Illinois spreads shrink as federal aid headwinds shift
Illinois spread penalties narrowed this week as impending Democratic control of the Senate brightened prospects for long-stalled federal aid for state and local governments to help plug COVID-19 pandemic-related budget holes.
With ratings one notch above junk and carrying negative outlooks, a potential infusion of federal help would ease threats posed by the pandemic’s tax wounds to Illinois’ investment-grade status as it would help close a $4 billion gap and fund pandemic costs after CARES Act aid is exhausted. Gov. J.B. Pritzker said this week he doesn’t expect to close the deficit in the lame-duck session that begins Friday.
“The reason spreads are narrowing is that the day of fiscal reckoning has been delayed,” said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners. "It’s all about stimulus and has everything to do with having Democratic control of the Senate and the House and a Democratic administration. Illinois is an injured credit and the expectation is now that they are going to get help from D.C.”
Municipal Market Data shaved Illinois’ 10-year spread to the AAA benchmark down to 165 basis points for a yield of 2.38% Wednesday. That compared to a spread of 197 basis points and a yield 2.68% just a day earlier.
The spread further tightened on Thursday with the 10-year narrowing by another 15 basis points to 150 bps over the AAA benchmark for a yield of 2.25% That put the spread at five bps better than at the start of 2020.
The state’s one-year landed at a 132 bp spread with the three-year at 148 bps and bonds 10 years and out at a 165 bp spread. That’s a narrowing of 20 bps on the one-year, 25 bps on the three-year, 32 bps on the 10 year, and a 25 bp improvement on the longer end from a day earlier.
On Thursday, they all tightened by another 15 bps.
“Spread narrowing is warranted because of the substantially improved prospects that the state will receive federal funds that should narrow Illinois’ current budget gap and reinforce current cash levels,” said Richard Ciccarone, president of Merritt Research Services. "From that standpoint, the state improves its position on the risk continuum. Any relief should provide an opportunity for them to help get their act together. The question is whether they will use it to do that.”
Illinois must close a $4 billion gap in the fiscal year that runs through June 30, half of which is due to pandemic tax losses. Pritzker last month announced $700 million of cuts but warned more are needed. The state borrowed $2 billion through the Federal Reserve’s Municipal Liquidity Facility that must be repaid in three years.
The state suffered a $2.7 billion tax hit in fiscal 2020 and closed the gap in part with a $1.2 billion note issue through the MLF that must be repaid by June 30.
Pritzker welcomed the results of the two Senate runoff races in Georgia that saw the Democratic candidates win by narrow majorities, essentially handing control of the Senate to Democrats if the results withstand any challenge or recount. While it is even split with 50 Democrats and 50 Republicans, Vice President-elect Kamala Harris would cast a tie-breaking vote when needed, giving the Dems the edge.
“I think we will start to see serious consideration of state and local funding finally because Mitch McConnell won't be able to block it … so I think that will be brought to a vote” under a Biden administration, Pritzker said of the incumbent Senate president who has long opposed local and state relief for pandemic-related tax hits.
Pritzker also believes the election results bode well for a potential repeal of the $10,000 cap on the deduction for state and local taxes Republicans included in the 2017 tax reform package. “I think we will see some movement" on that and it "will be great for lowering everyone's tax bill and the burden of property taxes,” Pritzker said.
As lawmakers return to work for a brief lame-duck session before a swearing-in ceremony Jan. 13 and start of the new legislative session, Pritzker said the timing of the budget fix is uncertain.
He has cast much of the blame on Republicans for opposing the progressive income tax amendment on the November ballot that would have allowed the state to raise the income tax rate on top earners, generating $3 billion annually. Critics warned it would smooth the way for future hikes on lower earners or retirees. Voters shot it down.
“We have to close that budget hole as soon as we can,” Pritzker said. “Lame-duck is relatively short to do everything we need to do to close the budget hole and we have not yet heard from the Republicans” on their suggestions for cuts, “so that's one challenge we need to overcome.”
The next year’s fiscal budget is typically unveiled in February, so the governor could couple a fiscal 2021 fix with the 2022 budget. The approved fiscal 2021 general fund budget totaled $43 billion.
Republicans say the ball in the Democrats’ court and warned the Democratic-controlled General Assembly would try to push through a general tax hike in the lame duck session. “They refused to listen to our warnings over and over again, and now, after voters just sent the Democrats a message, [House Speaker Michael] Madigan and his cohorts will be trying to sneak a tax increase,” said House Minority Leader Jim Durkin, R-Western Springs.
Durkin referred to prior comments from the embattled Speaker, who has suggested his leadership is needed should the governor pursue an income tax hike.
Madigan is fighting to retain the post but so far lacks the majority needed after the new legislature is sworn. A federal probe has resulted in criminal charges against close Madigan associates and former Commonwealth Edison officials on bribery allegations. Madigan has not been charged with any wrongdoing but federal filings have directly implicated the long time Speaker.
Democratic aides shot down the GOP warnings. “The only people talking about tax increases are Republicans. It's not happening,” said John Patterson, spokesman for Senate President Don Harmon, D-Oak Park.
Other fiscal and policy measures also await lawmakers, including ethics reforms, criminal justice reforms, legislation moving to an elected Chicago school board, pension funding issues, and redistricting.
Illinois is benefitting from other market momentum. As the lowest-rated state, Illinois trades at the widest spread among other sovereign states and those levels fluctuate depending on headlines over downgrade threats. The state is also especially subject to the market’s whims — narrowing when appetites favor higher-yielding paper and widening when there’s a flight to high-grades.
“More investors are taking a harder look” at Illinois as they ask themselves “would you rather buy the 6th largest state in the country by population or a junk credit,” said Daniel Berger, senior market strategist at MMD-Refinitiv.
Battered sectors like convention centers, transportation, and states like Illinois and New Jersey are benefitting from “a combination of positive news with vaccine availability” and the results of the Senate races, said Edward Lee, strategist at IHS Markit.
The state’s 10-year began 2020 at a 155 bp spread. As liquidity woes roiled the markets amid widening worries over the pandemic’s economic impact, Illinois’ 10-year spread swelled to 383 bps at the end of March. Spreads further widened and the state was stung with a record spread penalty as it borrowed in May paying a 452 bp spread on its 10 year bond. The 10-year hit a secondary market peak of 425 bps after the deal. Spreads narrowed later in the year as high yield demand grew. In September the spread was at 213 bps.
The spread in the state’s October sale landed at 270 bps on the 10-year in the primary market. The benefit of a Biden win but unclear Senate leadership and failed progressive tax amendment drove a widening with the mid-November 10-year spread back up to 300 bps. By mid-December investors were back to overlooking credit woes in a search for yield and the state’s spread narrowed to 228 bps.
Any potential aid would ease strains on downstream governments too as the state might forgo cuts to local government aid or education funding. Improved prospects for a healthy infrastructure package also are haping the market’s current view.
Aid can help keep what’s currently a $5.5 billion bill backlog in check but it’s no panacea to structural strains or the state’s $141 billion pension burden.
“Money given without conditions could erode long-term credit improvement if the state doesn’t use the help to straighten out its long-term pension and budget issues,” Ciccarone said.
“Illinois avoids a downgrade in the near term and the 2021 budget is solved but what's not clear is if Illinois will change its fundamental fiscal posture and get to structural balance, deal with pensions, and stabilize our tax base,” Battle said.