Worst-rated Illinois may lose market-beating return: muni credit

Illinois, which shares with California the lowest credit rating among U.S. states, is unlikely to outperform the $3.7 trillion municipal-bond market again in 2012 as lawmakers consider undoing a corporate-tax increase that helped balance this year's budget.

“The downside seems bigger than the upside” if lawmakers roll back the higher tax rates, said Guy Davidson, director of municipal investments at AllianceBernstein LP, which holds $30 billion of the debt. The firm has pared Illinois general- obligation bonds to 2 percent of its holdings from 3 percent in the first quarter of 2011, Davidson said.

“The bonds are a little expensive; I don't see them rallying a lot,” New York-based Davidson said. “Illinois had the political will to raise taxes, at least temporarily, but they've done very little to cut expenses.”

State and local debt issued in Illinois has returned 12.4 percent in 2011 through Dec. 27, according to Barclays Capital municipal indexes tracking prices and interest income. That's more than the 10.2 percent return for the overall market. It's the second-best among states after Wyoming's 12.7 percent.

U.S. states are confronting the fourth straight year of budget deficits as costs for pensions, health care and debt outstrip economic growth. They're also bracing for cuts in federal aid, the source of almost 30 percent of their revenue, as the U.S. deals with its deficit.

Illinois, the fifth-most-populous state, has an accumulated deficit of as much as $5 billion, or about 15 percent of its $33 billion budget, said Neene Owate, a municipal-bond analyst at AllianceBernstein.

Rolling back the tax increase risks inflating the deficit and weakening the state's creditworthiness. Illinois has $85 billion of unfunded pension liabilities, a long-term practice of delaying payments to vendors and of borrowing to balance budgets.

“They're hoping for economic growth to increase and grow out of their problem,” Davidson said. “You've got to have a lot of surpluses to work that down, and you have a tax increase that will expire at least by 2015 if not sooner.”

Lawmakers in January boosted personal and company income- tax rates 67 percent, the most in the state's history, to help close a $13 billion budget deficit. The state was coping with a backlog of more than $6 billion in unpaid bills and almost $4 billion of missed payments to underfunded pensions.

Personal income-tax rates went to 5 percent from 3 percent and company rates to 7 percent from 4.8 percent. The increases generated $6 billion for the fiscal year that began July 1.

Lawmakers have proposed reducing the corporate rate sooner than scheduled, an attempt Governor Pat Quinn would veto, said Tom Spalding, a senior vice president for Nuveen Investments Inc. in Chicago.

He favors bonds from higher-rated states such as Maryland, Virginia, Florida and Texas.

“The ones who control their own destiny in terms of spending and tax collections should do better next year,” Spalding said.

The Barclay's index for Illinois includes 1,889 bonds; Wyoming has six. The Wyoming index has an average maturity of 26.1 years compared with 14.3 years for Illinois.

Illinois bonds in a Standard & Poor's index of municipal debt haven't fared as well when price volatility is taken into account. Debt issued by borrowers in the state has a risk- adjusted return of 4.213 percent this year, according to data compiled by Bloomberg. Illinois ranks eighth among the S&P indexes by that calculation, behind others including California, Hawaii and Minnesota.

Lowest Rated

Illinois and California are the lowest-rated states by Moody's Investors Service at A1, its fifth-highest investment grade. Debt rated A has returned almost 3.7 percentage points more than AAA rated municipal bonds this year, according to the Barclays indexes.

Illinois general-obligation bonds maturing in five years currently yield about 1.35 percentage points more than AAA rated municipal bonds, Nuveen's Davidson said. In March, Illinois debt yielded as much as 2.3 percentage points more, he said.

The bonds benefited as the state closed its budget deficit and investors sought better returns in higher-yielding bonds, Davidson said. They'll be influenced next year by Quinn's spending-cut proposals and whether he can get them passed the Legislature, he said.

Bonds of California, with a budget that includes automatic spending cuts if revenue doesn't meet projections, will outperform Illinois, Davidson said. Governor Jerry Brown is readying $1 billion of cuts next month.

“California has more upside because it has mechanisms in place,” Davidson said.