OREANDA-NEWS. Fitch Ratings upgrades the following San Ysidro School District, California (the district) bonds:

--\$65.6 million election of 1997 general obligation (GO) bonds series D, E and F to 'BBB-' from 'BB+';
--\$28.0 million certificates of participation (COPs) series 2001, 2005, and 2007 to 'BB' from 'BB-'.

The Rating Outlook has been revised to Positive from Negative.

SECURITY

The GO bonds are general obligations of the district, payable solely from the proceeds of ad valorem taxes, without limitation as to rate or amount. The COPs are limited obligations supported by the district's covenant to budget and appropriate lease rental payments for the use of certain district properties, subject to abatement.

KEY RATING DRIVERS

IMPROVED FINANCES AND OPERATIONS: The upgrade to 'BBB-' for the GOs and 'BB' for the COPs is based on material improvements in the district's finances and operations. Recent financial results have exceeded forecasts and the district has also resolved several key management challenges, including a looming legal judgment and a teachers strike.

SIGNIFICANT CHALLENGES REMAIN: The district continues to generate operating deficits despite recent progress and faces additional challenges from enrollment declines and management turnover. The revision of the Rating Outlook to Positive from Negative reflects Fitch's view that further financial and management improvements which appear to be under way would increase upwards rating pressure.

MIXED ECONOMIC CHARACTERISTICS: The district participates in the broad and diverse San Diego regional economy, which has seen sustained growth in recent years. However, district home values and income levels remain well below citywide and state averages.
WEAK DEBT POSITION: Overall debt levels are high and amortization of direct debt is slow, while pension costs are expected to rise over the next several years.

COPs RATING LOWER: The lower rating for the district's COPs reflects the potential for reduced availability of resources for payment of appropriations debt as a result of the district's recent financial strains.

RATING SENSITIVITIES

STABLE FINANCES AND MANAGEMENT: Continued financial improvements and increased management strength and stability would result in upward rating pressure. The rating would be pressured negatively by operating losses that reduce reserves below state-mandated minimums and expose the district to renewed risk of county office of education or state oversight.

CREDIT PROFILE

The San Ysidro School District is located primarily within the southeastern portion of the city of San Diego, adjacent to the international border with Mexico, and includes 43,000 residents within 29 square miles. The district serves approximately 4,900 students from pre-school through eighth grade.

IMPROVED FINANCES AND OPERATIONS

The district's operations have seen reduced volatility in the past year, providing the basis for the current upgrade. General fund cash balances of \$6.9 million at the end of fiscal 2014 were nearly twice 2013 levels and district management is no longer projecting a cash shortfall and need for a state loan. The district's audited financial statements for fiscal 2014 included a going concern note. Financial projections provided by management for fiscal 2015 suggest the district will be able to contain operating deficits and maintain a state-mandated 3% minimum reserve through fiscal 2017, which Fitch considers reasonable based on expected revenue gains under the state's Local Control Funding Formula.

The district has also made progress in addressing several key operating challenges. Management recently negotiated an agreement with a vendor to eliminate a \$12 million legal judgment that had threatened the district with insolvency. In addition, district teachers are now under contract through the end of fiscal 2016 following a contentious labor dispute that culminated in a three-day strike earlier this school year. Negotiated agreements provide for 2% salary increases in fiscals 2015 and 2016.

SIGNIFICANT CHALLENGES REMAIN

The district continues to face substantial challenges. Financial projections by the district point to ongoing general fund operating deficits despite a generally positive revenue environment. Recent enrollment declines have contributed to these results, offsetting increases in state revenues and leading to structural imbalance in the district's general fund.
The district is constrained from seeking labor concessions through the term of recently negotiated contracts, limiting its options for addressing structural imbalance. Management retains the right to implement layoffs but hopes to reduce staffing through attrition to offset enrollment declines, and also expects that new home construction within district boundaries may reverse this trend in coming years.

The five-member governing board of the district has seen three new representatives in the past year and all five members are new to the board since 2012. The board is in the midst of recruitment for a permanent superintendent. The district has relied on interim appointments since the 2013 resignation of its former superintendent amidst a corruption scandal.

A recent state audit cited numerous instances where the district did not meet the requirements of federal programs that provide key district funding. Management expects to resolve these audit findings without financial penalty. The district's interim superintendent has placed two staff members on leave pending an investigation into why the audit results were not shared with management upon receipt.

MIXED ECONOMIC RESULTS

The district is part of the broad and diverse San Diego regional economy, which has seen sustained employment growth in recent years. San Diego's unemployment rate fell to 5.1% in February 2015, well below the state and national rates of 6.8% and 5.8%, respectively. Large employment gains over the past four years have contributed to these results and current employment levels for the city exceed pre-recession peaks.

District-level employment statistics are not available but census data portray a relatively low-income area within this generally wealthy region. Per capita incomes are roughly half of state and national averages. Household income levels for the district are approximately 80% of regional averages and poverty rates are notably higher.

The district's tax base increased by 3.5% in fiscal 2015 but remains 4.7% below its fiscal 2009 level. San Ysidro area home values, as reported by Zillow.com, increased by 8.8% year-over-year as of March 2015, suggesting good prospects for tax base growth in future years.

WEAK DEBT POSITION

Overall debt levels for the district are high at 7.2% of taxable assessed value and \$7,380 per capita. Amortization of direct debt is very slow with 12.4% of outstanding principal and accreted interest retired in 10 years. A proposed refunding of outstanding GO bonds would improve 10-year amortization to approximately 14%. Capital needs are limited as a result of the district's recent construction of several new schools and declining enrollment.

The district participates in two state-sponsored employee pension plans and faces steady increases in contribution rates over the next several years to address substantial unfunded liabilities. Carrying costs for debt service and retirement benefits were somewhat elevated at 23.5% in fiscal 2014 and will likely see steady increases over the next several years due to escalating debt service and pension rate increases. Other post-employment benefits are funded on a pay-as-you-go basis, resulting in a growing, though still modest, liability.

COPs RATING LOWER

The two-notch distinction between the COPs and GOs results from the district's continued financial risks and limited flexibility, which could reduce the availability of general fund resources for repayment of appropriation debt. Fitch typically maintains a one-notch distinction between GO and appropriation debt for higher-rated credits, but this distinction can increase at lower rating levels.