June 19, 2013

Relax, Bondholders, Illinois Won't Default

Marc Joffe

Principal Consultant, Public Sector Credit Solutions

Illinois is arguably in the worst financial condition of any U.S. state. But is it on the doorstep ofbankruptcy? If you were judging by the fruitless endeavors of the state’s legislature, you just might be fooled into thinking that default was a real possibility.

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(Corrects tax status of Illinois bonds in 10th paragraph.)

Illinois is arguably in the worst financial condition of any U.S. state. But is it on the doorstep of bankruptcy? If you were judging by the fruitless endeavors of the state’s legislature, you just might be fooled into thinking that default was a real possibility.

The lawmakers convened a special session yesterday intended to reduce the public alarm over the “Illinois Is Broke” headlines, then promptly punted the state’s retirement-funding problems to a joint conference committee and yet another special session after July 4. Both the bond market and the rating companies seem to have concluded that such failure to take action on pensions creates a serious risk of default.

Earlier this month, Fitch Ratings and Moody’s Investors Service (MCO) responded swiftly to the legislature’s previous failure to act on pension reform, downgrading the state’s general-obligation bonds to A- and A3 respectively, just four notches above junk status.

The implication is that Illinois bonds carry significant default risk -- meaning that bond investors face the prospect of delayed or reduced interest and principal payments. Taxpayers are paying for this perception of heightened risk through higher yields on Illinois bonds:Bloomberg News recently reported that Illinois bonds were yielding 1.43 percentage points more than bonds issued by the safest states.

But investors don’t face as much risk as the low ratings and high interest rates imply, as I find in a forthcoming working paper on Illinois credit risk to be published by the Mercatus Center. Pension underfunding may be undesirable, but it isn’t a major threat to municipal-bond holders.

Clean Record

Illinois (STOIL1) has defaulted before -- in 1842. The state has thus had 170 years of clean credit. In fact, no state has defaulted on general-obligation bonds since 1933. So the entire asset class has an 80-year record of consistent performance -- far better than the AAA rated residential-mortgage-backed securities and collateralized-debt obligations that melted down during the financial crisis.

And if you look at the reasons for the 1933 defaults in other states, you see why they haven’t occurred since. Louisiana temporarily defaulted that year because its funds were tied up in a failed bank -- something that no longer happens in the era of Federal Deposit Insurance Corp. support. While Arkansas defaulted due to a fiscal crisis, investors received all overdue principal -- albeit with a substantial delay.

When Arkansas defaulted, its interest costs were 30 percent of total revenue. My analysis of Illinois today evaluates the risk of its reaching this 30 percent threshold over the next 30 years. The 30 percent interest-to-revenue ratio does a good job of representing the factors affecting the decision of state officials to pay or default on bond obligations.

On the one hand, high interest costs crowd out other spending priorities, which is bad news for voters, and thus elected officials. On the other hand, defaulting means embarrassment and a temporary loss of access to the debt market, sharply halting deficit spending. The interest crowd-out effect would have to become pretty drastic for a rational politician to take the consequences of defaulting.

It could be argued that a 30 percent ratio is too high in an era when bondholders are held in less regard than they were back in the 1930s, but there is a big difference going in the other direction. Depression-era Arkansas bonds were primarily held outside the state; a larger proportion of states’ bonds are held in state today (often for tax reasons).

Thus, today’s municipal bondholders are a political constituency -- one that contributes to campaigns and votes.

Pension Protection

One other thing has changed since the 1930s: the legal protection for public-employee pensions, which are now virtually inviolate. So instead of looking at the interest-to-revenue ratio, I used a ratio of interest plus pension expenses to total revenue -- thereby considering the state’s two biggest uncontrollable costs together.

Total revenue is used rather than general fund revenue because states have the flexibility to lend money between funds to meet emergency spending needs -- such as averting an interest default.

In fiscal 2012, interest and pension costs accounted for about 10 percent of total Illinois revenue, far short of the feared 30 percent threshold. Yet with its severe pension underfunding, couldn’t Illinois quickly reach this threshold? A good way to think about this risk is to imagine what would happen if all state pension funds were completely exhausted. In that case, Illinois would cover pension expenses on a pay-as-you-go basis, just as the federal government does with Social Security (when you consider that the Social Security fund’s “assets” are just Treasury bonds).

If there had been no pension-fund assets in 2012, the interest-plus-pension expense over total revenue ratio would have been 12.7 percent instead of 10 percent -- still nowhere near the breaking point. It will rise somewhat in the near future, but will most likely fall back in the 2030s and 2040s as retirees receiving more generous public-sector benefits are replaced by those eligible for smaller benefits under a new system Illinois adopted in 2011.

While the state’s pension underfunding isn’t a serious risk for bondholders, it doesn’t make it right to transfer burdens to future generations -- those who may be less affluent than baby boomers. Meanwhile, even if state officials fail again to act, taxpayers shouldn’t be doubly penalized by having to pay interest rates reflecting an unjustified risk premium.

Clearly, bond-rating companies have much to answer for, but consider one parting fact: The ratio of debt to gross state product of Illinois is about 6 percent, and it has ratings in the single A range; Ontario, Canada, with a similar population and similar-sized economy, has a debt-to-gross-domestic-product ratio of 39 percent and ratings in the double A range. Something doesn’t quite add up.