In our view, community college bonds are an underappreciated sector when it comes to identifying safe and sustainable municipal investments.
On June 4, Illinois Gov. Bruce Rauner signed a $38.5 billion budget for fiscal year 2019,1 marking the state’s first on-time budget in four years. The budget passage eased fears of another protracted impasse and an immediate Illinois downgrade to junk (see A Credit View of Illinois’ Past and Future), which would have been a first for a U.S. state and a large bruise to the perception of state credit quality.
While the new bipartisan2 spending plan provides some near-term breathing room, it is important to understand the pros and cons in the new budget.
- State Likely to Remain Investment Grade, for Now
Illinois is rated Baa3(NEG)/BBB-(STA). The ratings agencies are likely to hold off, for now, on a downgrade into junk. Following the budget’s release, S&P said the budget was “consistent with the stable outlook S&P Global Ratings currently maintains on the state’s credit rating.”
- Full-Year Budget
Some lawmakers had voiced concern that the budget passed would only be a “half-year” budget that could be revisited with the November elections. Somewhat unexpectedly, the budget passed is “full-year” and thus could signal lower tensions in the Illinois legislature. Neither Gov. Rauner nor the legislature wanted a budget impasse to become a campaign issue. The budget passed in part because Gov. Rauner pulled back on his broader overhaul agenda, which included regulatory relief for businesses, workers’ compensation reforms, mandate relief on schools and a property tax freeze.
- Improved Spreads
Figure 1 shows that spreads have declined since the budget was announced. On May 31, following the Senate’s passage of the bill, general obligation (GO) spreads fell more than 20 basis points.3 The lower cost of capital could be beneficial to the state because it will likely tap lenders later this year.
- Boost in Local Government Revenues
The new budget restores a portion of the local shares of income tax that had been cut last year, resulting in a nearly $100 million increase in local government aid. In addition, earlier this year the state had imposed a 2 percent administrative fee on sales tax collections from local communities. The FY19 budget reduces that to 1.5 percent, translating to roughly $20 million in additional revenue for the state’s municipalities.
- Potential Benefits for Local Education and Healthcare Credits
The budget includes modest increases in state education aid, including a 2 percent bump for higher education institutions. This is important for Illinois education issuers that faced liquidity issues during the state’s budget impasse from 2015 to 2017. Gov. Rauner’s originally proposed budget included plans to shift some pension costs to school districts, universities and community colleges; however, this cost shift is not in the final budget. Notably, Gov. Rauner’s proposed 4 percent cuts to Medicaid providers did not reach the final budget. We generally view this as a benefit to healthcare and hospital credits.
- Caution Still Required on Governance
In our view, simply passing an on-time budget for one year is not necessarily an achievement; rather, it should be a routine outcome for a properly-functioning government. Instead, this is the first on-time budget since Governor Rauner took office. Illinois’ governance should still be closely monitored.
- State Not Completely Out of Downgrade Woods
Prior to the budget signing, Moody’s Investors Service signaled they were unlikely to be impressed by passage of an on-time budget. Absent material changes to the state’s longer-term credit trajectory, we believe Moody’s may lower the state’s rating within the next six to twelve months.
- State Still Plagued by Pensions and Unpaid Bills
The budget does not address Illinois’ growing pension problem. As of 2017, Illinois’ adjusted net pension liability (ANPL)4 was equal to $237 billion, or 3.1 times its revenue. This ratio was 50 percent higher than the next-highest state, Connecticut.
The unpaid-bill backlog stands at a hefty $7.5 billion,5 equal to a sizable 19 percent of FY19 budgeted spending. The legislature recently passed a bill that authorizes the state treasurer to invest available funds in the state’s unpaid receivables. Paydowns are important to avoid high interest rates on unpaid bills as mandated by state law. However, using available balances for this purpose could further compromise the state’s weak liquidity position.
- Still Minimal Reserves
Illinois has no money in its rainy-day account and this year’s budget does not add to operating reserve balances. This leaves the state highly vulnerable should it experience an economic rough patch.
- Budget Not Fully Structurally Balanced
The new budget is partially supported by one-time money and does not include new recurring revenues. These one-time revenues include $800 million of borrowing from special funds and $270 million from the sale of the Thompson Center Building. Notably, the budget does not incorporate the $300 million needed to cover state employee step raises that have been withheld during contract negotiations; courts have already ruled that these must be paid.
Finally, the new budget assumes $382 million of savings from pension buyouts. However, the state could realize less savings than expected if few workers accept the buyout.
- Little Being Done to Resolve Credit Stress in Harvey
The dire fiscal picture in Harvey, Illinois signals that the state’s local government issues are significant. Investors remain focused on the pension intercept dispute in the city and what it might mean for other local credits in the state. A resolution in Harvey may serve as a template for other cases of municipal distress in the state.
The state’s structural issues remain challenging. Looking forward, we believe the outcome of the November gubernatorial election could have significant implications for the trajectory of the credit. We look forward to keeping our clients updated on Illinois credit developments.
 The Illinois fiscal year ends in June.
 The budget passed the Senate 56-2 and the House 97-18.
 Thomson Reuters TM3 Municipal Market Monitor, as of May 31, 2018. Based on the 10-year IL GO Spread to the AAA GO Bond.
 The ANPL is a conservative measure of pension debt developed by Moody’s Investors Service.
 As of 06/7/2018, taken from https://illinoiscomptroller.gov/financial-data/backlog-voucher-report-bvr/.
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.