Fitch Rates $750MM Illinois GO Bonds 'A-'; Outlook Remains Negative

Fitch Ratings has assigned an 'A-' rating to the following general obligation (GO) bonds of the state of Illinois:

--$750 million GO bonds, series of May 2014.

The bonds are expected to sell via negotiation April 25, 2014.

In addition, Fitch has affirmed the 'A-' rating on approximately $28.2 billion outstanding GO bonds of the state of Illinois.

The Rating Outlook remains Negative.

SECURITY

Direct general obligation, full faith and credit of the state of Illinois.

KEY RATING DRIVERS

BUDGET TEMPORARILY STABILIZED WITH TAX INCREASE: Temporary increases in both the personal and corporate income tax rates, coupled with statutory spending limits, have closed a significant portion of the structural gap in the state's budget through the current fiscal year 2014.

NEED FOR LONG-TERM SOLUTION REMAINS: Due to the temporary nature of the enacted tax increases, the state will need to find a more permanent solution to the mismatch between spending and revenues. The Negative Outlook reflects the critical need to address this issue. The governor's recommended budget for the coming fiscal year would make these tax increases permanent and provide a basis for the state to achieve fiscal balance.

LARGE BALANCE OF DEFERRED PAYMENTS REMAINS: The state has a large general fund accounts payable backlog, which although reduced still totaled $4.2 billion at the end of fiscal 2013. The state prudently used higher than forecast income tax collections in fiscal 2013 to pay down a portion of the accounts payable balance.

LONG-TERM LIABILITIES HIGH: The state's debt burden is above average and rose during the recession with issuance for operational purposes. Continued borrowing is expected under the $31 billion capital plan. Further, unfunded pension liabilities are exceptionally high and are expected to remain so, even if pension reform survives legal challenge.

ACTION ON PENSIONS: Passage of pension reform legislation was a positive indication of the state's willingness to take action on this complicated issue after many failed attempts. Legal protection of pension benefits is particularly strong in Illinois and, as expected, legal challenge to the reform has been filed.

ECONOMY STRONG BUT RECOVERY SLOW: The state benefits from a large, diverse economy centered on the Chicago metropolitan area, which is the nation's third largest and is a nationally important business and transportation center.

RATING SENSITIVITIES

Maintenance of the 'A-' rating will require timely action in advance of the expiration of temporary tax increases in fiscal 2015. Deterioration in the state's financial position, as evidenced by excessive use of non-recurring revenues or additional payment deferrals, would likely lead to a downgrade. In addition, stabilization of the rating will reflect the extent to which pension reform enhances the funding levels of the pension systems and controls the growing impact of pension payments on the budget.

CREDIT PROFILE

Fitch's 'A-', Negative Outlook, on Illinois' GO bonds reflects the state's record of unwillingness to address numerous fiscal challenges, which as a result steadily increased in magnitude. In December 2013 the state did take a significant and positive step toward addressing one of these challenges with passage of pension reform legislation, (Act 98-0599) after several prior failed attempts. The measures are being challenged as unconstitutional; however, if the reform survives legal challenge it would reduce unfunded liabilities and temper the growth in pension payments required by the state.

A key remaining near-term challenge is the need for timely action on a more permanent budget solution to the structural mismatch between spending and revenues in advance of the expiration of temporary tax increases. Temporary increases in both the personal and corporate income tax rates that have been supporting the budget since 2011 are scheduled to begin to phase out in mid-fiscal 2015, which begins on July 1, 2014. The governor has proposed a budget alternative for fiscal 2015 that would make permanent these temporary increases and legislative leadership has indicated there is support for this approach.

HIGH LONG-TERM LIABILITIES

Illinois' long-term liabilities, particularly pension liabilities, are very high for a U.S. state and are expected to remain so even with improvement in pension funding from pension reform. Illinois is among the weakest of the states in terms of its ratio of debt and unfunded pension liabilities to personal income, at 25%, well above the median for states rated by Fitch.

As of the most recent actuarial valuation, dated June 30, 2013 and prior to enactment of Act 98-0599, the unfunded actuarial accrued liability was reported at $100.5 billion, resulting in a system-wide 39.3% reported funded ratio. Annual pension funding requirements have been increasing significantly and growing pension payments have been crowding out other expenditure growth and absorbing revenue growth. Pension payments from the general fund increased $972 million to $5.1 billion in 2013, an increase of 23%, reflecting in part the use of more conservative investment return assumptions. Pension payments increase a further 17.3% to $6 billion in fiscal 2014 and are scheduled to increase slightly to $6.1 billion in fiscal 2015. The governor's budget proposal prudently does not assume any savings from pension reform, given the ongoing legal challenge.

