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Municipal Perspective published on July 11, 2017

Roundup of Recent Credit News in Illinois and Connecticut

Illinois’ budgetary problems and Hartford’s exploration of bankruptcy have concerned municipal investors in recent months. Last week, two developments materially impacted credit risk in Illinois and Connecticut.

Illinois passed a budget, which is a credit positive …

Last Thursday, Illinois passed its first budget in two years. On balance, this is a credit positive for the state. The budget enacts a permanent income tax rate of 4.95 percent and a permanent corporate income tax rate of 5.25 percent, and cuts $3 billion from baseline FY18 spending. In our view, these fiscal changes should bring Illinois’ budget close to balance in FY18.

The budget deal also authorizes $6 billion in borrowing to pay down a portion of Illinois’ $14.8 billion bill backlog. While borrowing is not ideal, it is preferable to leaving the bills outstanding.

The budget is likely to lessen cash flow pressure on Illinois local credits that are reliant on state aid, such as the Regional Transportation Authority (RTA), hospitals or public higher education. Specifically, hospitals are likely to receive Medicaid payments in a timely manner, and the FY18 budget delivers a large increase in higher education funding relative to appropriations in FY16 and FY17.

… but Illinois’ fiscal health remains weak

We note the following:

  • The new budget passed because the Illinois legislature – including some Republican House members – pushed it through, overriding Republican Governor Bruce Rauner’s veto. As such, the budget may not represent a lasting accord between the governor and Illinois House Speaker Michael Madigan. This could impede an agreement next year if the budget needs tweaking or finishes out of balance.
  • The budget does not sufficiently address pension reform (see: Chicago Public Pension Ruling). Significant political capital has now been spent on tax hikes and budget cuts, potentially reducing the state’s flexibility for pension reform in the future.
  • With the FY18 budget, important fiscal levers have been pulled. Illinois spreads have remained rangebound over the past several years1 in part because the market never questioned the state’s ability to pay (see: A Credit View of Illinois’ Past and Future). However, it will be an increasing challenge for the state to raise taxes again or to cut spending even further.
  • Illinois credits continue to be exposed to ratings risk, particularly from Moody’s Investors Service. Moody’s has threatened to downgrade the state’s credit rating regardless of whether a balanced budget is enacted.

Connecticut has entered FY18 without a budget agreement

Under Connecticut law, the governor is required to maintain essential services via executive order authority until a new budget is enacted. Governor Dannel Malloy has outlined a budget that balances estimated revenue with expenditures, which should mitigate a significant run-up in payables.

That said, a main concern is that the absence of a budget will exacerbate the stresses facing Hartford, Connecticut’s capital. Hartford budgeted for $40 million in FY18 state funding that is now unlikely to materialize. As discussed in The Nutmeg State’s Economy Needs More Spice, Hartford faces a FY18 budget gap of just under $50 million and the mayor has sought advice from bankruptcy attorneys. Notably, Hartford lacks the political gridlock we commonly see in municipal insolvencies. The city’s problems appear to reflect its weak ability-to-pay metrics, as opposed to a lack of willingness to find political solutions.

In the case of a Hartford bankruptcy or out-of-court restructuring, we think there is real potential for a local GO bond default. Hartford has an elevated debt burden, and its GO bonds would likely be treated as unsecured in bankruptcy. Also, Hartford is best understood as a city under chronic fiscal stress. Its fiscal condition has been subpar for decades. In our view, insolvencies involving chronic distress (e.g., Detroit, Puerto Rico and Central Falls, Rhode Island) are more likely to result in low recoveries precisely because there’s not much economic activity to tax.

Breckinridge continues to emphasize in-depth, fundamental research

While we think the municipal credit backdrop is overall stable, we recognize that pockets of risk such as Illinois and Connecticut can have important implications for the broader municipal space. We continue to closely monitor these states.

 

[1] Municipal Market Analytics and Breckinridge Capital Advisors, as of July 1, 2017.

 

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.

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