Illinois’ Long Budget Nightmare Continues

Illinois’ budget debacle continues to impact credit ratings of the state’s general obligation bonds, as Fitch lowered its rating on February 1 to BBB, the same level as existing ratings assigned by Moody’s and S&P. Both Moody’s and S&P maintain negative outlooks on their ratings, and Fitch also maintained a Ratings Watch on the rating, even after the downgrade. In essence, Fitch will downgrade the state again if it fails to take action to address its budget crises.

Fitch telegraphed its rating intentions last month when it warned that it would downgrade the state if it failed to adopt measures to end its fiscal impasse. The unprecedented budget impasse began when a temporary income tax hike expired in 2015. The state failed to replace the taxes or cut expenses, and ended up operating the entire 2016 fiscal year without a budget. While the state enacted a temporary budget last summer covering only the first half of the current 2017 fiscal year, this only was intended to get the state through the November 2016 election, kicking the problem down to a new legislature. As a result, the new legislature not only inherited a political logjam, but also a structural budget deficit, over $11 billion of unpaid bills, dwindling liquidity and growing pension liabilities, complete with limited hopes for reform as previous efforts were blocked by state courts. The state has provided some protection for bondholders from the budget crises, as it has continued to set aside funds to pay its debt service on its GO debt as allowed by state statutes.

There may be hope that a bipartisan package of state Senate bills deemed the Grand Bargain can provide a path for the state to address its budget crises. The bills would reinstate temporary tax hikes, authorize the issuance of bonds to pay outstanding bills, and cut pension liabilities (along with enacting other non-budget reforms favored by the governor). It is not clear if the legislature will be able to attract enough votes to approve the Grand Bargain, as various groups oppose parts of the package. Subsequent to Fitch’s downgrade, S&P confirmed last week the negative outlook on its BBB rating of the GO bonds and indicated that failure to resolve the budget issues could trigger more downgrades. Even with the adoption of a budget package, S&P said improvements in its ratings for the state would not occur within the next two years. Fitch noted in its February report that the state would face another downgrade if it does not adopt a balanced budget for the upcoming 2018 fiscal year, and warned that it would downgrade the state to a non-investment grade rating if it failed to continue to set-aside funds for GO debt service payments.

As the budget impasse has extended from months into years, the credit spreads on state GO bonds have continued to widen, peaking at 250 basis points over the AAA scale at the end of 2016. While there has been some spread tightening in hope of the passage of the Grand Bargain, we expect that volatility in pricing will continue given the uncertainty over the passage of the budget bills, and liquidity could be limited, particularly if there are further delays in budget negotiations.

Source:  Bloomberg News, Fitch Ratings, JP Morgan, Moody’s Investor Service, S&P Global Ratings