UPDATE 1-Illinois tax hike lifts some credit worries

(Adds comments from Nuveen and Moody’s, background)

CHICAGO, Jan 12 (Reuters) - Raising income taxes boosted Illinois’s municipal bonds and attracted positive comments from rating agencies on Wednesday, but investors are still looking for the state legislature to clean up its fiscal house.

With Illinois facing a potential $15 billion budget gap, the Democrat-controlled legislature overnight passed a bill that would raise about $6.8 billion a year by increasing individual and corporate tax rates.

“Probably the panic will subside,” said Gary Pollack, managing director at Deutsche Bank Private Wealth Management in New York, cautioning the state still needs to balance its budget on an ongoing basis.

“They still have to bond out their pension commitment and operating costs, which is generally a no-no,” he added.

Illinois is in the worst shape among states for pensions, with only about 54 percent of its obligations funded.

Domenic Vonella, an analyst at Municipal Market Data, said there were signs some Illinois bonds were trading stronger on Wednesday although trading was light.

“The market’s relieved something has happened,” said Tom Spalding, a portfolio manager at Nuveen Investments in Chicago. He also said the state must take a harder line on the spending side of its budget.

The state’s credit default swap, or insurance against a bond default, fell to 295 basis points on Wednesday, 30 basis points tighter than on Tuesday and the first time in more than a month that it was below 300, according to Markit Intraday.

Illinois in some ways has surpassed California as the problem child in the $2.8 trillion municipal bond market as its deficit and debt issuance ballooned and credit ratings slid amid a political inability to deal with tough budget issues.

The state still has wider CDS than any state, including California, whose CDS were trading at 275 basis points on Wednesday.

Illinois’ individual income tax rate was increased temporarily to 5 percent from 3 percent and the corporate tax rate to 7 percent from 4.8 percent, despite protests from state Republicans and the business community that the move will impair the still weak economy.

Lawmakers also authorized borrowing $4 billion to make a pension payment, although another $8.75 billion bond issue to raise money to pay off a huge bill backlog failed to muster enough votes in the House. For details click on [ID:nN12176176].

Kelly Kraft, a spokeswoman for Governor Pat Quinn, said he will sign the bill into law as soon as it lands on his desk. She added he will continue to push lawmakers to pass a borrowing to pay bills.

Illinois lawmakers supporting the tax hike said the revenue increase would help improve the state’s sagging credit ratings, which are among the lowest of the states. But rating analysts said on Wednesday they need to mine the details of the tax plan.

“This is a positive development for the state. Illinois’ problems are deep and long developing,” said Bob Kurtter, an analyst at Moody’s Investors Service, which rates the state’s general obligation debt A1 with a negative outlook.

He added Moody’s will be evaluating the tax plan, its implementation and its results.

“It’s certainly a good step that they got the tax increase passed. Now we have to see how to put that in the context of a balanced budget,” said Karen Krop, an analyst at Fitch Ratings, which rates the state’s GO bonds A with a negative outlook.

Robin Prunty, a Standard & Poor’s Ratings Services analyst, said the legislature’s action will trigger a review of the state’s A-plus rating, which has been on a watch list for a possible downgrade.

“We felt all along (the state) had the ability to improve structural balance,” she said, adding that its “willingness” to do so had been a question.

Unlike some other states, Illinois does not need voter approval or a super-majority legislative vote for tax increases.

Spalding at Nuveen said the state, which was the second biggest issuer in the muni market last year behind California, has to curtail borrowing.

“It’s the only thing that’s going to help their bond rating,” he said. (Editing by Chizu Nomiyama)