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The state of Illinois: A crisis of politics, not economics

Our Blog Jul 13, 2017
Chad Farrington, CFA, Head of Municipal Bond Credit Research and Senior Portfolio Manager

Illinois is seen as a credit risk hot spot, but it hasn’t reached the point of no return. Not all Illinois municipal bonds pose the same amount of risk.

Illinois public ratings have experienced an impressive fall from grace, steadily sliding from AA- in 2009 to the lowest investment grade rating of BBB- from all three rating agencies. Although a budget was passed, a junk bond rating from at least one rating agency is still possible. If the rating agencies lower Illinois below investment grade, it will be the first U.S. state to be in this position since Arkansas defaulted during the Great Depression. The most astounding aspect of Illinois’s steady financial erosion is that it’s been entirely of its own making: structurally imbalanced budgets, underfunded annual pension contributions and temporary tax increases lapsing without corresponding spending offsets.

Puerto Rico? Not quite.
The Illinois liquidity crunch has drawn comparisons to the insolvent U.S. territory, Puerto Rico. However, there are fairly stark differences between the two governments, primarily the debt burden relative to the size of their respective economies.

Debt burden: Illinois versus Puerto Rico
Debt burden: Illinois versus Puerto Rico

Politics. Not economics.
Although the budget that was recently enacted includes tax increases and alleviates some of the short-term pressure of having no budget for the past two years, it does little to reform spending or address the longer term pension issues. We continue to believe Illinois has sufficient resources and tax base to fix its fiscal problems, but the solutions are politically difficult and state leaders have so far been unwilling to make the hard decisions to truly balance its budget.

Unfortunately, the increasing backlog of unpaid bills (generating close to $1 billion of unnecessary interest per year) plus underfunded pension systems make finding an ultimate solution more difficult. The path toward fiscal recovery will now require a painful combination of tax increases, new taxes and spending cuts. When there aren’t enough dollars to go around, repaying bondholders will take a backseat to paying pension obligations and providing essential public services.

What does this mean for investors?
To determine if they are comfortable with exposure to Illinois’s fiscal issues in a municipal bond portfolio, investors can ask themselves these two questions:

1. What is the type of muni bond? Illinois general obligation bonds are secured by the government’s pledge to repay bondholders — they’re largely impacted by the state’s ongoing fiscal problems. Other types of bonds, even if they’re issued within the state of Illinois, have sources of repayment and do not present as significant a risk, including:

  • Local general obligation bonds. Local government budgets derive most revenue from property taxes
  • Refunded bonds. Backed by U.S. Treasuries
  • Airport bonds. Benefit from strong transportation growth and low fuel costs
  • Water, sewer and energy bonds. Provide an essential service with a reliable revenue stream
  • Hospital, sales tax and tobacco bonds. Backed by diversified revenue streams

2. Will the risk pay off? Holding Illinois general obligation bonds is not for the faint of heart. But the yields do appear to compensate for the additional risk.

Bottom line
While we don’t believe Illinois is close to being unable to meet debt service, the state’s political leaders have taken it much further down the path of financial ruin than many ever thought possible. Just remember, not all types of muni bonds pose the same amount of risk — even if issued from within the state of Illinois.

Chad Farrington, CFA

Chad Farrington, CFA

Head of Municipal Bond Credit Research and Senior Portfolio Manager