Markets & Economy
Even After Passing Budget, Illinois Faces Fiscal ChallengesJuly 27, 2017
- Illinois has passed a budget after an impasse that lasted more than two years, but long-term fiscal challenges remain.
- Even after the budget deal, Illinois general obligation bonds have traded with elevated yield premiums, demonstrating the market’s lack of confidence in the issuer.
- The state’s problems demonstrate many of our long-held concerns about investing in general obligation debt and reinforces our corresponding preference for revenue bonds.
- Most of our exposure to muni issuers in Illinois consists of revenue-backed bonds that are generally insulated from the state’s fiscal challenges.
At T. Rowe Price, we have been carefully following Illinois’ fiscal challenges since long before its budget impasse began two years ago, and we believe the recent developments in the state are the latest example of why thorough credit research and careful security selection are increasingly important when investing in the muni bond market. Although the state finally passed a new budget on July 6, serious fiscal challenges remain for Illinois, including significantly underfunded pension systems and a large balance of unpaid bills carried over from prior fiscal years.
STATE’S GENERAL OBLIGATION DEBT PENALIZED BY MARKET DUE TO FISCAL CHALLENGES
While Illinois’ fiscal challenges have been years in the making and the state hadn’t passed a full-year budget for more than two years, the state’s problems escalated when its legislature again failed to pass a budget by the end of the regular legislative session in May. As a result, ratings agencies Moody’s Investors Services and S&P Global Ratings downgraded the state’s general obligation (GO) debt to the lowest investment-grade ratings—Baa3 and BBB-, respectively. Moody’s and S&P also downgraded the state’s appropriation debt, including bonds issued by the Metropolitan Pier and Exposition Authority, to below investment grade at Ba1 and BB+, respectively. The rating agencies warned that further downgrades were likely should the state enter a third fiscal year without a budget on July 1.
The Democrat-controlled state legislature returned for a special session at the end of June and finally passed a budget despite the objections of Governor Bruce Rauner, a Republican, who had vetoed the deal because of its significant tax increases and lack of long-term reforms. Although the state did not meet the June 30 deadline, the ratings agencies have held off on further downgrades for the time being, though Moody’s still has the state placed under review.
Although Illinois continued to service its bond debt during the two years it went without a budget, during that time the state allowed its unpaid bills to balloon to approximately $15 billion, hurting its public service functions and adding to the significant challenges that the state’s economy faces. While a relatively wealthy state, with a median household income at 107% of the U.S. average, Illinois’ revenues are down and its population has contracted during the past three years. Perhaps the biggest challenge for the state relates to its seriously underfunded pension systems. Collectively, the three largest Illinois pension plans reported net unfunded liabilities of $136 billion as of June 30, 2016.
As the political drama played out, the municipal market penalized 10-year Illinois GO debt, and yield premiums (spreads) versus equivalent-maturity AAA GO municipal bond debt temporarily escalated to beyond 300 basis points in June (100 basis points equal one percentage point). After the legislature passed a budget in July, the state’s bonds have rallied and spreads have compressed, although they remain elevated at above 200 basis points (Figure 1), a level that shows the market’s lack of confidence in the issuer. The high spreads will further strain Illinois’ finances when the state is forced to pay higher yields when it comes to market with what is expected to be about $8 billion in new bonds to pay off the bills it accrued during the impasse.
Although spreads have tightened since the state passed a budget in early July, Illinois bonds continue to offer elevated yields compared with other higher-rated jurisdictions.
REVENUE BONDS GENERALLY SHIELDED FROM POLITICAL DYSFUNCTION
Illinois is an outlier in some respects, but the state demonstrates many of our long-held concerns about investing in GO debt and reinforces our corresponding preference for revenue bonds in our municipal bond portfolios. Repayment of revenue bonds typically stems from revenues of specific projects or systems providing essential government services, and most revenue bonds are relatively well insulated from pension funding concerns. Moreover, the entities that issue revenue debt are less susceptible to the political dysfunction that can sometimes affect state and local governments.
Revenue-backed credits that are generally insulated from the fiscal cloud that hangs over the state, including bonds issued by the Illinois State Toll Highway Authority and Chicago O’Hare International Airport, represent the majority of our exposure to municipal issuers in Illinois. These are strong credits with clearly defined revenue streams, although they have traded at a discount recently due to the issues affecting the state and the city of Chicago. These securities represent strategic investments from our perspective.
While most of the Illinois-related securities we own in our portfolios are revenue bonds, we do have modest positions in the state’s GO bonds. We acknowledge that Illinois’ debt certainly faces challenges, but we also remain cognizant that the state has a functioning economy and significant flexibility to recover from its fiscal troubles if its political situation improves. As a result, with its 10-year bonds trading at yield levels that exceeded equivalent-maturity AAA rated municipal bonds by over 200 basis points during mid-July, we are generally comfortable having a measured level of exposure to the state’s GO debt in our national portfolios, particularly for shorter-maturity portfolios.
LONG-TERM REFORMS STILL NEEDED
Although the state now has a budget and the income tax increase will help address Illinois’ immediate budgetary stress, long-term fiscal challenges remain as the budget agreement does not address the state’s acute pension shortfalls. As a result, when investing in the state, we will continue to focus on revenue bonds and intermediate- to short-maturity state GO debt that offer a yield advantage. We will rely on our strong credit research capabilities to closely monitor developments in the state as well as other states that may face similar fiscal challenges.
As we acknowledged earlier, Illinois is in some ways unique, but stress in state and local budgets will increase as long-term liability issues get closer with each passing year. Some jurisdictions are taking proactive steps to control unsustainable legacy costs, but others appear unwilling or unable to address them. Yield spreads for these names will gradually widen as concerns about long-term liabilities become more tangible, and downgrades and defaults by government entities are bound to occur more frequently than they have in the past. In this environment, we believe an actively managed, broadly diversified tax-free portfolio holds benefits for investors.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of July 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
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