CHICAGO, June 2 (Reuters) - Cash-strapped Illinois, with the worst state credit rating in U.S. history, faces more potential financial pressures next week when a federal judge rules whether the government must accelerate $300 million in monthly Medicaid-related payments.
Being forced to make those payments sooner could weaken the state's ability to meet its obligations to pay investors who have bought its debt both before and during political gridlock that has left it without a proper budget for the past two fiscal years.
The state's political gridlock shows no sign of easing as the Democrat-led legislature and the Republican governor failed to agree a budget for a third year before ending the spring legislative session on Wednesday, triggering rating downgrades and causing bond prices to plunge and yields to soar.
Since it doesn't have a budget, Illinois operates in part under a system of state and federal court-ordered consent decrees that take spending discretion away from the state. This raises concerns that debt service on the state's bonds may get squeezed by additional court-ordered payments.
While State Comptroller Susana Mendoza has latitude to decide which bills get paid, the court orders are increasingly limiting her options.
Abdon Pallasch, Mendoza's spokesman, said a court ruling requiring an estimated $300 million more a month in core priority payments would be a tough challenge. "We could reach a tipping point any time now where the court-mandated payments exceed the revenue coming in," he said.
Illinois has accumulated a $14 billion pile of unpaid bills, equivalent to 40 percent of its general fund revenue.
Plaintiffs in one federal consent decree have asked a U.S. District Court judge to order Illinois to give a higher priority for medical care provider payments to ensure continued access for Medicaid recipients.
Tom Yates, executive director of the Legal Council for Health Justice, who is representing Illinois Medicaid recipients in the case, said a ruling is expected on Tuesday unless a resolution is reached with the state.
Illinois has argued that if the motion is granted, the state "will not have sufficient funds on hand to make all of the core priority payments."
Each month, priority payments of $1.85 billion are allocated to schools, local governments, payroll, bonds and consent decrees, consuming 90 percent of Illinois' monthly revenue, according to a court document filed by the state.
On Thursday, both S&P Global Ratings and Moody's Investors Service downgraded the state's credit rating to just one notch above junk status, a level that caused the yield spread on Illinois bonds over the benchmark to hit the widest in history.
One of those ratings could fall to junk soon after the July 1 start of the state's fiscal 2018 year if there is still no budget, according to S&P, which said Illinois risks entering "a negative credit spiral" that would exacerbate its fiscal distress.
Bond investors have taken comfort in an Illinois law that requires 1/12th of the next principal payment and 1/6th of the next interest payment - about $226 million - to be placed each month into a fund to retire the state's $26 billion of outstanding general obligation bonds.
"The bond payments are pretty sacrosanct around here," Pallasch said, adding that policy is not expected to change.
Illinois GO bonds due in 10 years now yield an all-time high of 258 basis points more than the muni market's triple-A benchmark. For the state's 20-year bonds, the spread hit a record 232 basis points, according to Municipal Market Data, a unit of Thomson Reuters. This indicates Illinois' borrowing costs are ratcheting higher.
If Illinois becomes the first state with a junk credit rating, the situation would get even worse.
"Many investors require investment grade ratings, so a rating reduction to the BB category could trigger selling pressure and higher yields and credit spreads," Janney Investment Strategy Group said in a report on Friday.
Concern is growing that debt service could be crowded out by an increase in other mandated payments.
S&P warned an expansion of the monthly core priority payments could call into question the state's ongoing willingness to fund its GO bond payments given the state's inadequate revenue base, particularly in the event of a deteriorating economy.
John Humphrey, co-head of credit research at Gurtin Municipal Bond Management, said there is a risk some of Illinois' core priorities will get reduced payments.
"This entire situation is unprecedented and the road ahead is very unclear," he said.
Reporting by Karen Pierog; Editing by Daniel Bases and Cynthia Osterman