06/03/2013 12:01 am ET Updated Aug 03, 2013

Illinois Pension Reform: Credit Concerns Rise After State Legislature's Failure


By Karen Pierog

CHICAGO, June 3 (Reuters) - Illinois' governor and lawmakers this week hope to revive efforts to address the state's pension funding crisis, but the cloud over the state's credit remains dark in the wake of the state legislature's failure on Friday to pass pension reform before it adjourned.

Illinois' general obligation bond rating, already the lowest among U.S. states, could fall even lower, and investors who buy the state's debt are likely to demand higher interest rates to take on increased risk, market participants told Reuters. The state is expected to sell up to $1 billion of general obligation bonds as early as this month as part of a $31 billion capital improvement program.

"I think (lawmakers) just provided support for the rating downgrade," said Richard Ciccarone, a managing director and chief research officer at McDonnell Investment Management. "And even if there is no downgrade, the state moved a notch deeper into the risk zone."

The three major credit rating agencies are closely monitoring the state's progress on dealing with a nearly $100 billion unfunded pension liability that is threatening funding for core state services such as education and public safety.

A Moody's Investors Service analyst on Friday repeated a warning that the agency could cut Illinois' A2 rating if efforts at pension reform failed.

Fitch Ratings already had put the state's A rating on a watch list for a possible downgrade due to the inability to address pensions. And Standard & Poor's Ratings Services in January cited a lack of action in pension reform when it downgraded Illinois' $26.6 billion of outstanding GO bonds to A-minus with a negative outlook.

Governor Pat Quinn and some state lawmakers warned about the potential downgrade as the Democrat-controlled legislature wound down its spring session. But pension reform fizzled as House Speaker Michael Madigan and Senate President John Cullerton remained at odds over the best approach.

Madigan was backing a plan that would unilaterally require current workers and retirees to accept reduced pension benefits, while Cullerton's approach would give them choices about how benefits might be cut.

Laurence Msall, president of the Civic Federation, a Chicago-based government finance watchdog group, said that without reform, pension costs are not sustainable.

"It's both disappointing and frightening that our legislature has allowed this situation to further degrade," he said, pointing out that pension payments, including debt service on outstanding pension bonds, will top $7 billion or 22 percent of the fiscal 2014 general fund budget and that amount will climb to almost a third of the budget in the coming years.

Quinn plans to meet with legislative leaders this week to try to forge a compromise.

Credit markets will closely monitor the pension negotiations, said Robert Amodeo, portfolio manager at Western Asset who helps oversee $30 billion in municipal assets.

"It will take some time before the market penalizes them. It will give them some time to call a special session," he said. "If talks break off, the marketplace will penalize them."

Illinois' so-called credit spread over Municipal Market Data's benchmark triple-A scale for the municipal market stood at 140 basis points in the latest week, the second widest spread after Puerto Rico among major muni debt issuers tracked by MMD.

Illinois' spread is three times that of California, which has taken steps to deal with its financial problems.

"Illinois is trading already below everything else and on the market, timing could not be worse," said Gregory Serbe, President of Lebenthal Municipal Asset Management. "Bonds in general gave up so much and we may see some widening of the spread on Illinois GO bonds from Monday."

Ciccarone said the state has until now benefited from historic low interest rates in the $3.7 trillion tax-exempt bond market as investors stretch for higher-yielding bonds. However, if overall rates continue to climb, Illinois' credit spread could widen.

"They've made the task of financing Illinois harder by their inaction in Springfield," he said, referring to legislators in the state capital.