What's a Bond Rating Worth?

Nov 1, 2012

At the very least, downgrades lead to negative press; at the worst, taxpayers pay a price.

When it comes to Illinois’ bond rating, what’s past is prologue.

Joan Walters was director of the Bureau of the Budget under Republican Gov. Jim Edgar, whose administration is fondly thought of by some at the Statehouse as the last truly fiscally responsible gubernatorial administration. 

During Edgar’s first four-year term as governor, Moody’s Investors Service, one of the two major credit agencies that rated Illinois at the time, downgraded Illinois’ bond rating three times, according to the state comptroller’s office. The state went from an Aaa rating in June 1990 to an A1 rating in February 1995. Standard and Poor’s downgraded Illinois twice during the same period. An A1 rating is one step above the state’s current A2 rating, which it received after racking up $8 billion in unpaid bills and $83 billion in pension debt, for which the credit rating agencies have repeatedly scolded the state and urged it to address.

When Edgar came to office, the state faced a $1 billion deficit and was months behind in paying its bills for Medicaid, the state-federal program to provide health care for the poor and nursing home care for low-income seniors. And unlike current Gov. Pat Quinn, Edgar intended to solve the problem without raising taxes.

“We got downgraded constantly,” Walters recalls. “They were almost an impediment. We set out to get the state on a good standing. The irony was, it was the previous administration that had built up all this debt for Medicaid, and they had a great rating. And then we come in, address it, actually make it transparent. We admitted to the payment cycle. We did drastic cuts. The governor was a no-new-taxes person, and the rating agencies just went batty.

“We never stopped cutting until we had sufficient resources to be a decent partner. Our goal was really to be a good business partner, and you weren’t that when you didn’t pay your bills.” 

The state has never been awarded a coveted Aaa rating since, with the high point being an Aa2 rating between June 1998 and June 2002. 

But does it matter? The result has been bad public relations, along with additional costs to taxpayers in the form of higher interest payments, but Wall Street has never turned its back when Illinois came calling with its hand out. The reason is relatively easy to understand.

Today, Illinois has the worst credit rating of any state, as measured by Moody’s, and the second-lowest credit rating of any state, as measured by S&P. By one estimate from the Chicago-based Civic Federation’s Institute for Illinois’ Fiscal Stability, a budget watchdog group, the state’s falling credit rating has cost taxpayers $550 million in interest payments for borrowing done between September 2009 and July 2010. Each downgrade draws new media focus on the state’s addled fiscal state, creating negative headlines.

But the state still has access to the credit market and no problem getting investors to purchase its bonds. Its A2 rating by Moody’s and A rating by Standard and Poor’s still mean that both agencies consider the state to have a low risk of defaulting on any money it is loaned. The ratings agencies have made a few positive comments about the state’s actions concerning the budget, particularly the decision to raise the state’s individual income tax in 2011 from 3 percent to 5 percent. 

“In the last three years, we’ve gotten pension reform, tax increases, workers’ compensation, reform of unemployment insurance, reform of EPA permitting,” says John Sinsheimer, the state’s director of capital markets, whose job is partly to be the main contact investors and the credit rating agencies have with the state. “The list goes on and on. Illinois Jobs Now is the first capital [construction] program in over a decade. It was passed in 2009 as a bipartisan program. 

“The will to govern in Illinois is alive and well. Admittedly, it can be a bit noisy. Admittedly, it can be a bit messy. Ultimately, the investors understand the will to govern does exist, and things do get accomplished.”

While a few investors might feel warm and fuzzy about the politics at the Statehouse not being as bad as they seem on the surface, experts say the one thing that truly gives them confidence that they will get their money back if they loan it to Illinois is in Article IX, Section 9, of the Illinois Constitution, along with state law concerning bonds. The Constitution says that debt is backed by the full faith and credit of the state. 

“We have a series of statutory and constitutional statements that really force the comptroller to reserve money as cash comes in at the beginning of each month, and then on the last business day of the month, she’s required to transfer monies into the general obligation bond retirement and interest account,” Sinsheimer says. “Because of the way the general obligation bond act is written, she understands if she fails to do that, we can compel her to do that.”

That’s not always the case in other states. In California’s referendum-laden constitution and statute book, a chunk of tax revenue has to go to education before a dollar is set aside for bondholders.

“In fact, California called us wanting samples of our language, our statutory language,” Sinsheimer says. 

Richard Ciccarone, managing director and chief research officer at Chicago-based McDonnell Investment Research LLC, agrees that the state has strong statutory provisions in place. Section 15 of the General Obligation Bond Act requires the comptroller to transfer money each month sufficient to pay the interest and principal on state-issued bonds before they are due to be paid back.

“They’re saying we think we’re still going to get paid,” Ciccarone says of the agencies’ credit ratings of Illinois. “In the case of a lot of investors, they feel that because of the track record of states — which is one official default during the (Great) Depression and none since — and because of state’s provision that they’re going to set aside [some] of each month’s cash toward debt service, that you wouldn’t have an issue here of not being able to pay.”

However, Ciccarone says there are no risk-free investments, and investors must consider all scenarios, even ones that may seem far-fetched.

“I’ve always been concerned personally about any crisis in which it could get so bad, in which there would be a choice that has to be made between employees and debt service,” he says. “You don’t want to be in a situation where you’re only paying your bondholders and not providing essential services of government.” 

