Many investors think of Michigan, the home of Detroit, as having troubled finances, but actually Illinois tops the list as the worst-rated state in the country. After seven months without a budget, the state decided to sell $480 million worth of general obligation bonds to pay for transportation projects. It will still have to pay a field of 4.2% for that debt, which is a full 1.5% higher than benchmark debts and 0.4% greater than its last bond sale.
Below, MunicipalBonds.com takes a closer look at Illinois’ financial situation to determine if the state’s high-yielding bonds are a good investment opportunity.
Political Turmoil
Illinois Republican Governor Bruce Rauner has been battling the Democrats who control the General Assembly for over seven months to approve a state budget. Along with the budget, Gov. Rauner has attached a number of pro-business, union-weakening measures that the General Assembly believes will limit workers’ rights and hurt the middle class. Many state programs – including universities – have been pinching pennies in the meantime.
The governor believes that an agreement will be reached between January and April of this year, but lawmakers on both sides remain firmly entrenched in their positions. With some universities threatening to close their doors as early as March, lawmakers are likely to reach some kind of consensus in order to maintain their political strength among voters. Many other government programs have also been cut or scaled back beginning this year.
Low Credit Ratings
Illinois’ political and fiscal turmoil since 2009 has led to a series of downgrades from the three major credit rating agencies. The latest downgrades came from Moody’s and Fitch, who downgraded the state’s bond from A- to BBB+, which is just three steps above “junk” levels. S&P maintains an A- credit rating for the state. According to the agencies, Illinois’ financial condition could weaken further due to an impasse with the governor and legislature with no plan in place.
Aside from the impasse, the agencies expressed concern over the state’s $111 billion unfunded pension liability. Plans had been drawn to cut benefits in order to reduce the liability, but the state Supreme Court voided the law, which limits options for regulators. Triple-B-rated bonds still found a home in the credit markets, but the high costs of these bonds means that the state may simply be kicking the can down the road rather than addressing the problem.
Few Real Risks
Illinois collects more than $3,000 per capita in state and local taxes each year, making it one of the highest per capita tax revenue-generating states. While its fiscal management system isn’t functioning properly, there is still revenue to back bond repayments, and the likelihood of default is seen as being very low. There’s sufficient liquidity and cash flow to continue making monthly payments to bond holders, which means the state is not another Puerto Rico or Detroit.
For investors, this means that the 4.2% bond yield could be an attractive income-investing opportunity for those willing to hold the bond through maturity. The big risk is that the state will get worse before it gets better, sending prices lower and yields higher in the future. Investors that were planning on selling the muni bonds rather than holding them through maturity could then face losses on their investment as lawmakers struggle to come to an agreement.
The Bottom Line
Illinois is experiencing a troubling budget crisis that threatens to shut down schools and public services. This has caused credit agencies to downgrade the debt to near-junk levels. Despites its political troubles, the state does have sufficient liquidity and cash flow to continue servicing its debt payments, and as such, default risks remain low. Investors planning to hold these bonds through maturity may want to consider them, but others may want to wait for a budget to shake out.
