Illinois will add to its more than $30 billion debt load with a bond sale on Wednesday, testing yield-hungry investors’ desire to lend to the state as it grapples with continuing political and financial issues.
Illinois is the worst-rated state in the municipal market. The Prairie State’s credit quality has crumbled in recent years as expenses have far outpaced revenues.
Since the 2008 financial crisis, fiscal woes have also afflicted some other states and cities, which, like Illinois, face potentially debilitating pension liabilities. Investors have given most others a pass, though, because states are still generally thought of as safe credits.
That’s because of their ability to raise revenues through taxes and slash expenses, as well as their inability to file for bankruptcy. No state has defaulted on its general obligation bonds since Arkansas in 1933.
But “Illinois has increasingly become an outlier among the 50 states,” wrote Moody’s Investors Service analysts in October before a state bond deal. The rating firm pegs it at Baa3 and has a negative outlook on the state, meaning it could be downgraded further.
Like Moody’s, S&P Global Inc. and Fitch Ratings grade the state slightly above noninvestment grade, or junk, at “BBB-” and “BBB,” respectively.
While its debt is technically rated as investment grade, its bonds currently trade in line with junk municipal debt, according to Thomson Reuters Municipal Market Data.
One of Illinois’s biggest problems: political logjams. State lawmakers have squabbled over everything from taxes to pensions. The state went more than two years without a budget before passing one in July 2017.
Now, with another budget deadline looming, some investors are skeptical that Illinois will be able to reach a fiscal deal soon after it issues millions of dollars in fresh debt.
Illinois is supposed to pass a fiscal 2019 budget by May 31. Last summer, Republican Gov. Bruce Rauner wasn’t able to reach agreement with Democrats or Republicans, leading politicians from both parties to make the rare move of overriding his veto of a tax increase, reaching a budget deal and averting a junk rating.
Investors and credit rating firms are watching this week’s debt sale closely. The state plans to sell $500 million in tax-exempt debt on Wednesday with maturities ranging from 2019 to 2043.
Fitch Ratings said in a recent report that if political gridlock returns, Illinois could be downgraded once again.
“The question becomes, do they run into the same problem they ran into last year?” said Nicholos Venditti, a Santa Fe, N.M., portfolio manager at Thornburg Investment Management, which oversees $11.5 billion in municipal bonds.
“Now probably isn’t the time to be buying Illinois’ bonds” unless investors expect political woes to dissipate later this year, he said.
The state’s debt is already some of the most volatile of its kind in the municipal market, Mr. Venditti said. There is likely more turbulence ahead given the political clashes that have dominated the statehouse in the past, he said.
Some investors said demand for higher-yielding investments could woo investors on Wednesday. Additionally, lawmakers’ willingness to pass a budget last year was a positive sign to some.
Another factor that may work in the state’s favor this week: Yields on Treasurys—which often compete with municipal debt—have climbed since last year but still remain historically low. Bond issuance from states and cities has also been light this year, according to traders.
“It’s not going to go smoothly, but I think it’s going to happen,” said Chris Brigati, New York-based head of municipal trading at Advisors Asset Management, speaking of a budget deal. “It’s Illinois, and things don’t go easy.”
The state could be forced to sell its debt this week at higher yields than where bonds currently trade in the secondary market, said Daniel Berger, a senior market strategist at Thomson Reuters’ Municipal Market Data. Yields rise as bond prices fall.
Investors currently demand more yield from Illinois general obligation bonds than they do from some tobacco bonds, data from Thomson Reuters Municipal Market Data show—an unusual instance and potential sign of deteriorating faith in some state-issued debt.
Illinois has accumulated a massive load of unpaid bills. Through last year, some hospitals, doctors and dentists didn’t get paid for patient care, and the state was late paying utilities bills to Springfield, its capital city. It had about $8.9 billion in unpaid bills as of March 1, according to the state. That is substantially greater than most states, according to Fitch Ratings.
Earlier this year, a lawmaker floated other financing means, such as issuing pension obligation bonds again. Pension obligation bonds entail selling debt to fund retirement systems and investing the money. Such a move counts on investments like stocks surpassing the cost of bond interest. Illinois has one of the biggest pension shortfalls in the country, with more than $200 billion in pension debt, according to Moody’s calculations.
Injecting other uncertainty into the state’s finances, Mr. Rauner, a former venture capitalist, is up for re-election this November in the Democratic-leaning state. The billionaire has routinely clashed with Democratic House Speaker Michael Madigan, who has sat atop the House for more than 30 years.
Write to Gunjan Banerji at Gunjan.Banerji@wsj.com