Illinois heads into market with budget reckoning looming

Bonds

Illinois heads into the market Tuesday facing questions about its ability to hold on to investment-grade ratings should voters reject a progressive income tax amendment and federal relief remain stalled.

The state will take competitive bids Tuesday on $850 million of general obligation paper to fund capital projects and ongoing pension buyout and acceleration programs. The deal offers four series: a $125 million taxable tranche, a $325 million tranche, a $300 million, and $100 million.

“There’s no new taxing power. The idea here is to make it fairer,” Illinois Gov. J.B. Pritzker says of the progressive income tax measure.

U.S. Air Force/Senior Airman Jay Grabiec

Sycamore Advisors LLC is advising the state and Chapman and Cutler LLP and Burke, Burns & Pinelli Ltd are bond counsel.

Illinois’ secondary market spreads have widened 10 basis points over the last week with the 10-year set at a 281 basis point spread to Refinitiv Municipal Market Data’s AAA benchmark, its one-year at a 225 basis point spread, and its long, 25-year at a 268 basis point spread. Triple-B spreads, where the state is rated, are trading at spreads of 98 basis points, 126 basis points, and 137 basis points on the 1-year, 10-year, and 25-year, respectively. The state paid record spread penalties in its last sale in May.

The trading levels already reflect the market’s view that the bonds don’t represent an investment grade credit and “from our view point, the rating agencies have been patient but at some point they have to make a move if the numbers warrant it,” said Michael Pietronico, chief executive officer of Miller Tabak Asset Management.

Illinois’ $43 billion general fund budget hinges on about $6 billion of uncertain funding that includes about $1.3 billion from a move to a progressive state income tax structure and federal relief for tax losses.

The former relies on voters Nov. 3 approving a constitutional amendment championed by Gov. J.B. Pritzker that lifts the flat tax requirement. A federal relief package remains elusive amid stark differences between the Democrat-led House, GOP-led Senate and Trump White House.

The budget is balanced in their absence by issuing up to $1.2 billion of general obligation bonds to offset the loss of new income tax revenue in the second half of the fiscal year and up to $5 billion through the Federal Reserve’s Municipal Liquidity Facility, which the state was the first to use for its $1.2 billion note issue in the spring.

Illinois remains eligible to borrow more than $8 billion through the MLF at a set rate based on its ratings of 3.30%. The state must submit a notice of interest by early December for the program that currently expires at the end of the year.

Pritzker recently directed state agencies to identify 5% in cuts for the current fiscal year that runs through June 30 and 10% for fiscal 2022 and top administration officials have long warned of potential double-digit income tax hikes on all if the amendment fails.

The state can avoid a downgrade “whether or not it becomes law” Pietronico said of the tax amendment as “it’s about what they do on the spending side. If they address that, it would be better long term for the finances of the state.”

Some investors might have to sell in the event of a downgrade, but many who can only hold investment grade debt have likely already trimmed their positions so there may not be a big price reduction but it would represent “a political embarrassment for the government,” Pietronico said.

Tax Debate
If voters amend the state constitution to scrap the flat tax requirement, Pritzker’s plan would scrap the current 4.95% flat personal income tax rate with the highest tax bracket set at 7.99% for a single filer making at least $750,000. Corporate rates would rise to 7.99%. It would raise $3.1 billion for a full year with increases imposed on the top 3% of filers. The administration has previously said it would generate at least $3.5 billion of new revenue.

The amendment battle has pitted Pritzker, who has put some of his own wealth toward funding a group fighting for passage, against other wealthy Illinois residents like Ken Griffin, founder of Citadel, who is pouring millions into advertisements against it.

Opponents argue the tax could further drive higher-end residents out of state and that the state can’t be trusted with an infusion of new tax revenue without structural changes on spending and pension debts. Opponents also believe that lifting the flat tax requirement could usher in higher taxes on the middle class and make it easier to swallow a small tax on retirement income. Illinois is one of three states that does not tax retirement income.

“There’s no new taxing power. The idea here is to make it fairer. The existing ability for the general assembly to raise revenue or to keep revenues the same or to decrease revenues in the state — that doesn’t change,” Pritzker said last week.

To pass muster, the amendment requires either 60% support among those voting on the question or more than 50% of those casting a ballot.

The Illinois Municipal League has taken no position because the state has not committed to restoring cuts to the percentage of income taxes shared with local governments, but Chicago Mayor Lori Lightfoot supports the change.

The Center for Tax and Budget Accountability agrees with Pritzker on the fairness issue. “It is unfair because such a system fails to allocate tax burden in a manner that correlates with ability to pay, thereby worsening the substantial growth in income inequality that has occurred in the private sector over the last four decades,” the think tank writes of the current system.

The Tax Foundation recently issued a report in opposition warning that the state would reduce its competitiveness because the change would impose some of the highest individual and corporate income taxes among states. The neighboring states of Indiana, Iowa, Kentucky, and Missouri have all cut income taxes in recent years, it said.

“Illinois would trail its peers in just about every aspect of its tax code. If businesses and individuals are leaving the state now, these policies can only make the problem worse,” said Senior Policy Analyst Jared Walczak.

The civic arm of a prominent Commercial Club is opposed in the absence of structural budget and policy reforms. “The result will be further loss of jobs and people, long-term cuts in critical social services, a shrinking tax base burdened with growing debt, and a guarantee that Illinois will continue to have the worst credit rating of any state in the country,” a statement read.

Rating agencies affirmed the state at the lowest investment grade level with negative outlooks and red flags throughout the reports over the decisions coming due on borrowing and spending that will guide whether the state avoid a cut to junk.

None of the three say a failed referendum would trigger a downgrade, but the state will need to tread cautiously and action would be needed during the state’s annual fall veto session in late November.

“A downgrade could be triggered by the lack of a credible path to reversing those measures quickly, once an economic recovery finally takes hold, or by a reliance on short-term measures that materially compound the state’s long-term challenges such as its pension liability burden,” Fitch said.

Fiscal measures that greatly add to the state’s near- or long-term liabilities including a reduction in pension contributions to provide fiscal relief and a large or persistent structural imbalance that leads to significant increase in the state’s unpaid bills or other liabilities could drive a downgrade, Moody’s said.

“With the need for additional borrowing, an elevated bill backlog, and lingering substantial structural imbalance, Illinois could exhibit further characteristics of a non-investment-grade issuer,” S&P Global Ratings has warned.

The state closed out fiscal 2020 with a $210 million surplus after closing the shortfall caused by $2.7 billion of COVID-19 wounds to tax collections as revenues performed about $300 million better than the revised estimates. Revenues were revised downward by $4.6 billion for fiscal 2021 but the state will also need to repay $500 million in internal fund borrowing and $1.2 billion of notes.

The state’s list of issues it advises potential buyers of under “investment considerations” covers the weight of its debt from a $7.3 billion bill backlog — which was up to $8.3 billion last week — and a $137 billion pension tab for a system just 40.3% funded as well as the pandemic’s ongoing impact.

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