By Adam Stern
As the municipal market advances into the second month of 2018, investment grade credit fundamentals are stable and there are few obvious catalysts to spur near-term deterioration.
On June 1, Moody’s Investors Service and S&P Global Ratings downgraded Illinois’ general obligation (GO) bond ratings to one notch above junk, to Baa3/(NEG) and BBB-(*-), respectively, from Baa2(NEG)/BBB(NEG). (Fitch Ratings rates the GO BBB(*-)). The prospect of a junk-rated state is a concerning development for the municipal market. Illinois’ impending downgrade to below investment grade would be a first for a U.S. state and another example of recent credit “novelties” in the municipal market, such as Detroit’s landmark bankruptcy and Puerto Rico’s ongoing insolvency. It is a reminder that, at least in some areas of the municipal space, willingness-to-pay continues to erode – even nine years after the onset of the Great Recession. In this white paper, we aim to:
The recent Illinois downgrades resulted from lawmakers’ failure to enact a balanced budget by May 31, the deadline for passing bills by a majority vote in Illinois. It is now very likely that Illinois enters FY181 without a balanced budget for the third year in a row.2
Illinois’ bond rating is now the lowest of any state in the modern era (Figure 1).3 Unfortunately for policymakers, taxpayers and other stakeholders, the ratings may fall still further. S&P has assigned a “CreditWatch negative” to the Illinois GO rating, which is more punitive than a negative outlook and implies that additional rating action will be taken by the end of July. If Illinois fails to enact a structurally balanced budget by that time, S&P is likely to drop Illinois to below investment grade. Moody’s and Fitch seem likely to follow suit, assuming they don’t act sooner.4
Illinois’ weakening credit fundamentals are mostly a combination of four factors: its long-term refusal to responsibly fund its pension debts, its unwillingness to balance operations, its weak institutional controls that allow unbalanced operations, and a rapidly escalating liquidity crisis.
It is increasingly possible that the state will begin to finance some of its pile of unpaid claims. The state’s borrowing costs, though high relative to yields on AAA municipal bonds, remain well below the penalty rate that it pays on its unpaid bills. As Figure 3 illustrates, Illinois’ 10-year bond yield on June 6 was 270 basis points (bps) higher than the AAA scale. This implies a 4.5 percent interest rate, far less than the 9-12 percent penalty interest charged on unpaid bills.19 For comparison, Illinois’ borrowing costs are now about the same as those for a BB-rated corporate borrower.20
Borrowing to fund the bill backlog without enacting a balanced budget would significantly weaken Illinois’ credit profile. It would convert the state’s operating deficit from one that is financed with internal liquidity to one that is reliant on market access.
Sovereign issuers routinely tap the bond markets to finance their deficits, but this is more challenging for states and is highly unlikely to benefit Illinois. Unlike a sovereign country, Illinois lacks a central bank or its own currency. It also lacks a large group of captive buyers, such as banks or insurance companies, for its bonds, and it’s unclear how much Illinois paper the market can realistically absorb. A steady supply of billions of dollars in Illinois bonds is likely to be unsustainable. Finally, we don’t believe Illinois offers a compelling growth story: It is unlikely to use bond proceeds to increase its gross state product (GSP) – and tax receipts – in excess of its annual borrowing costs.
Even more immediately, and apart from the prospects of Illinois tapping the capital markets to close its budget gap, a federal judge has mandated that the state “substantially comply” with a federal consent decree prioritizing Medicaid payments. The judge’s order heightens the risk that Illinois officials will be forced to choose between honoring debt service payments and making other mandated payments.21
Finally, if Illinois’ bond rating falls to below investment grade, it will trigger termination payments on some of the state’s swaps.22 The mark-to-market value of Illinois swaps was $112 million in February 2017.
Despite the risks, the prospects of an Illinois default remain relatively low in our view. To begin with, the state’s ability to service its debt and recover from its budget stalemate remains intact. Illinois’ FY18 budget deficit is expected to be $7.1 billion.23 The state can close about $5 billion of this gap by returning income and corporate income tax rates to their pre-2015 levels.24 It can likely generate another $3 billion by ending certain tax expenditures, holding operating spending growth to 1.5 percent per year for the next few years and/or shifting 20 percent of pension costs for teachers and higher education providers to K-12 schools, community colleges and universities.25 These are all proposals that the legislature has considered over the past few years. If adopted, these changes would likely raise enough to close the current-year budget deficit and help pay for a partial financing of the state’s backlog of bills.