The country’s poor economy, which the Federal Reserve has tried to bolster by keeping interest rates low, led to the state’s receipt of a record-low interest rate when it went to the bond market in January. In August, the initial sale of $50 million in 10-year technology bonds yielded investors 2.49 percent, a rate Sinsheimer says would have been even lower if the state had not been downgraded.

“If you’re going to have a credit crisis, and you think it’s temporary, this is a good time to have one because you’re in a period of absolute low rates, and the penalty difference is not as great as it could be and will be if you have a change in interest rates,” Ciccarone says.

While 2.49 percent seems low, Illinois stacks up quite unfavorably to blue chip, Aaa-rated states. When compared with other states with lousy credit, Illinois’ bonds weren’t doing well in after-market trading when Illinois Issues checked on September 24.

Thompson Reuters has a municipal bond market monitor that measures the best Aaa-rated bonds. The best Aaa bonds received interest rates of 1.78 percent, according to the Thomson Reuters scale that day. Ten-year Illinois bonds, based on representative trades, yielded 3.8 percent. Investors received a 2.45 percent yield on California-issued bonds. Investors received a 1.93 percent yield on bonds issued by Texas.

“The interest rates at which they were paying on an absolute basis are low by historical standards, but they are above what you would pay for a similarly rated credit ... for other states,” Ciccarone says. 

“They’re able to access the market. They’re a major, major borrower. They [investors] would consider the liquidity of state government to be something desirable, particularly when they’re getting better yields on it. Right now, there’s enough to make it possible for the state to issue new debt. But they’re doing it at a price for their credit weakness.”

Part of the reason California’s interest rates are lower is because it, like most states and the federal government, exempts interest earned on its bonds from income taxes, known in financial circles as being “double exempt.” Illinois does not have a complete income tax exemption on interest for bonds it sells. 

“It’s partly due to the fact they’re double tax-exempt there,” Ciccarone says of the interest rates on California bonds. “It’s hard to say all of that’s due to a double tax exemption … in part it’s due to the market perception of Illinois’ credit quality.”

The credit rating agencies failed to predict the collapse of Aaa- or AAA-rated companies during the 2008 financial crisis, so investors are increasingly doing their own credit examination of borrowers and using Moody’s, S&P and the third agency, Fitch, as a checkpoint for their own work. Sinsheimer believes investors actually view Illinois more favorably than the ratings agencies.

“Their analysis of the risks that state faces, plus their analysis of, politically, does the state have the will to govern and to get things done, leads there to be more investors,” Sinsheimer says. 

“From the analysts I talk to and the investors I talk to, I don’t think that’s true,” Ciccarone says, when asked if he thought Sinsheimer’s analysis was correct. “I think there’s a case to be made that they view it as worse.” 

Ciccarone pointed to the wide spread between Aaa-rated bonds and the state of Illinois’ rates.

“If interest rates go up and there’s no cure for the state of Illinois on its financial fix, that difference will be even more.”

But there is another measurement for the health of the state’s credit — how much investors pay for the now-famous financial instruments that were one factor in nearly bringing down the whole economy.

When sizing up the health of a state’s bonds, looking at the price of its credit-default swaps — which are basically an insurance policy that pays out to the investor if the state defaults — can also be a useful measurement, although CDSs are not as widely used for state bonds as they are for corporate bonds. 

Illinois’ credit-default-swap price had fallen to 263 basis points on September 28, a 24-point decrease since S&P downgraded the state from A+ to A on August 28, when it was 287 basis points, according to Markit Intraday, a firm that prices CDSs. That means it would cost $263,000 to insure $10 million of Illinois debt over 10 years. 

“Illinois has come down around bond sale ... this is probably where John gets a little bit more confidence is he sees the CDS market has improved,” Ciccarone says. “It’s like a [public opinion] poll. And from a poll standpoint, this poll just improved for the state of Illinois since September.”

The intricacies of the bond market aside, the state’s low bond rating is costing real money. The Civic Federation analysis compared the interest rates received by other states with what Illinois got for its $9.6 billion in bonds between September 2009 and July 2010 and calculated how much additional money it would cost the state, coming up with $550 million as a worst-case scenario. By point of comparison, the governor proposed spending $96 million on the Department of Agriculture, $289 million for the Department of Natural Resources and $403 million on the Illinois State Police in his Fiscal Year 2013 budget.

“I wouldn’t disagree. I think there’s a wide variation based on how you calculate it,” Sinsheimer says. “We’ve been saying that for a long time. Being downgraded does cost us more. It will take money away from other programs, which is why it’s so vital that we address the challenges that are facing the state and address them quickly.”

The bond rating shouldn’t be the motivation to deal with the state’s problems anyway, Walters says.

“We’re losing partnerships for services. If we expand Medicaid, where are we going to find doctors that are willing to wait that long for payment? Those are the issues that we should be focused on. To me, the bond rating is only a flash in the pan indication, perhaps a sign of increased debt in the future if we’re paying higher interest rates,” she says.

“What should be the driver is that if we don’t get this under control, the annual cost to [fund] the pension system is going to be more than we can afford without cutting programs even more while we try to pay bills on time. I think people have become inured to it. Perhaps they’re doing us a favor by making a big deal out of it and reminding everybody that we can’t just sit back and forget everything’s OK.” 


The Rating Agencies

Illinois Bond Ratings


Chris Wetterich is interim editorial page editor at The State Journal-Register and has covered government and politics in Springfield since 2005.

Illinois Issues, November 2012