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  • Muni Nation

    Something is Rotten in the State of Illinois

    Jim Colby ,Portfolio Manager
    March 30, 2017
     

    My apologies, Mr. Shakespeare! But it certainly seems to me that there is.

    The state of Illinois could very well lose its investment grade rating, sooner rather than later. Nearly two years without a budget, unfunded pension obligations, and a backlog of bills do not presage an easy future for the state's finances.

    Another Year without a Budget

    Illinois may not be another Detroit. Or another Puerto Rico. But it has all the characteristics of a disaster just waiting to happen.

    As midnight struck on December 31, 2016, Illinois had not had a budget for nearly two years. And its deficit was in the billions ($11 billion of unpaid bills). Now, in mid-March, little has changed: there is still no budget and the deficit deepens at the rate of $11 million a day.1 On March 28, with unpaid bills of $12,389,967,202.802 the state looks as if it could soon lose its investment grade rating.

    Hopes of a "grand bargain" between Democrats and Republicans, with votes in the state's senate on tax increases, school funding reform, and other measures, evaporated on March 1, when Governor Rauner involved himself in the process and Republican support vaporized.

    The standoff between the legislature (controlled by the Democrats) and Governor Rauner (a Republican) grows ever more rancorous, ever more insoluble, and a credit down grade ever more likely.

    A Matter of Property Taxes

    One of the most, if not the most, intractable problem remains Rauner's refusal to budge on freezing property taxes. To Rauner's thinking, freezing property taxes will lead to an increase in economic activity, induce more business formation, and, possibly, entice companies to re-locate to Illinois. Well, it hasn't happened. And the deficit has mushroomed.

    Two constituencies to have been hit particularly hard are schools (particularly in Chicago) and state municipalities. In addition, both service providers and vendors remain unpaid. Matters have come to such an impasse that, on February 14, the Chicago Public Schools (the third largest public school system in the U.S.) sued the state, calling its funding "discriminatory."3

    How the Mighty Have Fallen

    Perhaps reflective of both its robust general obligation repayment statute and its sovereign powers over revenues and spending, the state has been able to maintain a solid credit profile. In 2016, not only was Illinois (together with its agencies and its cities) the fifth largest issuer of municipal bonds, but also, at the end of the year, only three states – California, New York, and Texas – had more municipal bonds outstanding.

    U.S. State and Territory Municipal Bonds Outstanding – Top Ten
    December 31, 2016

    State/Territory U.S. $ Billion
    California 602.2
    New York 410.6
    Texas 362.1
    Illinois 172.7
    Florida 154.5
    Pennsylvania 137.7
    New Jersey 127.6
    Ohio 112.1
    Massachusetts 110.9
    Puerto Rico 101.8
    Source: Bank of America Merrill Lynch

     

    U.S. State and Territory Municipal Bonds Issuance in 2016 – Top Ten
    December 31, 2016

    State/Territory U.S. $ Billion
    California 65.0
    Texas 52.6
    New York 44.3
    Pennsylvania 20.4
    Illinois 20.2
    Florida 18.7
    Massachusetts 15.5
    Michigan 13.2
    New Jersey 12.8
    Ohio 11.4
    Source: Bank of America Merrill Lynch

    Now, however, despite its obvious economic strength, the state is currently the lowest rated in the country, with Fitch, Moody's, and Standard & Poor's rating it either BBB or Baa2. This is the lowest for a state since Massachusetts in 1992.4 (Massachusetts is now one of the higher rated states in the U.S.)

    While Illinois is on negative watch at Fitch Ratings, both S&P and Moody's Investors Service have assigned it a negative outlook. Should no budget deal be struck by July 1 this year, the start of the 2018 fiscal year, the likelihood of downgrades from S&P and/or Fitch is strong. When, on February 1, Fitch downgraded $25.9 billion in outstanding general obligation bonds to 'BBB' from 'BBB+', it noted: "Fitch expects to resolve the Rating Watch within the next six months based on an assessment of the state's fiscal trajectory as it starts fiscal year 2018. If the state continues on the current path, a further downgrade would be warranted."5

    Speculative Territory – Only a Couple of Notches Away

    While it would take a couple of downgrade notches for Illinois' general obligation debt to become speculative, a single downgrade for its moral obligation and appropriation-based debt would take it into speculative territory. According to all three rating agencies, not in recent memory has any state's debt been rated as speculative.6

    The Consequences?

    Dire.

    The indexes which govern the construction of the entire suite of municipal ETFs at VanEck have, as might be expected, exposure to the State of Illinois, and its political subdivisions, in proportion to the rules governing each index, as well as the issuances which come to market. Should a downgrade occur, not only will the cost of capital rise for the state, but the allocation of bonds amongst the VanEck ETFs will likely shift to the speculative part of the marketplace and possibly cause the geographic profiles to change for all ETFs.

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