CHICAGO – Already the lowest rated state, Illinois suffered a new downgrade ahead of $1.8 billion in bond sales.
S&P Global Ratings late Friday dropped Illinois general obligation bonds one notch to BBB and left a negative outlook on the rating. State appropriation backed debt is now on the cusp of losing its investment grade status because it was lowered one notch to BBB-minus. Moral obligation sunk further into junk rating territory after being lowered one level to BB.
"The downgrade reflects our view of continued weak financial management and increased long-term and short-term pressures tied to declining pension funded levels," said S&P analyst John Sugden.
The state plans to refund $1.35 billion of GOs in a negotiated sale on Oct. 13 and return Oct. 17 with a $480 million competitive new money GO deal.
The state's tax-supported debt totals $34.42 billion, which includes GO debt, Build Illinois Bonds, and other tax-backed and moral obligation bonds. S&P assigns high-grade ratings to the Build Illinois bonds based on their sales tax support.
The state is mired in a budget impasse that has resulted in the approval of only partial appropriations and a stopgap spending plan designed to fund operations until January in the hope that lawmakers will be able to act then after putting the November election behind them.
The state has the worst- funded pension system in the nation with $113 billion of unfunded pension obligations that consume $7 billion of annual revenue, with most coming from what's estimated at a roughly $33 billion general fund.
Four of the five funds that make up the state's pension system, including the two largest, have lowered their assumed rates of return this year and have reported weak earnings of late which will further pressure the state to increase contributions.
Bank of America Merrill Lynch and Jefferies are running the books on the $1.34 billion GO refunding, which is expected to generate about $100 million in net present value savings and shorten the maturity on the refunded bonds by one year.
The $480 million new money deal four days later is to fund capital projects with a large amount going to transportation.
Illinois already pays the widest credit spreads of any state. On its most recent GO sale in June, it saw spreads of about 185 basis points to the MMD top-rated benchmark on its 10-year maturity.
"This report underscores Illinois' need for tangible pension reform after career politicians deliberately underfunded the system for decades," Gov. Bruce Rauner's administration said in a statement. "Gov. Rauner continues to fight for pension reform and other fundamental, structural reforms that will free up resources to help balance the budget."
The S&P action puts the state's rating on par with the Baa2 and negative outlook Moody's Investors Service assigned to the new bonds Wednesday.
Fitch Ratings Thursday affirmed the state's BBB-plus rating and left the credit on negative watch. Fitch warned that it will resolve the placement in January when lawmakers have said they plan to return for a lame-duck session to tackle a budget plan.
S&P took a dim view of the state's long history of structural imbalance, its management, the impact of a roughly $6 billion budget gap on operations, and a mounting bill backlog that could hit $11 billion by the end of the fiscal year in June.
The Illinois rating is supported by above-average income levels, substantial flexibility to adjust spending and taxes, a deep and diverse economy, and strong GO statutory protections. S&P raised a red flag, however, about the sturdiness of those protections.
"Although we don't foresee this in the immediate future, challenges to the state's debt payment priority could emerge should liquidity dwindle to the point where it affects the state's ability to provide essential services," analysts wrote.
The state has about $3.1 billion a month available to cover debt service, providing 12.5 times coverage of the approximately $200 million that is required to be transferred from the general fund into a GO Bond Retirement and Interest account known as GOBRI. Cash balances in various accounts totaling $9 billion can also be tapped if needed.
To stabilize the rating, leaders need to come some agreement.
"To the extent that a structural solution continues to elude elected officials, credit quality could continue to erode," S&P analysts wrote.
Rauner, a Republican, and the Democrat controlled General Assembly have been at loggerheads since he took office in early 2015. He has refused to raise income or other taxes to offset the loss of revenue from the partial expiration of the 2011 hike unless Democrats agree to items on his "turnaround agenda."
Democrats are deeply opposed to many of those items, including worker's compensation and tort reforms and local government labor reforms which they believe argue would hurt the middle class while Rauner says they are necessary to improve the state's economy.
Further credit erosion would impact state floating-rate debt, although pressures have eased due to some renegotiated terms. The state has $600 million of variable-rate debt hedged with swaps. The counterparties are Barclays Bank PLC, Bank of America N.A., JPMorgan Chase Bank N.A., and Deutsche Bank AG.
Four of the swaps have termination triggers if the state GO rating falls below the BBB-minus/Baa3 level while one has a threshold one notch lower. The swaps are negatively valued at $153 million.
Six banks provide credit support including JPMorgan Chase, PNC, Wells Fargo, State Street, RBC, and Northern Trust. The current 2.85% fee increases to 3.35% if one of the state's ratings drops to the BBB-minus level and then to 5.35% at the junk level. The LOCs expire Nov. 27. The state is in negotiations on replacements. Without new ones in place, the state would face a three-year term out of the debt at higher rates.
The state also faces retiree healthcare pressures with its other post-employment benefits liabilities of $34.8 billion. The state covers the benefits on a pay-as-you-go basis which cost $905 million. The courts shot down the state's attempt to shed the benefit as well as its past efforts at reforming pension benefits due to strong constitutional protections afforded benefits.
Illinois is in rare rating territory. New Jersey is S&P's next lowest rated state at A. S&P rated California BBB in 2003 and 2004. It rated Louisiana BBB-plus in 1988 and Massachusetts was at BBB in 1989.
Fitch rated California BBB before ratings recalibrations in 2003 and 2009. Moody's said the only state at the same level since the 1970s was Massachusetts which from 1990 to 1992 was rated Baa. However, that rating predated the firm’s 2010 recalibration of ratings and would equate to an A2 rating now, leaving Illinois an outlier in Moody’s ratings history. Moody's did not assign 1, 2, or 3 modifiers then.
