The state of Illinois has its fair share of political dysfunction, a lack of financial oversight and a need to address its long-standing deficits.
All of this has led to its financial challenges, including the lowest credit rating among the 50 U.S. states. The state is on the verge of going into junk status for its credit ratings. Thus far, the state has gone without a complete budget for an unprecedented two straight fiscal years and there are looming concerns over their unfunded pension liabilities.
After the Puerto Rico fiasco, investors are more careful about potential defaults from other local and state governments and protect their money or have it tied up in legal battles. From the investor’s standpoint, defaults, or the mere risk of a default of their investment holdings, can have a significant impact on the total return and liquidity of their portfolio.
In this article, we will take a closer look at the state of Illinois’s financial strain, the contributing factors and what challenges it presents for current or potential municipal debt investors.
Be sure to learn what the Puerto Rico crisis meant for investors and how it impacted them.
The Political Influence on Financial Operations
The situation for Illinois may seem quite similar to the financial strains and the outcome for Puerto Rico, and the problem is accentuated by the state’s failure to implement a budget that addresses the government’s longstanding financial deficits. In addition, the state’s rising pension liabilities and unpaid bills make up almost half of their operating budget. These looming concerns have existed for a very long time and have been exacerbated by political dysfunction.
Check out our article here to learn whether it was worth investing in the high-yielding Illinois bonds.
The political influence on the state’s finances is evident; Bruce Rauner, Governor of Illinois, has made it clear he will not change his position on freezing property taxes. He believes that freezing property taxes is a way to enhance economic activity and potentially attract new business to Illinois. Gov. Rauner is assuming that the state’s lost property tax revenue growth can and will be compensated by business activity and growth. However, these tactics have not shown any progress in terms of increased business activity.
Impact on the State’s General Obligation Debt and Revenue Debt
When choosing between general obligation debt and revenue-backed debt for a distressed issuer, revenue bonds are generally far more protected from political dysfunctions and financial mismanagement of their general fund. Due to the freezing of property taxes – typically the primary source of general fund revenue for local and state governments – general fund revenues have been stagnant.
Keep our glossary of municipal bond terminologies handy to familiarize with different concepts commonly used by municipal investors.
However, the state’s financial liabilities have been on the rise. Analysis from VanEck suggested that by the end of 2016, the state had $11 billion in unpaid liabilities growing at $11 million a day. Although the state continued to service its bond obligations during the two years without a budget, it has allowed its other financial obligations to balloon. The state’s three largest pension funds reported $136 billion of unfunded liabilities as of June 30, 2016. Due to these financial challenges, the state’s general obligation debt is severely penalized in the debt markets and by the credit rating agencies.
For instance, the state’s GO bonds were being traded at enormous spreads, 300 basis points or 3%, compared to the AAA GO municipal debt. After the state legislature successfully passed a budget in July of this year, the spread had narrowed by almost 1%, but investors are still very skeptical and showing a huge lack of confidence in Illinois GO debt.
However, revenue bonds, as the name suggests, are primarily issued to fund projects for essential service utilities that provide critical services to maintain public health and safety, like water, wastewater and electricity. Since revenue bonds are utilized to fund critical services, they provide investors with the assurance of stable and sustainable revenue streams that are also better protected from economic downturns. In an ideal situation, if the revenue stream sees a decline or the operational cost is increasing for the enterprise debt, the oversight commission will act on either increasing the fees or cutting the cost to maintain the appropriate covenant coverages. In the case of Illinois, investors are still skeptical due to the lack of financial oversight on the revenue streams.
Check out this article to learn more about general obligation and revenue bonds.
Key Considerations for Investors
As most investors follow the municipal debt markets very closely, the situation for Illinois may be very reminiscent to the financial troubles of Puerto Rico. Here are few of the important things to keep in mind:
- If you are holding any Illinois debt instruments – either GO bonds or revenue debt – you should carefully analyze the backings of your debt and consult with a financial professional before Illinois debt goes below investment-grade.
- If you are a holder of municipal bonds, you must track all the news, credit ratings and changes in financial policies related to your municipal issuers. These will have a crucial impact on the marketability of your debt.
- If you are thinking about buying Illinois debt because the yields are enticing and you are confident you’ll be able to sell the investments before they go further down in value, you should reconsider.
- If you are looking at buying Illinois debt, consider revenue bonds. Where both revenue bonds and GO bonds provide stable income and diversification for an investor portfolio at relative risk, it’s imperative to understand the complete structure of net revenue pledges, as they can be more lucrative and safer than GO bonds. A simple comparison would be: if an individual loses his job in an economic downturn, would he or she be more likely to pay his water and sewer bill, or make his property tax payment? Investors must understand the intricacies of both debts, along with the understanding of the pledged revenues and credit characteristics of the issuer.
Be sure to check out this article to remain aware of the due diligence process for evaluating municipal bonds.
Bottom Line
In conclusion, although the State of Illinois has recently passed a budget and looking to access the municipal markets for issuing debt, financial concerns are very much still looming. Municipal debt investors must carefully analyze the state’s debt portfolio, the revenue streams backing that debt and the potential worst-case scenarios before making their investments.
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