Tax measure's failure puts Illinois bond ratings on the spot

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Deep spending cuts and possible tax hikes lay ahead as Illinois works to stave off a downgrade to junk-bond status after voters rejected a progressive income tax structure, Illinois Gov. J.B. Pritzker said.

With all three of the state’s ratings at BBB-minus or equivalent — the final step above speculative-grade — and carry negative outlooks, the constitutional amendment’s defeat Tuesday further fueled market worries over whether the state can hold on to its investment grade status.

“There will be cuts and they will be painful,” Illinois Governor J.B. Pritzker said after voters rejected his proposal to replace the state's flat income tax rate with a progressive system.

The state’s general obligation bonds traded 30 to 50 basis points wider over the Municipal Market Data’s AAA benchmark Wednesday.

At the end of the day, MMD-Refinitiv reset the state’s spreads 30 basis points wider across the curve, pushing the 10-year to a 314 bp spread. That ran counter to the municipal market that saw a narrowing of 10 bps, said Daniel Berger, senior market strategist at MMD-Refinitiv.

“Had the fair tax passed we would have been on a course toward long term stabilization of our state’s finances, balancing the budget, eliminating the backlog, making our pension payments, and investing in a rainy-day fund,” Pritzker said.

A proposed rate structure would have raised rates on the top 3% of earners. Now the flat state income-tax rate remains a mandate in the state constitution.

The bruising failure of the measure leaves the Democratic governor midway through his term, without his signature proposal to help stabilize the state’s battered finances.

Illinois is weighed down by a long-term structural budget gap of several billion dollars, $137 billion of unfunded pension liabilities, and an unpaid bill backlog that was at $8.4 billion this week.

The COVID-19 pandemic added to the strains with between $6 billion and $7 billion of revenue losses for fiscal 2020 and 2021.

“There will be cuts and they will be painful,” Pritzker said, blasting the GOP and wealthy backers of the anti-amendment campaign, who portrayed it as a route to raise taxes across the board. “We are going to do what it takes here to balance our budget and to begin the journey here of fixing the structural problems of the state.”

The administration will begin with cuts but “there is a point at which, there is no doubt that without revenue some of those cuts will start to hit things that do affect working families and I don’t know that anybody wants that to happen…everything is on the table because the fiscal challenge of the state is an extraordinarily high priority for me and I think all the time about our credit rating,” he said.

The rating agencies will give Pritzker and the state legislature a little time — they all issued stern warnings Wednesday, but made it clear action to shore up state finances is needed.

Pritzker recently asked agency heads to identify 5% cuts in the current budget and to present fiscal 2022 plans with a potential 10% cut.

The state could also raise the current 4.95% flat rate by 1% income to replace the revenue that would have been generated by Pritzker's proposed tax rates. The proposed tax rate structure was projected to generate between $1.2 billion and $1.3 billion in fiscal 2021 and $3.1 billion annually.

The legislature's annual veto session is scheduled to begin in late November but the rising number of COVID-19 cases in Illinois has created questions about the timing. A high vote threshold is needed to pass legislation, creating another challenge.

Pritzker could wait on a potential tax hike until a lame-duck session in early January when a lower vote threshold is needed. Pritzker said the state needs to act “expeditiously” but one Democratic legislative aide cautioned that any tax hike could prove a tough sell with lawmakers given the amendment’s fate.

Pulling about 45% of the vote, the amendment ran 10% behind Joe Biden in Illinois. Pritzker spent more than $50 million of his own wealth to back a campaign promoting it while opponents raised about $60 million.

The state also in the coming weeks must settle on how much it will borrow through the Federal Reserve’s Municipal Liquidity Facility and the terms as the deadline to submit a notice of interest is in early December.

"The MLF will no doubt have to be part of the solution but we need to make other structural changes and I've asked the leaders to step with proposals to do that," Pritzker said Thursday. He did not address the size or timing of an MLF borrowing.

The prospect of federal aid was buoyed with Senate majority leader Mitch McConnell’s comments Wednesday that he wants quick action on a relief package and is now open to local and state government relief.

The state was the first to borrow from the Fed's MLF in May with a $1.2 billion, one-year note issue at a rate of 3.82% assigned based on its ratings. The term is limited to three years and the current rate for Illinois is 3.30%.

The $43 billion general fund budget relied on up $5 billion of MLF borrowing and up to $1.2 billion of GO bond authority.

Few market participants saw the tax change as a panacea for the state’s fiscal woes, but it would have helped alter the landscape.