Additionally, Illinois’ bonded debt burden remains manageable, and there is no strategic incentive for the state to default. Illinois’ debt service costs were less than 6 percent of all-funds revenue in FY16, and annual principal and interest payment requirements decline over the next several years. Debt-to-personal income is 4.9 percent, an elevated but still manageable ratio.26 All of this suggests that there is little benefit to the state from defaulting – but much to lose. A default would increase Illinois’ fiscal problems by making its pension and liquidity challenges even harder to manage.
Another reason near-term default risk is low is that Illinois retains substantial liquidity outside of its general fund. The state reported holding just under $11 billion in cash as of May 30. We think it’s likely that lawmakers would act to appropriate some of these funds to forestall an unnecessary default on the state’s bonds.
Importantly, we also note that Illinois looks nothing like the states that have defaulted in the past. The last state to default, Arkansas in 1933, owed half of its annual revenue to debt payments.27 Before that, several states defaulted in the 1870s and 1840s, but debt servicing costs in those cases dwarfed the amounts faced by Illinois today. In 1841, interest expense alone exceeded annual revenue in Louisiana, Florida, Maryland, Alabama and Mississippi. These states repudiated obligations that financed failed (and nonessential) public banks.28 In addition, Illinois bears important distinctions from Puerto Rico and Detroit (Figure 4).
Finally, Illinois’ long-term economic prospects – assuming that it can reach a budget agreement soon – are relatively good. Illinois’ median household income is 107 percent of the national median and the state’s economy is well-balanced across employment sectors. It is also home to the nation’s third- largest city, Chicago. Few states can boast that they are host to a strategic asset like Chicago.
Illinois’ below-average growth rate over the past few years is in no small part the result of its poor fiscal choices. A change in fiscal policy direction would likely improve the state’s economic trajectory.
Even considering the above, it is important to note that we are not downplaying the real risks now facing investors in Illinois. Current taxation and spending policy is unsustainable and threatens the state’s long-term ability to service its debts and adequately provide for public services. Notably, bondholders might find it challenging to enforce their rights if the state actually defaults. Nowhere in the state’s General Obligation Bond Act does Illinois waive its sovereign immunity rights.29
Comparisons between Illinois and Puerto Rico in the popular press and among some retail investors are likely inevitable at this point. With that in mind, it bears repeating that Illinois’ fiscal stress – although noticeably more acute than it was a year ago – remains only superficially similar to that of the commonwealth.
As Figure 4 illustrates, median household income in Illinois is almost three times that of Puerto Rico. The unemployment rate in Illinois is 4.7 percent, compared to 11 percent in Puerto Rico, and key debt metrics reflect far lower leverage in Illinois. Notably, Illinois’ net pension liability is just under 25 percent of gross state product compared to 58 percent in Puerto Rico.
There are other subtle differences as well. Illinois’ anchor city, Chicago, endows it with an economic engine that, by virtue of the city’s size, reputation and existing infrastructure assets, can attract capital and a talented pool of labor. Puerto Rico lacks an inherent metropolitan asset of this sort.
And unlike Puerto Rico, Illinois has no public bank that injects systemic risk into its public sector. Puerto Rico’s Government Development Bank was a major enabler of its credit stress. The bank held deposits for public entities and then made loans to public issuers. When certain loans went unpaid, the liquidity of public depositors became questionable, and the whole of Puerto Rico’s public sector (which includes a concentrated group of only 40+ issuers) was enveloped in the commonwealth’s credit stress.
In contrast, Illinois’ thousands of local issuers maintain deposits at third-party institutions. In most cases, eligible investments include only highly rated securities.30 Notably, Illinois’ current bond rating is too low for most governments to invest in.31
The bottom line is that for the time being, Illinois’ credit stress remains a “willingness” issue while Puerto Rico’s stems from an inability to pay its debt obligations.
We anticipate that Illinois lawmakers will reach a budget solution before the state’s unwillingness to meet its obligations transforms into an inability to honor its debt contracts. However, negotiations are likely to bear fruit only against the backdrop of a crisis. We see at least three paths to a budget agreement:
Although we expect that a budget accord will eventually materialize because political and/or market pressure will become overwhelming, there is a real possibility that this conclusion is wrong. Lawmakers have proven unwilling to bridge their differences for two years, and some would prefer to defer a budget deal until after the November 2018 gubernatorial election. The governor has said he supports a continuing appropriation bill for state employee salaries.34 The state has also taken steps to allow third parties to buy state receivables and collect interest on its unpaid bills.35 Actions like these allow the state to avoid enacting a balanced budget.
Investing in Illinois bonds now requires a degree of patience. While we are not suggesting that Illinois credits are suitable for any particular investor, we believe they can make sense for some investment strategies. To that end, we recognize that every investor is different and we urge all investors to consult with their financial advisers before taking any action in their portfolios.
