Updated: Jul 10, 2018
July 9th, 2019
According to Wikipedia, Janus is the ancient Roman god of “beginnings, gates, transitions, time, duality, doorways, passages, and endings”. Fittingly, the so-called Janus decision from the US Supreme Court on June 27th may usher in significant changes in the relationship between state and local governments and public employee unions, with potential impact on the entire municipal credit landscape.
The "Janus vs AFSCME" case was filed in Illinois back in 2015 by then Governor-elect Bruce Rauner but was thrown out due to lack of standing. It was revived when actual state employees, including Mark Janus, a social worker in the Illinois Department of Healthcare and Family Services, joined the suit. Backed by several local conservative groups, Janus sued the American Federation of State, County & Local Municipal Employees ("AFSCME"), claiming it is a violation of his First Amendment rights for Illinois (and by extension, other states) to force non-union government workers such as himself to pay dues to the unions that they chose not to join, particularly when some of those dues have been used to advance the unions' own political agendas.
Given the potential nationwide impact of the case, no one was surprised that it eventually ended up in front of the US Supreme Court. In a landmark decision last week, the Court ruled in favor of the plaintiffs, striking a major blow to the labor unions' financial resources, with potential long term negative impact on their membership and their political power.
Needless to say, we in the municipal market have a big stake in the outcome of the case, to the extent that any weakening of the public unions' bargaining power may lead to improved prospects for public pension reform across the nation. Nowhere is this more true than in Illinois: the Land of Lincoln is one of the most heavily unionized states in the nation and it boasts a particularly unassailable alliance between the powerful public unions and a predominantly Democratic legislature.
Should long-suffering Illinois bondholders rejoice? Not so fast. By sheer coincidence, this week also marks the one year anniversary of the political breakthrough that allowed Bruce Rauner to sign his very first state budget since taking office in 2015. As you may recall, the Governor had to be dragged kicking and screaming into the budget agreement as members of his own party, unnerved by the threat of a downgrade to below investment grade by the rating agencies, joined their colleagues across the aisle to override his veto of a record-setting $5 billion permanent income tax hike.
After more than two years without a budget, resulting in severe negative downstream impact on most state and local entities, the end of political gridlock was welcomed by muni investors, leading to a dramatic tightening in Illinois GO spreads. But, as we pointed out in past columns, the FY 2018 budget actually did very little to solve the state's long term fiscal problems, or even some of its short-term challenges for that matter. The conservatively-leaning Illinois Policy Institute sums it up as follows:
"The fiscal year 2018 budget is expected to end up $590 million in the red, according to the Governor’s Office of Management and Budget. And despite politicians’ claims to the contrary, the recently enacted fiscal year 2019 budget is not balanced either (...)
Lawmakers never passed a revenue estimate – a basic first step of budgeting – and are spending as much as $1.5 billion more than realistic revenue projections. Some of the gimmicks include: counting on $300 million for selling the Thompson Center for the third year in a row, banking $422 million in pension savings that – while generally good policy – is speculative at best in budgetary terms, ignoring $412 million in court-ordered back pay to government union workers, and using $800 million in fund sweeps and borrowing from other state funds (...)"
And, of course, the elephant in the room remains the State's massive $130 billion unfunded pension liabilities, as pension reform proposal after pension proposal continued to be shot down by the local courts, ostensibly under intense political pressure from the unions.
One thing Governor Rauner and the State legislators have accomplished over the past year is to lower the fiscal bar for the State, to the point that the mere passage of the current fiscal's budget was viewed by market participants as a significant positive credit development! Never mind that the same old budget tricks that led to the Prairie State to its current fiscally distressed state remain very much in the playbook.
Thus, despite the initial positive response from market participants to the Janus ruling, as examplified by Moody's recent public statement on Twitter, it would be unrealistic to expect any near-term positive impact on the Illinois credit. Over the long run, one can hope for a loosening of the symbiotic (some may say unholy) alliance between the unions and the state's Democratic Party machine. Illinois' propensity to tax and spend can be traced back to the unions' historical ability to deliver campaign funding and its members' political support to key Democratic legislators, including one named Mike Madigan.
All that said, in many ways, Illinois remains the purest credit play among all the state General Obligations (G.O.). Unlike other states like New Jersey or Connecticut, there is no double tax exemption here to distort credit spreads. Nor is there any relative scarcity of supply to artificially drive investor demand: the State and many of its local government units, notably the City of Chicago, are never shy about accessing the capital markets on a fairly regular basis. When in doubt, borrow.
To illustrate the point, let's compare Illinois' spread history to that of Connecticut and New Jersey.
Chart 1: Illinois, Connecticut and New Jersey 10 year GO Spreads: July 2016-July 8, 2018
Source: Municipal Market Data
As shown in the chart above, Illinois G.O. spreads in the 10 year maturity range have tightened dramatically from the peak of +335 bps on June 8th, 2017 to about +170 bps currently. By comparison, the spreads for Connecticut and New Jersey, two states that we believe are still in the fiscal cellar from a credit standpoint, have actually tightened slightly. At +85 and +75 bps, respectively, Connecticut and New Jersey appear wildly over-valued. As two of the states most affected by the SALT deduction limitations imposed by last December's tax reform act, their trading values have been distorted by increased demand for tax shelters from in-state investors. One-time revenue windfalls from tax reform have also served to obscure the true fiscal picture for these two northeastern states.
As Ted Dabrowski pointed out in a recent Wirepoints piece, one should hardly expect the unions to roll over and play dead. If nothing else, the SCOTUS decision may serve as a rallying cry for Illinois' public employees and their Democratic Party allies and, perhaps, solidify their support for J.B. Pritzker, the Democratic candidate for Governor. At this point, although the Janus ruling will clearly be viewed as the highlight of Gov. Rauner's political legacy, it's unclear to us whether he will get much of a bump in the polls from it. It would be quite ironic if the Governor's political victory ends up paving an easier road for his probable Democratic successor to make headway in the area of pension reform.
In any event, until we get past all the election year noise, we believe Illinois bondholders are well compensated for any potential downgrade risk at current credit spreads, even if further spread compression seems unlikely for the balance of the summer. The rating agencies will be inclined to sit tight and give Illinois the benefit of the doubt until a new Administration moves into Springfield.
When it comes to pure credit plays, there are worse relative values out there than Illinois G.O. bonds.
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