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Illinois on brink of becoming first state rated junk if budget crisis not averted

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Illinois, already the lowest-rated U.S. state, on Saturday entered an unprecedented third-straight fiscal year without a budget, crippled by the partisan impasse between its Republican governor and Democrats who control the legislature.

The consequences could severely harm the state, the fifth largest in the nation, which is sitting on a nearly $15 billion backlog of unpaid bills, about 40% of the state’s operating budget. Illinois is now flirting with a junk credit rating. That means investors could be hit, too, although the state’s pledge to keep up with bond payments has preserved bond values so far.

State House lawmakers, trying to reach a compromise deal, met on Saturday but wrapped with no budget vote. They plan to meet again on Sunday. The fight has already claimed a key player in the negotiations with Thursday’s abrupt resignation of Senate Republican Leader Christine Radogno, once considered a voice of compromise, who grew infuriated with the inaction.

The fiscal-year deadline caught up with new other states. Maine and New Jersey announced Saturday that their respective government operations shut down indefinitely after lawmakers failed to reach budget deals before Friday’s midnight deadline.

In Illinois, lawmakers were hopeful but sober about the prospects. “We’re like a banana republic. We can’t manage our money,” said Illinois Republican Gov. Bruce Rauner, who was elected on his pledge to reform pensions and reduce union power, at one point during the process. For his part, Mike Madigan, the Chicago Democrat who is House Speaker, is insisting on linking non-budget demands to the budget discussion, including an education funding overall (Illinois is one of only a handful of other states that rely on property taxes to fund schools).

Past-due bills are a big strike against Illinois’s credit standing, but Standard & Poor’s, which rates the state BBB-minus or one step away from the “junk” rating that would be the first for any state, has warned about a chronic structural deficit. S&P has Illinois on warning for a downgrade to BB-plus. The state is rated Baa2 by Moody’s Investors Service and BBB by Fitch Ratings, both with negative outlooks.

S&P analyst Gabriel Petek had this to say when his firm downgraded the state’s credit to one notch in early June: “The rating actions largely reflect the severe deterioration of Illinois’ fiscal condition, a byproduct of its stalemated budget negotiations …”

An “unrelenting political brinkmanship” poses a threat to the timely payments for state priorities, which places the state at risk of “entering a negative credit spiral” in which further credit downgrades could hurt its already weak liquidity, he said.

Spillover effect?

The state’s uninsured general obligation debt traded this week as high as 95 cents on the dollar, well above junk equivalents. Much of Illinois’s $25 billion in outstanding general obligation debt is held by individual investors. Money management giant Vanguard Group has $1.2 billion of the state’s bonds spread across seven mutual funds. It is the biggest holder among all mutual fund firms that own a total of $4.5 billion in Illinois bonds, according to research firm Morningstar.

Most mutual funds have rules limiting their investment in junk-rated debt, although rules typically do not force them to sell debt that has fallen into junk. At Vanguard, mutual funds are allowed to hold a “modest allocation” of junk bonds, a spokesman told The Wall Street Journal.

Analysts predict investors could demand an additional half-percent to a percent in interest as compensation for the perceived risk that comes with a junk rating. That will tack on an additional $5 million to $10 million for every $1 billion the state borrows. Illinois already pays a premium. When it last sold tax-exempt debt in November 2016, the state paid yields of 4.4% for 20-year bonds. In contrast, 20-year bonds issued by the state of Wisconsin around the same time yielded 2.8%, The Wall Street Journal reported.

The situation has prompted some comparisons with Puerto Rico, which earlier this year announced a historic restructuring of some of its $70 billion in debt through courts after negotiations with bondholders fizzled.

New Jersey and Connecticut, among the lowest-rated states after Illinois, face their own budget problems and mounting liabilities. But New Jersey and Connecticut still have a long way to go to match Illinois’s ratings risk; they are rated several notches higher by S&P and Moody’s Investors Service. Other than Illinois, New Jersey, and Connecticut, the lowest rating of any other state is AA-. There are nine states rated higher than the U.S. itself even, with full AAA ratings.

Unlike city and county governments, states cannot legally declare bankruptcy, whereby they force creditors, bondholders and pensioners to absorb some of the loss, although a state could technically default on its bonds. The last time a state declared bankruptcy was Arkansas in 1933, in the throes of the Great Depression.

Bob DiMella, co-head of municipal managers at MacKay Shields, said at a Morningstar conference earlier this year that he found Illinois bonds more attractive than New Jersey equivalents in part because Illinois, for all the political pain of the budget process, was “trying to rectify” its situation while New Jersey appeared to be in denial over its falling revenues. Connecticut wasn’t far behind with its own revenue issues, he said. Even bigger, the municipal market had already somewhat discounted Illinois bonds, meaning they were better priced relative to risk than other muni bonds.

Read the full article on: Market Watch