Fitch Rates Kentucky SPBC's $388MM Project 108 Revenue Bonds 'A '; Outlook Stable
--\$129.6 million revenue bonds, project no. 108 series A;
--\$258.5 million revenue refunding bonds, project no. 108 series B.
The bonds are expected to be offered through competitive sale on or about the week of Jan. 26, 2015.
Fitch also affirms the commonwealth's implied general obligation (GO) rating at 'AA-' and the 'A+' rating on approximately \$6.3 billion in appropriation-backed debt issued by the SPBC, the Kentucky Infrastructure Authority, the Turnpike Authority of Kentucky, the Kentucky Asset/Liability Commission, and the Lexington-Fayette Urban County Government Public Facilities Corp. The affirmation does not include appropriation debt issued on behalf of Bluegrass station, the Kentucky River Authority, and the Kentucky State Fair Board which Fitch rates separately.
The Rating Outlook is Stable.
SECURITY
The project 108 bonds are special and limited obligations of the SPBC, payable solely from revenues derived under financing/lease agreements between the commission, as lessor, and the commonwealth's finance and administration cabinet, as lessee. The project 108 bonds are backed by appropriations from the commonwealth's general fund.
The implied GO rating of 'AA-' reflects the general credit quality of the commonwealth. Kentucky has not issued GO debt in several decades.
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KEY RATING DRIVERS
MOST STATE DEBT IS APPROPRIATION BACKED: Kentucky's debt is primarily in the form of lease rental bonds requiring appropriation for debt service. The commonwealth's lease financing mechanism is well established, highlighted by automatically renewable leases and covenants to seek appropriation for debt service. Fitch rates appropriation-backed debt supported by the general fund and road fund one notch below the commonwealth's implied GO rating.
LIMITED OPERATING FLEXIBILITY: The commonwealth's operating flexibility is constrained compared with that of most states with weak depleted reserves and a continuing reliance on nonrecurring revenue sources, though no further deficit bonding is included in the current biennial budget. The last biennium ended with an unexpected revenue shortfall, but current year performance is in line with the budgeted forecast.
COMPARATIVELY HIGH LONG-TERM LIABILITIES: The commonwealth's combined debt plus unfunded pension system liabilities are amongst the highest for U.S. states. Recently adopted pension reform measures, including a commitment to full actuarial funding for one of Kentucky's systems, are a positive step. But significant challenges remain, including a continually underfunded teachers' plan.
STEADY JOBS RECOVERY: Kentucky's economic recovery from the recession has been solid as the commonwealth recently returned to its pre-recession peak employment levels. Other trends including labor force contraction, below-average population growth and low levels of educational attainment pose long-term demographic challenges for Kentucky.
RATING SENSITIVITIES
FUNDAMENTAL CREDIT CHARACTERISTICS: The implied GO rating is sensitive to the commonwealth's ability to address budgetary challenges in more sustainable ways and gradually restore fiscal flexibility. The 'AA-' rating incorporates Kentucky's currently narrow fiscal position, although continued reliance on non-recurring measures to maintain balance could trigger negative rating concern.
LINKED TO IMPLIED GO RATING: The rating on the commonwealth's appropriation-backed debt is linked to changes in the commonwealth's implied GO rating, on which the rating is based.
CREDIT PROFILE
Kentucky's 'AA-' implied GO rating reflects the commonwealth's limited fund balances following depletion amidst recession-driven revenue shortfalls, continued reliance on one-time measures in the current biennial budget, and a high liability position, including unfunded liabilities for state-supported pension systems. Kentucky continues to face budget balancing challenges despite some economic recovery, indicating a structural problem that goes beyond the impact of cyclical recession and recovery on its financial operations. In each of the past five biennial budgets, beginning in fiscal 2007 as well as for the current biennium which began on July 1, 2014, the commonwealth has relied on one-time solutions to balance its budget, including depletion of reserves, debt restructuring, and borrowing for operations. No deficit bonding is included in the current biennial budget.
