Illinois bond yields rise amid worry over credit rating downgrade

Illinois' bond yields have jumped sharply after the local Supreme Court last week ruled that measures aimed at narrowing a yawning pension deficit were unconstitutional, raising the prospect of another credit downgrade for the lowest rated US state.

The downward pressure on bond prices, which move inversely with yields, stands to hurt investors, including pension plans that own paper issued by the mid-western state, focusing renewed attention on the US municipal debt market. Investors are attracted by the tax advantages afforded by owning municipal debt, particularly in US states that have high local tax rates.

Illinois' 2033 bond rose as much as 16 basis points higher to 5.47 per cent on Monday, according to Bloomberg pricing in the wake of the state's Supreme Court unanimously ruling against a pension reform package passed in 2013. Illinois sought to reduce its pension liability by $21bn by tweaking some of its benefit provisions, but that was deemed as breaking the state's constitution said the court.

John Mousseau, a director of fixed income at Cumberland Advisors, expects further weakness for Illinois bond prices and noted to clients: "With Illinois unable to gain relief from its staggering pension costs, expect to see massive cutbacks in the state government. This may be easier said than done."

Governor Bruce Rauner is already scrambling to come up with ways to plug a budget deficit estimated at $6.7bn in the fiscal year starting July 1, and the Supreme Court setback could cost the state its already lowly "A-" credit rating from Standard & Poor's and Fitch, and A3 from Moody's.

Standard & Poor's last week put the Illinois on "CreditWatch with negative implications," and Moody's published a bearish note on the fiscally challenged US state.

"Although our rating on the state had assumed these measures would not be implemented, rejection of the pension benefit legislation puts the state under increased pressure to devise a way to pay for liabilities created through decades of insufficient contributions," Moody's said in the report.

One partial solution could be for Illinois to push the funding burden for teachers and university staff pension plans down to school districts and universities, but this would weigh heavily on the creditworthiness of local governments and state universities, Moody's noted.

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"To date, the state has not tried to orchestrate a funding strategy that assumes it will need to satisfy the existing pension liabilities over the long term," the Moody's report noted.

A senior municipal bond banker last month told the FT that Illinois could be a bigger longer term risk than Chicago, the state's biggest city, which is itself struggling to restore the health of its finances. "Illinois scares me a little bit, they haven't acknowledged their problems for 20 years," he said.

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