Indeed, Illinois’ fiscal challenges have tainted all bonds in the state, and Illinois credits that rely on state aid or are otherwise directly connected to the state now carry an elevated degree of ratings-downgrade risk. In 2016, Moody’s downgraded 75 Illinois credits but upgraded only 12.36 Public higher education ratings in Illinois have been particularly impacted by the budget impasse, as state aid for higher education has been interrupted during the two-year budget stalemate.
That said, there are plenty of Illinois securities that retain strong credit fundamentals. Some investors may find value in these credits.
Illinois is home to 6,962 political subdivisions (the most among U.S. states) and over 2,000 municipal borrowers.37 This variety of local government issuers provides investors with a broad universe of tax-exempt bonds to purchase, few of which, in our opinion, are likely to default even if the state is unable to stabilize its credit fundamentals in the near term.
Credits that we prefer include certain school districts, special districts that receive little state aid (like certain forest preserve and park district bonds) and bonds whose credit fundamentals only partially track the state’s economic and fiscal health. S&P notes that many school districts remain virtually untouched by the state’s budget impasse,38 and credits like Illinois AAA-rated state revolving loan fund or the state’s huge and vital Metropolitan Water Reclamation District of Greater Chicago (Aa2/AA+) are at a remote risk of default, in our view.
Importantly, even if Illinois’ fiscal distress further metastasizes, we think there is a low risk that the state pursues a government consolidation or dissolution effort that negatively affects bondholders.39 Consolidating or dissolving local governments sometimes helps states access cash held at more solvent public entities. California pursued this kind of policy in 2012 when it dissolved 400+ Redevelopment Agencies (RDAs).40 But in California, no RDA bonds experienced a monetary default on account of dissolution. Moreover, as we outlined in a June 2015 white paper, Illinois law generally provides for property tax levies to remain in place if a local government is dissolved.41
The state of Illinois is blazing a new – and unwelcome – path in the municipal bond market. Without a budget agreement in the next few weeks, it is likely to become the market’s first ever junk-rated state. Illinois’ credit stress is an outcome of the state’s extreme unwillingness to address its growing fiscal imbalances. The state’s distress is fixable with solutions that seem politically reasonable by any objective measure. However, the state is nearing a credit tipping point in which its unwillingness to enact a structurally balanced budget will turn into an inability to meet debt obligations and essential service needs. We believe lawmakers still have time to restore Illinois to fiscal sanity. But it may take a market or budget crisis to force the issue.
 Illinois’ fiscal year end is June.
 Illinois’ constitution requires that, absent a 3/5ths vote of both houses, laws passed after May 31 of a given year will become “effective” after the following May 31. This means that a budget bill passed on June 1 or later by only a majority vote cannot become effective by the start of the next fiscal year, which begins on July 1, 2017. See: Illinois Constitution, Article. IV, Sec. 10.
 Standard & Poor’s earliest state bond ratings appear to have been assigned in 1956 to Colorado and Kansas. See: Standard & Poor’s “History of State Ratings”, June 2, 2017. Moody’s “Rating Changes for the 50 States from the 1970s,” (last updated in October 2016) suggests that the agency may have rated some state securities before 1970, but we are unaware of any such ratings.
 On May 23, 2017, Fitch suggested it would downgrade Illinois in early July if it enters FY18 without a balanced budget. The 2018 fiscal year begins on July 1, 2017.
 The ANPL is a conservative measure of pension debt developed by Moody’s Investors Service. The 3.2x ratio is a Breckinridge calculation based on data from Moody’s Investors Service and Merritt Research Services. See Moody’s state adjusted net pension liability rankings, 2015, and Merritt Research Services for government revenue, FY15.
 Based on review of CAFRs and Merritt Research Services data.
 State of Illinois, Annual Continuing Disclosure, FY16, p. 10.
 Auditor General’s Summary, Chapter 1. “Report on the Actuarial Assumptions and Valuations of the Five State-Funded Retirement Systems,” December 2016.
 Illinois Pension Code (40 ILCS 5, Articles 2, 14, 15, 16 and 18).
 Commission on Government Forecasting and Accountability, “Financial Condition of the Illinois State Retirement Systems,” Appendix A, p. 99. March 2017
 Teachers Retirement System of the State of Illinois, FY16, p. 7 of introduction.
The personal income tax rate fell from 5 percent to 3.75 percent and the corporate income tax rate fell from 9.5 percent to 7.75 percent. Moody’s Investors Service credit opinion on Illinois, June 1, 2017.
 The Civic Federation, “Illinois Spending Continues Without an FY2016 Budget,” August 20, 2015.