Pension reform is expected to both reduce unfunded liabilities and temper the growth in pension payments required by the state. Fitch believes the enacted reforms would provide a substantial improvement in the funding scheme for the state's pensions by moving to a closed ARC funding schedule with a goal of 100% funding (versus the prior statutory plan that only targeted 90% funding) and requiring significant payments above what the ARC would indicate once outstanding series 2010 and 2011 pension obligation bonds mature. Fitch has stated that pension reform that enhances the funding levels of the pension systems and controls the growing impact of pension payments on the budget is necessary to stabilize the credit. The state's actuarial analysis of the reform estimated savings of $145 billion over the next 30 years and a $25 billion reduction in unfunded liabilities should the reforms be found constitutional. Legal protection of pension benefits is particularly strong in Illinois and while the state believes it has made sufficient accommodation to survive the constitutional challenge, the outcome of litigation is unknown and could have a negative impact on the state's future fiscal operations.

The state's net tax-supported debt, at 5.9% of 2013 personal income, is at the high end of the moderate range and debt levels have increased with the state's issuance of GO bonds for operational purposes in fiscal years 2010 and 2011. Illinois provides a strong GO bond pledge, including an irrevocable and continuing appropriation for all GO debt service, and continuing authority and direction to the state Treasurer and Comptroller to make all necessary transfers from any and all revenues and funds of the state. The state funds debt service one year ahead on a rolling 12-month basis.

COMPREHENSIVE BUDGET SOLUTIONS STILL NEEDED

The temporary increase in tax revenue, in conjunction with enacted hard spending limits moved the state closer to budgetary balance for fiscal years 2011 through 2014. Medicaid reforms implemented in the fiscal 2013 budget also made significant progress toward alleviating some pressure on the general fund. However, under current law the tax increases will begin to phase out in 2015; thus, the state is once again faced with a significant budget balancing decision to make permanent the tax increases, make severe expense reductions, or identify new revenues.

The governor has proposed two alternative budgets for fiscal 2015; one based on current law with expiring tax rates and a second recommended budget that makes permanent the higher tax rates. The current law budget is balanced through large spending cuts. Even with the higher taxes maintained, however, the recommended budget would rely on a small interfund borrowing ($170 million or 0.4% of forecast general fund revenues) to balance. The recommended budget includes a total of $650 million in interfund borrowing, the balance of which would be used to pay down accumulated accounts payable.

The enacted budget for fiscal 2014, which began July 1, was conservatively based on an assumed decline in revenue following a strong fiscal 2013 and controlled most discretionary spending to accommodate growing pension payments and increased healthcare expenses. Despite the assumption of reduced revenues, tax revenues through March have increased 4.4% on a year-over-year basis. Solid year-over-year growth is seen in personal income tax receipts (+4.1%), corporate income taxes (+8.4%) and sales and use taxes (+4.1%). The budget is expected to be balanced on an operating basis within the limitations of the pre-reform pension funding schedule, but does not address the accumulated accounts payable backlog beyond applying any operating surplus to reducing the backlog.

MODERATE ECONOMIC GROWTH

The Illinois economy is centered on the Chicago metropolitan area, which is the nation's third largest and a nationally important business and transportation center. Illinois' economy has gradually shifted, similarly to the U.S. in general, away from manufacturing to professional and business services. The remaining manufacturing sector includes more resilient non-durables, and is less concentrated in the auto sector than are surrounding states (Indiana, Michigan, and Ohio). While the state economy was not as negatively affected by the recession as some of these neighboring Midwestern states, it did contract faster than the national economy. Total non-farm employment declined 4.9% in 2009, versus the national rate of 4.3% and essentially matched the U.S. rate of decline at 0.8% in 2010. Modest growth resumed in 2011 with year-over-year job gains of 1.1% followed by 1.3% growth in 2012 and 0.8% growth in 2013, weaker than the U.S. rates of 1.7% in 2012 and 2013. Illinois' job recovery continues to be weaker than the national recovery; non-farm employment grew 0.5% as of February 2014 while the U.S. grew 1.5%. The state's unemployment rate has typically exceeded that of the U.S. over the past decade and was unusually high at 130% of the U.S. rate at 8.7% as of February 2014. Wealth levels remain above average. Per capita income is 105% of the national average, fifteenth among the states.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's report 'Tax-Supported Rating Criteria', this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria', dated Aug. 14, 2012.

--'U.S. State Government Tax-Supported Rating Criteria', dated Aug. 14, 2012.

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=827219

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