* Illinois rated lowest among 50 states by Moody's and S&P
* Public pensions unfunded liabilities at $96.8 billion
* $500 mln bond sale on Wednesday
CHICAGO, Jan 25 (Reuters) - Illinois' credit rating took another tumble on Friday as Standard & Poor's Ratings Services pushed it down to the lowest level among all states and said it could fall further.
The one-notch downgrade to A-minus affects $26.6 billion of outstanding general obligation debt and marks the second in five months by S&P, which had lowered Illinois to A from A-plus in August. The rating agency also placed a negative outlook on the lower rating, saying legislative consensus and action would be needed to tackle the state's huge unfunded public pension liability.
"While it is unusual for a state rating to fall into the BBB category, lack of action on pension reform and upcoming budget challenges could result in further credit deterioration, particularly if it translates into weaker liquidity," S&P said in a report.
The legislature and Governor Pat Quinn have failed to reach a consensus on any measure to tackle the $96.8 billion unfunded pension liability, most recently during a lame-duck session that ended Jan. 8.
S&P cited Illinois' lower pension funded ratios and lack of action on pension reforms for the latest downgrade, pointing out that a legislative consensus on reforms will be difficult to achieve as a deal has eluded the state over the past couple of years.
Even if reforms are enacted there is the potential of lengthy legal challenges, the rating agency added.
State labor union officials have said they will go to court to fight pension changes and they are confident they will prevail given strong protections for pension benefits in the Illinois Constitution.
"It could be awhile before (the state sees) any meaningful reduction in liability or budget relief," said Robin Prunty, an S&P analyst.
Leaders of the Democrat-controlled legislature called for action in the wake of the latest downgrade, although it was unclear if any of the pension reform bills introduced in the new session that began Jan. 9 has enough support to pass.
"The General Assembly must act in order to avoid further damage to our credit rating by achieving consensus on meaningful pension reform that can pass the House and Senate this spring," said House Republican Leader Tom Cross in a statement.
A spokeswoman for Senate President John Cullerton, a Democrat, said he will continue "to push constitutional reforms to stabilize our pension systems and restore confidence in the state of Illinois."
S&P's action came ahead of the sale of $500 million of Illinois general obligation bonds on Wednesday. While the state has had no problem selling its bonds in the $3.7 trillion municipal bond market, investors are demanding fatter yields for taking on the riskier credit.
"The market has been saying they believe in the state and its general obligation pledge and believe in its ability to pay," said Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management.
But he warned that investor interest could fall off if Illinois' ratings slip into the less desirous BBB-category, raising the state's borrowing costs even more.
With the downgrade to A-minus, Illinois joins California in having the lowest rating among states S&P rates, although California's outlook is positive.
Illinois' A2 rating with a negative outlook from Moody's Investors Service is the lowest state rating from that credit agency. Earlier this month, Fitch Ratings put Illinois on a watch list for a potential downgrade of its A rating over the next six months.
A drop into the BBB category would keep Illinois just above the BB category, where debt is considered junk.
S&P said an upgrade for the state was highly unlikely.
"We believe there is limited upside potential for the rating in the next two years given the size of the accumulated deficit and the liability challenges Illinois faces but will evaluate the state's progress in addressing key budget and pension challenges," the rating agency said.
An Illinois legislative commission reported in November that the state's unfunded pension liability jumped to $96.8 billion at the end of fiscal 2012, up from $83 billion in fiscal 2011. The funded ratio, which was already the lowest among states, fell to 39 percent from 43.3 percent.