 Illinois’ attorney general, Lisa Madigan, has twice sought to enjoin the state from paying state employees in the absence of a legislative appropriation. A recent Illinois Supreme Court case strongly suggests that the state cannot pay state employees their full salary without a state appropriation, but Gov. Bruce Rauner prefers to continue to pay state employees because not doing so would lead to a government shutdown – and perhaps force a resolution to the state’s budget impasse. Doug Finke, “Illinois Supreme Court won’t take up state employee pay case,” The State Journal-Register, March 20, 2017.
 A group of Medicaid beneficiaries and providers has sued the state for failure honor consent decrees imposed in 1992 and 2004 (and reimposed/agreed-to in 2015) that mandated the state ensure adequate healthcare access to certain vulnerable populations covered under Medicaid. It is not entirely clear to us that (a) federal court consent decrees should last for 25 years or (b) that recent Medicaid law precedent endows these providers and recipients with standing to sue in the first place. See: Armstrong v. Exceptional Child Center, Inc., 135 S. Ct. 1378 (2015) and briefs for the state in the ongoing dispute over accelerating Medicaid payments under the Memisovski and Beeks consent decrees.
 National Conference on State Legislatures, “Fiscal Brief: State Balanced Budget Provisions,” October 2010.
 30 ILCS 105, Sec. 25.
 Governor’s Office of Management and Budget, five-year projection, FY17 (interest costs at 9 percent added by Breckinridge).
 30 ILCS 540.
 BB-rated borrowing cost per Bloomberg on June 6, 2017.
 Order of Judge Joan Lefkow, U.S. District Court for Northern District of Illinois, Eastern Division, June 7, 2017. See also Kim Geiger, “Federal judge weighing whether Illinois must prioritize paying Medicaid bills,” Chicago Tribune, June 7, 2017.
 Moody’s Investors Service credit opinion on Illinois, June 1, 2017.
 Governor’s Office of Management and Budget, five-year projection, FY17.
 Commission on Government Forecasting and Accountability, p. 15, March 2, 2017.
 Breckinridge estimates based on the Governor’s Office of Management and Budget’s five-year projections, and Illinois’ FY16 CAFR.
 Standard & Poor’s Illinois opinion, June 1, 2017.
 Monica Davey, “The State that Went Bust,” New York Times, January 22, 2011.
 Masayuki Otaki, “Comments on: The Anatomy of Sovereign Debt Crises: Lessons from the American State Defaults of the 1840s,” Japan and the World Economy 10, 267-293, p. 280. (1998). See also: John Joseph Wallis, Richard E. Sylla, Arthur Grinath III, “Sovereign Debt and Repudiation: The Emerging-Market Debt Crisis in the U.S. States, NBER, September 2004.
 30 ILCS 330.
 30 ILCS 235/2.
 Many governments invest their deposits with the state treasurer via the Illinois Funds, the state’s local government investment pool. The treasurer invests this money but is not the custodian on the account.
 Southern Illinois University Carbondale, Paul Simon Public Policy Institute, March 24, 2017.
 Associated Press, “Supreme Court Won’t Take up Appeal of State Worker Pay Case,” USNews.com, March 20, 2017. Available at: https://www.usnews.com/news/best-states/illinois/articles/2017-03-20/supreme-court-wont-take-up-appeal-of-state-worker-pay-case.
 The Civic Federation, “State of Illinois FY 2018 Recommended Operating and Capital Budgets,” p. 14, May 9, 2017.
 Through the Vendor Support Initiative program (VSI). In this program, a third party pays a vendor 90 percent of what the state owes the vendor but hasn’t paid. When the state finally pays its bills, it pays the third party, plus interest. See May 2017 report from Illinois’ Commission on Government Forecasting and Accountability.
 Moody’s Investors Service Q1 2017 Public Finance Rating Revisions.
 U.S. Census of Governments and Breckinridge analysis of Bloomberg data, June 2017.
 Standard & Poor’s, “Many Illinois School Districts are ‘AAA’ Despite State Budget Challenges,” June 7, 2017.
 The Civic Federation, “Transform Illinois Coalition Pushes Ahead on Government Consolidation,” April 11, 2017.
 See a description of the Redevelopment Agency dissolution process. Available at: http://www.dof.ca.gov/Programs/Redevelopment/.
 70 ILCS 1505/18.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
By Adam Stern
As the municipal market advances into the second month of 2018, investment grade credit fundamentals are stable and there are few obvious catalysts to spur near-term deterioration.
Podcast recorded August 23, 2016
In this week's podcast, Adam Stern, Director of Municipal Research, discusses global populism and its potential impact to U.S. state and local governments.
As we enter 2019, portfolio manager Matt Buscone discusses what’s top of mind in the muni market for our investment team.