By: Ted Dabrowski and John Klingner
Financial markets react to news – good and bad – far faster than the credit rating agencies do. If that holds true today, then expect Illinois to be junk rated soon. The bond markets are already pricing Illinois bonds at interest rates that amount to junk-level yields.
Illinois 10-year bonds traded 3.81 percentage points over what AAA-rated states like Indiana’s traded at. That penalty – the 3.81 percentage points – is a record high for Illinois, reflecting how risky the state’s credit has become.
A simple example looks like this: If Indiana, Iowa or Missouri, three of Illinois’ neighboring states with AAA ratings, were to borrow money today from the bond market for ten years, they would have to pay an yearly interest rate of around, let’s guesstimate, 2 percent.
For that same money, Illinois would have to pay a 5.81 percent interest rate. It’s a massive penalty for a U.S. state to pay.
The graphic below shows how that penalty spread has spiked to 3.8 percentage points in recent weeks. The penalty is now above the previous high of 3.37 percentage points, which occurred during the budget impasse of 2017.
Even before the COVID-19 crisis hit, Illinois’ credit rating had collapsed to just one notch above junk. The state’s $241 billion in pension debts, its chronic budget deficits, billions in unpaid bills and its failed governance were the key reasons why Illinois was already the nation’s worst-rated state.
The bond markets are now pricing in billions more in Illinois budget deficits as revenues dry up and spending increases as a result of the economic shutdown and stay-at-home orders. Pension debts, already the highest in the country, will jump due to the stock market meltdown and collapse in interest rates. Illinois is also being punished because it had no rainy-day funds to weather the storm. It was the least prepared state in the country for a recession.
Moody’s and S&P both recently revised their outlook to “negative” for Illinois (See Appendix for their commentary). If either ratings agency follows through, Illinois would be the first state in the nation to ever be rated junk.
The situation for Illinois’ politicians today is particularly difficult. The typical gimmicks that they’ve long used to avoid reforms – the same ones that landed Illinois with a near-junk rating in the first place – are no longer available to them. Borrowing any meaningful amount (without some sort of federal backing) will be extremely difficult. Shorting the pension funds will trigger even more punishment from the rating agencies. And reamortizing pension debts further into the future – can kicking – won’t be accepted either.
Look for House Speaker Mike Madigan, Gov. J.B. Pritzker and Mayor Lori Lightfoot – who continue to categorically reject reform after reform, including an amendment to the pension protection clause – to ask for a federal bailout. They’ll try to blame the Coronavirus for all of Illinois’ woes.
Here’s Gov. Pritzker just last week: “I think a lot of it is going to depend upon the federal government. I mean there’s just no one else who can step in the, you know, to help our state finances, the way that the federal government can.”
So far, the bond market isn’t buying it, as it prices in a junk rating for Illinois. Let’s see how long it takes for the rating agencies to catch up.
Read more about Illinois’ financial crisis:
- Moody’s new report shows Illinois is nation’s outlier when it comes to pension debts
- As the crisis deepens, keep an eye on Illinois’ unpaid bills
- Coronavirus impact may push Illinois state pension debt to over $300 billion
- Illinois had one hour’s worth of rainy day funds before the Coronavirus hit
- Illinoisans will be among nation’s hardest hit in next recession
Moody’s rating outlook
Revision of the state’s outlook to negative from stable aligns with our view of the likely effects of the coronavirus pandemic, which will reduce tax collections and likely cause substantial current-year pension investment losses, both of which will weigh more heavily on Illinois, given its existing weaknesses relative to other states. Federal government support will mitigate some of the direct budgetary burden, but the state will face liquidity pressures that may lead it to near-term actions such as adding to its balance of unpaid bills. The state is also more likely to take actions that add to long-term liabilities, in view of impending revenue shortfalls, growing health and social burdens and pension fund investment losses.
Moody’s warned of the factor that could take Illinois into junk:
- Fiscal measures that greatly add to the state’s near- or long-term liabilities
- Large or persistent structural imbalance that leads to significant increase in the state’s unpaid bills or other liabilities
- Reduction in pension contributions to provide fiscal relief
- Substantial assumption of debt or pension liabilities accrued by local governments
S&P’s rating outlook
“The negative outlook reflects our anticipation that there is at least a one-in-three chance that economic conditions worsen to a degree that affects the state’s ability to maintain credit characteristics in line with the investment-grade rating level,” said S&P Global Ratings credit analyst Geoffrey Buswick.
We will be watching to see if the stimulus as currently allocated is sufficient for Illinois to fight the COVID-19 pandemic; if the anticipated growth in the bill backlog does not create service delivery problems; and if the current market volatility worsens the funding status of the already poorly funded pension plans. Over the intermediate term, we believe that the state will need to take further action to achieve sustainable structural balance and address its pension liabilities to maintain an investment-grade rating.
In addition, the rating reflects our view of governance risks that we view as being above the sector norms due to the constitutional limits the state faces to modify its growing pension costs, and that the state is not contributing to meet static funding, limiting current and future budgetary flexibility. However, we view the state’s environmental risks as in-line with our view of the sector. Our outlook revision also reflects our view that the COVID-19 pandemic’s impact on the state’s economy, budget, and forecast is a social rating factor elevating the public health and safety issues. If economic activity resumes, however, and credit metrics are upheld, we could revise the outlook to stable.