ONGOING FISCAL CHALLENGES
Revenues fell short of the budgeted estimate by \$91 million in fiscal 2014 (1% of revenues), largely due to weakness in the personal income tax (PIT) which only became clear in the final quarter of the year. The PIT is the largest general fund revenue source, generally comprising around 40%. As with several other states, the commonwealth reports that lingering effects of the 2013 federal income tax increase drove down final and estimated tax payments in fiscal 2014. Fitch anticipates this effect to be one-time in nature, and notes that withholding revenues were up 1.7% for the year, the same growth rate seen in fiscal 2013. Sales tax revenues (typically one-third of general fund revenues) also indicated fundamental economic stability as they beat budgeted expectations. The overall revenue shortfall only became clear in the last quarter of the year, providing very little opportunity to balance the budget with expenditure reductions. Instead, the Governor enacted various non-recurring measures including \$50 million in fund sweeps and a \$21.2 million draw on the budget reserve trust fund.
The fiscal 2015-2016 biennial budget includes a range of expenditure measures and fund transfers to achieve balance, and actual revenue performance through December is largely in line with the official forecast. Kentucky's revenue forecast is for general fund revenue growth of 3.6% in fiscal 2015 and 2.7% in 2016. The budget, enacted before the fiscal 2014 shortfall was recognized, relies on robust PIT gains of 6% in fiscal 2015 and 4% in 2016. The budget projects annual sales tax revenue growth at less than 1% and 2.1%, respectively, in fiscal 2015 and 2016. Positively, general fund revenues through December 2014 are up 3.5% year-over-year (yoy) versus the 3.6% budgeted forecast with both PIT and sales tax revenues exceeding their targets. Corporate and coal severance taxes are both falling well short of the forecast through December. Fitch views the current year forecast as attainable, but subject to some risk particularly given the volatility of corporate tax revenues and the healthy assumed PIT growth rate.
The budget includes a substantial \$370 million in fund sweeps, \$98 million in general fund budget cuts across a broad range of agencies, and \$166 million in estimated savings under federal ACA Medicaid expansion. Kentucky reports Medicaid savings are on track through the first half of the fiscal year. Fitch typically views fund transfers as non-recurring sources, but the amount of fund-sweeps is in line with the amounts included in prior budgets going back for at least eight biennia indicating these are consistently available (and utilized) revenues. Positively, the budget also includes full actuarial funding for the state's contribution to one of its major pension systems, as required in reform legislation enacted in 2013.
Reserves will likely remain very light through the biennium. Use of the fiscal 2014 ending general fund balance of \$69 million in the current biennial budget precludes any further restoration of Kentucky's budget reserve trust fund (BRTF, the rainy day fund). Instead, the commonwealth's enacted budget envisions a \$13.7 million drawdown in fiscal 2016, leaving the BRTF balance at a very modest \$63.4 million (or less than 1% of annual general fund revenues) at the end of the biennium.
SLOWLY RECOVERING ECONOMY
Economic growth in the commonwealth has been somewhat inconsistent coming out of the recession and is now at or near national performance. Despite a decade of contraction, Kentucky continues to have an oversized manufacturing sector relative to the national economy. This sector had been recovering since bottoming out in early 2010, but growth has more recently plateaued with a 1.3% gain in November 2014.
While gains in automotive-related employment had been a key factor in the recovery, the state reports nondurable goods sectors like plastics and chemicals have been somewhat unsteady. In fact, durable goods manufacturing was up 3.7% yoy in November while non-durables declined 2.7%. Overall, the commonwealth's non-farm employment is up 2.1% yoy as of November, slightly ahead of the national rate (2%). The three-month moving average of 1.7% still trails the national 2% rate. Kentucky's November 2014 unemployment rate of 6% is down sharply from 8.1% a year earlier, but remains above the 5.8% U.S. rate and is being pulled down by a disappointing 2.6% contraction in the labor force. The labor force weakness, along with the commonwealth's below average population growth (1.7% since 2010 versus 3.3% for the nation) and low educational attainment (among the lowest states for rate of adults with bachelors degrees) limits the commonwealth's potential for future economic growth. Commonwealth wealth levels are also weaker than most other U.S. states as Kentucky's per capita personal income approximates 80% of the U.S. average and currently ranks the commonwealth 45th among the states.
