficit for fiscal years 2012 and 2013, we could lower the rating this year,” lead analyst Robin Prunty wrote.

Fitch also praised efforts to rein in state spending by the imposition of caps through fiscal 2014, but it too stressed the state’s need to enact a long-term solution to the imbalance between spending and revenues because the enacted income tax hike is temporary.

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