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Don attended the Chicago CFA Society Distinguished Speaker presentation by John V. Miller, CFA, Nuveen Asset Management’s Co-head of Fixed Income and Head of Municipals on March 9, 2016.  The presentation focused on the fiscal situation of the state of Illinois and the city of Chicago.

John shared his perspective that Chicago is truly the tale of two cities. Chicago has many structural strengths, including it being a transportation hub, education center, having significant mass transit assets and the most Fortune 500 corporate relocations in 2015. Unfortunately the severity of Chicago’s financial picture is very bleak. Even worse is the Chicago Public School system which is living paycheck to paycheck.

There are no quick fixes for Illinois or Chicago’s fiscal situation. At a minimum it will take two or more years to address. That is because the fix will likely require a change to the Illinois constitution, which has been interpreted by the Illinois Supreme Court as not allowing renegotiation of pension contracts after an employee has been hired.

Another reason why it will take time to correct the financial situation for the state and the city is that these bad fiscal policy decisions have been occurring since 2004.  Illinois has a $100 billion pension liability. Whereas debt service for the state is manageable at about 5% of revenues, when you add pension payments, 41% of all the state’s revenues will be used to fund pension liabilities and debt service. This is on top of the current state budget deficit, which is 25% of total state revenues.

Chicago is slightly worse than Illinois using the same metrics. Although Chicago was quick to act when it was downgraded last year and had to refinance all of their interest rate swaps. One bit of good news is that Chicago has very little floating rate debt.

The most negative aspect of all this is that Chicago Public Schools and the Chicago Board of Education are being used as political footballs to generate pain points. Once the crisis hits the school children and their parents, the question of which party gets blamed, will determine how much taxes get raised and/or structural reform takes place. Historic recovery rates on defaulted municipal bonds average about 84 cents on the dollar.

It is very likely that income tax rates will increase in Illinois. At 3.75%, Illinois has the sixteenth lowest state income tax rate. Hopefully the increase will be coupled with some structural reform.

One additional positive is that municipal bonds were the best performing and lowest volatile, fixed income asset sector in 2015.  If tax rates go up, municipal bonds become even more attractive under current tax law. If you want to see if municipal bonds have a place in your financial plan, call D3 Financial Counselors at 630-271-0033.