Fixed Income

Keeping Illinois exposure on a short leash

The problem isn’t economic – it’s political – as the Republican governor and the Democrat-controlled legislature remain deadlocked over how to eliminate the state’s chronic budget shortfalls.

06/19/2017

Philip Villaluz

Head of Municipal Credit Research

Keeping Illinois exposure on a short leash

On June 1, Moody’s and S&P downgraded the State of Illinois general obligation bond rating to Baa3 and BBB-, respectively. They also maintain negative rating outlooks and warned of a downgrade to junk without a budget for the new fiscal year which begins July 1. Fitch rates the state BBB with a negative outlook. By way of background, Illinois hasn’t had a budget for almost two years, driving up the backlog of unpaid bills to a record $14.7 billion and financially straining local public entities that rely on state aid.  The problem isn’t economic – it’s political – as the Republican governor and the Democrat-controlled legislature remain deadlocked over how to eliminate the state’s chronic budget shortfalls.  While we expect the price of Illinois debt to rally if a political accord is reached, we do not expect ratings upgrades.  We believe Illinois municipal debt ratings will remain under pressure as the fifth most-populous state tries to manage a public retirement system that has more than $129 billion of unfunded liabilities.  The political gridlock is also negatively impacting social services.

July 1 is an important date to watch; it’s the beginning of the new fiscal year and potentially sets a few things in motion – a likely downgrade to below investment grade and a requirement to pass a stopgap measure or interim spending authorization. In terms of impact on the broad municipal market, we believe some volatility may result from any downgrade of Illinois issuers, but we do not expect to see any contagion risk. Like the rest of the market, we will continue to closely watch the political game play out between now and the general elections in November 2018.

So what’s to like?

Legal protections for bondholders are solid; general obligation (GO) bond covenants statutorily require the state treasurer and comptroller to transfer funds to the general obligation bond retirement and interest account (GOBRI) monthly from general fund revenue to cover debt service. The state funds debt service in advance every month for the payments due in the next 12 months –there is sufficient revenue one year in advance. We believe there is a reasonable path towards structural balance given the state’s low income tax rate, broad sovereign authority, as well as the maintenance of the GOBRI account. The state’s financial flexibility includes:  the unlimited authority to raise individual income taxes which are low at 3.75%, the ability to push liabilities down to local governments, issuing IOUs, or selling state assets. Furthermore, the rating agencies assign the same rating for all maturities of a GO bond – regardless of the 12 month revenue in hand. Therefore the rating is the same for short-maturity paper as it is for longer-term bonds. Therein lies an interesting relative-value opportunity.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.