Illinois’ lingering fiscal problems will be center stage in the U.S. municipal bond market next week as the state sells $3.7 billion of bonds and as its governor unveils a budget plan for the upcoming fiscal year.

While the state has taken steps to raise taxes and curb spending, years of overspending have left it with a big structural budget imbalance and its unfunded pension liability has mushroomed to the highest of all the states.

With no money for its fiscal 2011 pension payment, Illinois is turning to taxable general obligation pension bonds for a second year. In January 2010, the state sold $3.46 billion of five-year pension bonds to make its fiscal 2010 payment.

Next week’s $3.7 billion issue is structured so the state makes no debt service payments until 2014 and extends maturities to 2019, according to the deal’s preliminary official statement.

Concerns that Illinois still has a way to go before it reaches fiscal stability could depress prices and increase yields for the bonds.

“The state has raised taxes, but it’s still not enough to cover the budget deficit,” said Gary Pollack, a managing director at Deutsche Bank Private Wealth Management in New York.

“Do I think the (bond) issue will be priced attractively to sell? The answer is yes,” he added.

The spread for Illinois’ 10-year bonds over Municipal Market Data’s benchmark triple-A scale has narrowed to 205 basis points from an all-time high of 225 basis points last month, but remains the widest spread among the 50 states, according to MMD.

Morgan Stanley is scheduled to formally price the pension bonds on Thursday, a day after Governor Pat Quinn lays out his spending plan for fiscal 2012, which begins July 1.

The Democratic governor has a bit more breathing room after the legislature approved temporary increases in the individual income and corporate tax rates last month that are expected to raise about $6.8 billion annually.

But even that revenue is not enough to erase a deficit as high as $15 billion that the state faces heading into fiscal 2012.

In an interview this week with Reuters Insider, the state’s Republican Comptroller Judy Baar Topinka warned Illinois is approaching a cliff as its continues to spend more than it takes in.

“We cannot spend money we don’t have,” she said.

The tax hike helped the state dodge a ratings downgrade, with Standard & Poor’s affirming an A-plus rating with a negative outlook, Moody’s Investors Service keeping its A1 rating with a negative outlook and Fitch Ratings affirming an A rating and revising the outlook to stable.

All three agencies said the state remained a credit concern due to its large structural budget deficit, huge unfunded pension liability and escalating debt issuance.