Moody’s lays out landmines to Illinois investment grade status
Illinois must tread cautiously as it considers piling on new debt or other one-time gimmicks to soothe coronavirus-driven revenue wounds if it wants to keep its investment grade rating, Moody’s Investors Service warned in a new report.
The state’s “ability to weather the coronavirus pandemic without hurting its credit quality will require keeping growth of its long-term liabilities within its capacity to pay,” Moody’s said in the report. “Revenue pressure from pandemic to worsen Illinois’ massive and growing pension liability without fiscal adjustments.”
Moody’s rates the state’s general obligation debt at the lowest investment grade level of Baa3 — the same level as Fitch Rating and S&P Global Ratings. All three assign a negative outlook.
While structural measures taken to address the pandemic’s revenue hits and mounting cost pressures could help stabilize the rating, a specific peril Moody’s cites is pension funding. The state’s $137 billion unfunded tab and weak funded ratios are already a black mark for the state’s credit profile and liabilities could grow depending on market performance.
Gov. J.B. Pritzker proposed a 2019 budget that relied on a pension re-amortization for near-term relief but he dropped it. Prior administrations enlisted strategies that included shorting or borrowing to cover pension contributions which are set under a 1995 schedule to reach 90% funding by 2045.
Moody’s said it would view any such tactics like a pension holiday or reamortization as a credit negative. "Underfunding pensions again could lead to further credit deterioration, depending on the degree of underfunding, the state's other financial strategies and the performance of its pension investments,” said Moody’s lead Illinois analyst Ted Hampton.
Other tactics Moody’s labeled as threats to the state’s ability to stabilize its finances over the long term included deficit borrowing or increasing the payment backlog — which is now hovering around $7 billion — by underfunding retiree and employee health benefits.
“While these tactics draw little political resistance, they reinforce a practice of borrowing (or deferring payments) to address the consequences of short-term fixes in the past,” Moody’s said.
The fiscal 2021 budget relies on up $6.2 billion of borrowing. That includes $5 billion through the Federal Reserve’s Municipal Liquidity Facility as an advance on the state’s gamble that federal relief will eventually be forthcoming and $1.2 billion should a progressive income tax amendment fail next month.
Pritzker has ordered departments to identify potential cuts totaling 5% this year and 10% in the next budget should federal relief remain stalled and warned of a potentially steep across-the-board income tax hike if the referendum fails. A cut of 11% in spending this year would be needed to offset a $3 billion loss of revenue. State tax revenues were cut $4.6 billion this year but it must also repay notes and interfund borrowing used to help offset a $2.7 billion fiscal 2020 revenue blow.
The Moody’s report comes 10 days after one from S&P that warned mounting fiscal pressures could lead the state down a path in which it “would exhibit further characteristics of a non-investment-grade issuer” in the absence of federal relief.
Illinois’ 10-year bond held this week at a 271 basis-point spread to Municipal Market Data’s AAA benchmark, up from a 215 basis-point spread one month ago. It held at the 215 basis-point level until S&P issued it’s warning with the spread rising that week to 261 basis points. MMD sets the BBB benchmark on the 10-year — where Illinois is rated — at a 130 basis-point spread to the AAA.
The state’s one-year bond is up 30 basis points since mid-September and long term bonds are up 55 basis points.
Pensions are particular sore spot and the state has little to maneuver without further setting back funding levels as their health faces further threats from low interest rates and weak investment returns. The Teachers' Retirement System — the largest of the state’s five funds — recently reported a June 30 fiscal year end return rate of 0.52%. It assumes a 7% rate.
“For Illinois, with its unusually high pension burden, such underperformance combined with reduced growth in capacity to pay threatens further erosion of credit quality,” Moody’s said.
Moody’s cast a grim picture on Illinois’ fiscal prospects even amid a potential fiscal 2021 recovery as “the state's leverage will likely become more burdensome, reflecting decreased tax revenue and new borrowing to address operating deficits.”
New revenue, should voters approve the progressive income tax constitutional amendment on the November ballot, will only go so far. “Fiscal austerity and tax hikes may help, but the state's credit will likely worsen if the economic recovery falters and the state relies too heavily on tactics that add to liabilities,” Moody’s said.
The Democratic governor has championed the amendment — which was opposed by the legislature’s GOP minority — that allows the state to scrap its flat tax. If approved, the state would raise rates on the top 3% of earners generating about $1.2 billion in the second half of fiscal 2021 and $3.6 billion annually in a post-recovery.
The revenue only helps if the state avoids a corresponding increase in spending and Moody’s believes additional tax hikes will be needed such as extending its sales tax to services which could raise $1.2 billion to $2.9 billion of new annual revenue.