MuniLand: Falling Into High Yield

The distribution of state general obligation credit ratings is skewed toward the ultra-high grade (AAA/AA+). The reasons for the disproportionate number of ultra-high grade ratings are states’ taxing authority, expenditure controls and economic diversity. So do the inherent credit strengths of state general obligation bonds create a credit rating floor? Moody’s recently opined that state powers do not. Focusing on Illinois, the credit service observed, “Inherent credit strengths of high wealth levels, low employment volatility and a large diverse state economy are not enough to prevent the state from breaking through the speculative grade credit barrier.” This comment suggests that if states mismanage credit factors such as liquidity levels, budget planning and pension liability, they might face enough downside credit risk to fall below investment grade. Unfortunately, Illinois exhibits all of these downside credit factors. The Civic Federation (an independent Illinois-based non-partisan public policy research organization) reports that Illinois is planning to issue moral obligation debt through the IL Finance Authority to ease a cash flow crunch. Governance and budgeting is poor, as evidenced by the fact that the legislature and governor have yet to pass a fiscal year 2016 budget. And, finally, pension liabilities are growing exponentially. Our internal credit models indicate that there is a significant likelihood of further downgrade to Illinois’ credit rating. The market is already pricing the Illinois G.O. at below investment grade yields. Because so much of the downgrade risk is priced into the G.O. bonds, and because new supply will be limited, the credit looks compelling on a relative value basis. However, the political risks are currently unquantifiable, which makes the credit off-limits for us despite its high yields.

Sources: Moody’s Credit Service, The Civic Federation and SNWAM Research