“The rating agencies have been clear: reliance on one-time measures will put negative pressure on the rating,” Nuveen’s municipals team said in an email. “Relying on deficit borrowing through the Fed’s MLF, waiting for potential federal aid and letting the backlog of accounts payable grow without any other action will eventually lead to a downgrade.”

Market perceptions
Municipal bond market participants say action is needed in the next two months.

“If they raise the state tax rate very quickly and make general attempts to cut spending, which is hard because they have to stimulate the economy, I think they can avoid a downgrade,” said Vikram Rai, head of credit research at Citi. “The governor is in a difficult spot.”

Rai warned in October that a downgrade loomed if the tax vote failed.

Rai believes the rating agencies are in a tough spot. They may not want to lower the floor on a state rating to junk but have to demonstrate consistency in rating actions.

“Does Illinois deserve to be below investment grade? Absolutely not, because Illinois, like any state, has many levers to address their fiscal challenges,” Rai said.

Vikram Rai, head of credit research at Citi, believes the rating agencies are in a tough spot with Illinois.

The state is already trading as a high-yield credit, said Howard Cure, director of municipal research at Evercore Wealth Management.

“The only thing that can save them is putting together a structurally balanced budget,” Cure said. “I think they have essentially two months until the end to show what their plans are to balance the budget and if it’s going to be one-time answers, borrowing in particular, they will lose their investment-grade rating.”

Cure sees the pain being pushed to local governments and schools that would in reaction turn to their tax bases or raise fees and tuition to avoid cuts.

“The Fair Tax failed because it was not part of a larger plan to repair the state’s finances and not accompanied by any honesty about pension costs crowding out other expenditures,” Nuveen’s municipal team wrote. "Failing to pair the tax change with an amendment allowing pension benefits to be changed was a lost opportunity."

Spreads
Illinois spread penalties have fluctuated in tandem with negative headlines and market turmoil. Heading into the election, the one year, 10-year, and 20-year were set at a spread of 160/284/272, respectively. That reflected some widening from the state’s October sale that benefitted from election anticipation of a blue wave based on polls, Berger said. On Wednesday, MMD reset them at 190/314/302 bps.

The 10-year hit a peak in June 2017 of 335 bp as the state’s budget gridlock threatened to extend into a third fiscal year. The state shattered that record in May when the 10-year hit a 417 bp spread as Illinois planned two borrowings amid growing concerns over the pandemic’s blows.

Illinois may offer a good buying opportunity for some, said Matt Fabian, partner at Municipal Market Analytics. While the risk of a cut to junk is materially higher and state bond spreads may continue to inch wider “the risk of the state defaulting is still near zero, so this does present a buying opportunity for managers with an ability to ride out the volatility and willing to assume that IL is already a junk-rated credit.”

Rating Agencies
Fitch Ratings, Moody’s Investors Service, and S&P Global Ratings all issued warnings that amendment's failure puts further roadblocks in the state’s path to stabilizing its finances but would not by itself trigger negative action.

“Illinois will need to consider other options to balance its budget,” Eric Kim, Fitch’s head of state government ratings, said in a commentary. “Illinois’ upcoming post-election legislative session could be particularly consequential this fiscal year.”

In its last report, Fitch warned that a downgrade could be triggered “by the lack of a credible path to reversing” one-time measures to deal with the pandemic or “by a reliance on short-term measures that materially compound the state's long-term challenges such as its pension liability burden.”

Moody’s in a special comment said it considers the amendment's failure a “credit negative” because it “makes greater reliance on deficit financing more probable” and other “credit-negative strategies such as deferring near-term pension contributions."

“We are looking to see to what extent Illinois addresses its budget gap through recurring measures rather than just relying on borrowing or other one time sources,” S&P lead Illinois analyst Carol Spain said in an interview.

Moody’s expects the state to pursue recurring fiscal strategies to mitigate the impact but sees a difficult political road ahead.

“We are looking to see to what extent Illinois addresses its budget gap through recurring measures rather than just relying on borrowing or other one time sources,” S&P lead Illinois analyst Carol Spain said in an interview.

S&P is also watching the state’s cash position closely and says the size and repayment plan for the expected MLF borrowing will also weigh on the credit profile analysis. “We will have a better view in the next one to two months,” Spain said. The state also will provide an updated revenue forecast later this month.

Update
The story was updated with a comment from Gov. J.B. Pritzker about the MLF
November 05, 2020 4:34 PM EST
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