Market observers see Illinois holding its fiscal ship steady for now
Illinois Gov. J.B. Pritzker’s proposed fiscal 2021 budget doesn’t raise any red rating flags, Moody’s Investors Service lead state analyst Ted Hampton said.
That was the good news from an initial assessment offered by Hampton as all three rating agencies that rate the state’s general obligation bonds begin their deep dive into the $84.5 billion budget package that includes a $42 billion general fund.
Moody’s assigns Illinois its lowest investment grade rating, Baa3. Fitch Ratings has the state at BBB and S&P Global Ratings at BBB-minus. All three assign a stable outlook.
“I don’t see anything in this budget that is consistent with the issues we’ve discussed that would be threats to the credit standing,” Hampton said in an interview, cautioning that the rating agency was early in the review process and had not yet discussed the proposed budget with the state’s finance team. It’s also only a proposal, subject to the legislative process.
“Overall this is something that doesn’t seem to pose any threat or do any harm” to the state’s near-term rating outlook, but it doesn’t appear to make progress either, as “the overarching problems still are there even if this budget is put in place,” Hampton added.
The budget doesn’t rely on one-time revenue gimmicks, according to Pritzker's finance team. It would make the more than $9 billion statutory pension certified contribution of which $8.6 billion comes from the general fund with another $100 million supplemental contribution if voters in November approve Pritzker's proposal to adopt a graduated income tax system. It incorporates $225 million in savings from various initiatives including reduced healthcare expenses under new employee contracts.
The proposal sets aside $1.4 billion in spending on education, local government tax sharing programs, and employee group health insurance expenses, which would only be freed up if voters approve the constitutional amendment to allow a progressive income tax rate structure instead of the current flat-rate requirement. The measure would eventually generate $3.6 billion annually by raising rates on top earners, according to the administration.
The amendment's uncertain fate is among concerns some market participants expressed, along with disappointment at the lack of progress tackling the state’s $137 billion unfunded pension tab or its unpaid bill backlog that hovers between $6 billion and $7 billion.
“We haven’t gone backwards on the gimmick front. However, the state budget is precariously balanced on the outcome of an election in November. That doesn’t make things better or worse, just uncertain,” said Brian Battle, director of trading at Performance Trust Capital Partners. “The state is gambling that these new revenues will solve the short- and long-term problems. I believe that expectation is misplaced.”
The plan may be most notable for what it didn’t include: any effort to short or push off scheduled pension contributions.
Last year, Pritzker’s proposal to re-amortize the 1995, 50-year pension payment schedule by seven years sparked rating agency warnings that it could lead to further rating deterioration. The administration dropped the proposal after a $1.5 billion tax windfall last April.
“There’s no proposal to water down the pension commitment” and that’s a good thing especially since the statutory payment, though it meets the state’s legal obligation, still falls wells short of an actuarial level, Hampton said.
While the budget doesn’t move the needle downward or upward at first sight, there are potentially some positives. The budget puts $50 million toward the near empty rainy day fund in addition to $50 million this year and pending legislation backed by Pritzker would lay out rules for further deposits when the backlog is reduced.
“It’s not substantive, but it’s a start,” Hampton said.
Passage of the graduated tax and the revenue that would come with it based on proposed rates would ease pressures on the state’s overall financial state even if it doesn’t commit to spend a bigger piece beyond $100 million on pensions next year and $200 million in subsequent years, Hampton said.
Having additional revenue to cover other expenses “will make the state’s pension look more manageable,” Hampton said.
Fitch’s lead Illinois analyst, Eric Kim, said Pritzker’s decision to hold back the $1.4 billion underscores the importance of the tax change to his plans. “Clearly the graduated income tax hangs over this budget proposal,” Kim said, reserving judgment on the plan until he’s dug further into the details and speaks with state officials. “It's an important piece of the state's fiscal picture.”
The attention, after passage of the final budget plan, will turn to the November ballot.
“The state will have to determine, if the budget is enacted as it is, whether it will follow through on those items or will it take alternative actions. That’s what we will be looking at is how the state responds,” Kim said. Some measures, if paid for, could drive up the bill backlog.
One portfolio manager offered a mixed review of the budget calling the pension payments a positive but the lack of a pension fix a negative.
“The long-and-short of it is they are not doing anything” to tackle the liabilities, the Midwest-based portfolio manager said. “I’m not surprised, but I’m not thrilled.”
Battle said he wasn’t surprised either and worries about the state’s long-term prospects even if the graduated tax is adopted. “There’s no serious discussion of expense reductions, just more spending, and given the magnitude of the state’s problems we should be doing more now,” Battle said.
With a mostly status quo budget, market participants believe the state should continue to see its spreads benefit from market conditions. The state’s near-term stability and investors' thirst for any form of higher-yielding paper given the record low interest rate environment have shrunk the state’s spreads to lows not seen in a decade.
The state’s yield penalties have materially narrowed over the last year. The state’s 10-year general obligation bond was trading at a 183 basis point spread to Municipal Market Data’s top benchmark last year at this time. The 10-year is now at a 132 basis point spread to MMD.
Trades last week cracked the 100 basis point spread mark, said IHS Markit strategist Ed Lee. An 11-year bond traded at an 86 basis point spread and a nine-year bond traded at an 85 basis point spread. Rates have mostly exceeded a 100 bp spreads beginning in 2010, according to MMD data.
“Rates are low and spreads are narrow so there’s no penalty or price for political risk for Illinois,” Battle said.
“Our initial reaction is that the governor has succeeded in meeting the technical requirement that he propose a reasonably balanced budget and he has done that by relying on the reserves he’s going to hold back if his proposed graduated income tax doesn’t pass,” said Laurence Msall, president of the Chicago Civic Federation.
“We have questions about the reserves and how this works if the graduated tax doesn’t pass. What’s plan B” to also address pensions, the
backlog, and pledges of property tax relief, Msall said. “We are glad there are less gimmicky tax proposals and glad the state is making its full pension contribution.”
“I think there are some things in the budget that signal the state is going in the right direction” like consolidation plans and rainy day fund deposits, said Michael Belsky, executive director of the Center for Municipal Finance at the University of Chicago’s Harris School of Public Policy. “Holding aside the funds until the tax vote is prudent on their part.”
Pensions and the backlog are the more burdensome strains and Belsky sees the need for additional revenue sources that could come from extending the sales taxes to services or taxing higher retirement incomes. “At some point the pension payment is going to require additional resources,” he said. “You can’t grow or cut your way out of it.”
Pritzker during his address made clear his opposition to a constitutional amendment that would allow the state to ease the restrictions on pension cuts from the existing pension clause.
The Democrats who control the state legislature mostly praised the speech but called Pritzker’s proposal to hold back $150 million from the $350 million planned annual increase in evidence-based educational aid a potential sticking point.
“I think that poses some challenges,” said Sen. Heather Steans, D-Chicago.
Republicans, who opposed the graduated tax amendment, accused the governor of holding hostage education funding. They say more than $600 million in natural tax growth and departmental cuts in the 6% range would allow the state to meet spending needs without the tax.
“We think the foundation of this budget is poor” because relying on a $1.4 billion tax increase “is shortsighted” and lacks “fiscal discipline,” said Senate Minority Leader Bill Brady, R-Bloomington.
To offer the two separate tracks that could result in cuts if the tax doesn’t pass potentially causes a “world of hurt,” said House Minority Leader Jim Durkin, R-Western Springs. “I just felt that that's a wrong approach.”