HIGH LONG-TERM LIABILITY LEVELS
Kentucky's liabilities are high for a U.S. state with the combined ratio of debt and unfunded pension liabilities (adjusted by Fitch) representing 22% of 2013 personal income (as of Fitch's May 2014 report, 'Pension Pressures Continue: 2014 State Pension Update'). This is well above the median amongst U.S. states of 6.1%. Net tax-supported debt alone was a moderately-high 5.6% of 2013 personal income. This includes general- and road fund-supported appropriation debt, and debt paid from other state agency funds. Kentucky has long used state agencies for its capital financings, which depend on biennial legislative appropriations for security, and has well-established policies and procedures that recognize such obligations as debt. Although payment is subject to legislative biennial appropriations, the securing financing agreements are automatically renewable.
Under the new GASB 67 standard for pension systems, the Kentucky Employees Retirement Systems (KERS combined non-hazardous and hazardous) reported a 25.4% ratio of pension assets to liabilities in fiscal 2014 with a net pension liability of \$9.2 billion borne essentially by the commonwealth. While not directly comparable, the actuarially determined funded ratio was 23.9% in fiscal 2014 with an unfunded actuarial accrued liability of \$9.4 billion. Fitch notes that KERS parent, Kentucky Retirement Systems (KRS), is engaged in a legal dispute with a non-profit entity that has historically participated in KERS called Seven Counties Services (SCS) that could affect annual costs for the commonwealth. SCS is one of 14 community mental health centers (CMHCs) under contract with the commonwealth to provide certain mental health services. Last May, SCS won federal bankruptcy court approval to file for chapter 11 bankruptcy, rather than chapter 9, which would have required commonwealth approval. A primary reason for the bankruptcy filing was to discharge SCS' obligations to KERS. Several other CMHCs are engaged in related litigation to similarly discharge pension obligations. Fitch already incorporates the liabilities for all CMHCs in its calculation of KERS' pension liabilities and funding for these organizations, including annual pension costs, already comes largely from the commonwealth.
The reported ratio of pension assets to liabilities for the commonwealth's other major state-supported retirement system, the Kentucky Teachers Retirement System (KTRS), was 45.6% in fiscal 2014 with a significant net pension liability of \$21.6 billion. Per GASB 67, KTRS reports that under current policy pension system assets will be depleted in plan year 2036 and are therefore insufficient to fully cover liabilities. While concerning, Fitch notes disclosure of this depletion date is not surprising as it largely reflects the commonwealth's lack of a full ARC funding commitment for KTRS. Kentucky's contribution to KTRS has been short of the full ARC for seven of the past eight years. The fiscal position of Kentucky's pension systems have deteriorated partially due to investment losses and the failure to fully fund actuarially calculated annually required contributions (ARCs).
Recent pension reforms address some of the commonwealth's pension-related problems, but challenges remain. 2013 legislation established a statutory full ARC funding commitment for KERS and the current biennial budget follows through on that with full funding for both years and KERS does not report a GASB 67 depletion date. The reforms did not address KTRS and its significantly larger liability. Fitch anticipates the current legislative session will include active discussion around KTRS' funding challenges and the agency will monitor any enacted changes with a focus on how they affect the plan's liability position and commonwealth annual funding demands. Fitch views the KTRS issues as a challenging but not insurmountable problem for the commonwealth. Kentucky' fiscal 2014 KTRS pension contribution was 68.4% of the ARC, leaving a gap of roughly \$260 million or 2.7% of annual general fund revenues. In the context of a stable economic and revenue environment, Fitch anticipates the commonwealth could address that gap in a sustainable manner as it recently did with KERS or the KTRS other post-employment benefit liability.
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