Why Illinois’ rating stability remains fragile

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Illinois’ rating stability remains fragile due to spending and economic strains on the horizon, S&P Global Ratings’ lead Illinois analyst Carol Spain warned in a recent presentation.

Rising costs to manage the state's $134 billion of unfunded pension liabilities, an unpaid bill backlog that is down but still high at $6.1 billion, escalating Medicaid costs, and a slight structural deficit in the $40 billion general fund budget loom large in fiscal 2021.

At the same time, economists project a slowing revenue picture next year with the potential for a recession. Illinois lacks a rainy day fund that other states have built up with flush coffers in recent years.

“I think it’s stable, but I give the caveat” that the stability is “within the very near term,” Spain said during a presentation at the rating agency’s higher education credit forum in Chicago last week.

S&P gives Illinois its lowest investment grade rating of BBB-minus. Moody's Investors Service does likewise at Baa3, and Fitch Ratings is a notch higher at BBB. All assign a stable outlook.

In the case of an economic slowdown the “options that the state has are limited” especially given its lack of any reserves, Spain said. “We are expecting even in the absence of an economic slowdown” that “next year’s budget will be difficult.”

To balance next year’s books, the state can’t count on passage of a constitutional amendment allowing it to shift to progressive income tax rates in November 2020. Even if it does pass, revenues won’t begin flowing until late in the fiscal year. In the event of a slowdown, the more than $3 billion projected from a change in the tax system with proposed increases imposed on top earners could fall far short. If it fails, the state has not announced a backup plan.

“Illinois is on thin ice” with lots of uncertainty that could result in a slide backwards in the status quo on pensions and slight progress on revenues this year, Spain said in an interview after the presentation.

Due to all the uncertainty over spending and economic pressures and the outcome of the referendum it’s still too early to tell whether the state’s rating is at risk in the next fiscal year, Spain said.

Illinois public higher education received its best funding bump in years for fiscal 2020 with an additional $154 million provided in the state budget. That followed frozen and declining funding during the two-year state budget impasse that ended in July 2017. The state’s new $45 billion capital budget provides $2.9 billion for higher education.

“This might be just a short-term bump” that can’t be counted on going forward, Spain said of the increased operating aid. Gov. J.B. Pritzker has made education funding a priority but in the event of a slowdown the state’s “options might be limited” which could translate into spending cuts.

S&P rates seven of Illinois’ nine public universities and they range from speculative-grade to the single-A category. Most struggled to manage through the impasse, were hit with downgrades, and are still trying to recover on the enrollment and reputational fronts.

Nationally, the higher education sector is strained by growing expenses, constrained revenues, issues of affordability and competition and their impact on balance sheets, said Laura Macdonald, analytical manager for S&P U.S. higher education.

The trend has been for the strong to get stronger and the weak weaker. “It’s at the lower end” where the challenges are most pronounced, she said.

S&P has seen more growth in the BBB category for private institutions with almost 70% now rated in the single-A and BBB categories while 85% of public universities are rated in the single-A to double-A category.

Even higher-end private universities are struggling with strategies to remain competitive on tuition and housing issues and trying to squeeze out balance sheet savings while also meeting capital needs and education trends.

The prominent University of Chicago, rated in the double-A category, is eyeing the use of forward starting swaps as a means to take advantage of the record low rates to refund debt that’s not yet callable.

While issuers are flocking to taxable structures in the aftermath of the 2017 federal tax overhaul that eliminated advance refundings, U of C chief financial officer Ivan Samstein sees potential in swaps.

“We have been looking at a synthetic refinancing” and that’s despite the “bad rap” that swaps took after the 2008 financial crisis as bad bets made by borrowers resulted in added interest costs as rates fell, Samstein said during a panel discussion. “They have an effective role in the right place and right conditions.”

The university is looking at a forward starting swap structure tied to the upcoming call dates on two of four tranches with calls looming in the next few years. The allure is the expectation of 39% in present value savings, Samstein said. The four total $800 million in par but the school would limit the transaction to two of the four tranches.

The university would benefit if rates go up but lose out if they fall. “We looked at these transactions and we don’t have the drag of the escrow, we are able to benefit and lock into the low interest rate climate and we are able to do so in a manner where the forward premium is de minimis” due to flattened yield curve, Samstein said. “We’ve not yet made a final decision but we do see a value in the structure.”

Samstein said while taxable structure works for certain types of project funding, they leave too much savings on the table for refundings and tax-exempts are preferable because of the value he places on traditional call features over the make-whole typical in the corporate market. “You have to look at the value of the call option,” he said.

Indiana-based Purdue University, which carries S&P's top rating, is at the forefront of a potential trend that could unfold in the coming years with its 2017 acquisition of the online school Kaplan University. “Building a brand takes time” and growth prospects remain solid, Purdue University Global CFO Christopher Ruhl said during a panel discussion explaining why the university opted to acquire an online school instead of launching its own.

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