NEW YORK--(BUSINESS WIRE)--Fitch Ratings assigns an 'A+' rating to the commonwealth of Kentucky State Property and Building Commission's (SPBC) $20.145 million judicial branch agency fund revenue bonds, project 109.
The bonds are expected to be offered through negotiated sale on or about the week of Sept. 15, 2015.
Fitch also affirms the commonwealth's implied general obligation (GO) rating at 'AA-' and the 'A+' rating on approximately $6 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 109 bonds are special and limited obligations of the SPBC, payable solely from revenues derived under a lease agreement between the commission, as lessor, and the commonwealth's administrative office of the courts (AOC), as lessee. The project 109 bonds are backed by agency fund appropriations to the commonwealth's judicial branch, which are essentially all of its appropriations.
The implied GO rating of 'AA-' reflects the general credit quality of the commonwealth. Kentucky has not issued GO debt in several decades.
KEY RATING DRIVERS
ALL JUDICIAL BRANCH APPROPRIATIONS AVAILABLE: Fitch rates judicial branch agency fund revenue bonds equivalent to general fund-supported appropriation debt of the commonwealth because the branch's operating agency (AOC) has full discretion to utilize any funds appropriated to it for lease payments. The commonwealth's general fund is the primary source of judicial branch appropriations, accounting for nearly 90% of funding in the current biennium. Lease payments used to pay debt service are subject to biennial appropriation, warranting the one-notch distinction from Fitch's implied GO rating on the commonwealth.
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 of 'AA-'.
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. Fiscal 2014 ended with an unexpected revenue shortfall, but fiscal 2015 performance was $165.4 million ahead of 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. Pension reform measures in 2013, including a commitment to full actuarial funding for one of Kentucky's systems, are a positive step, but significant challenges remain, including a consistently underfunded teachers' plan.
STEADY JOBS RECOVERY: Kentucky's economic recovery from the recession has been solid as the commonwealth returned to its pre-recession peak employment levels last summer. Other trends including labor force contraction, below-average population growth and low levels of educational attainment do pose long-term demographic challenges.
RATING SENSITIVITIES
LINKED TO IMPLIED GO RATING: The rating on the commonwealth of Kentucky's appropriation-backed debt is linked to changes in the commonwealth's implied GO rating, on which the rating is based.
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.
CREDIT PROFILE
The commonwealth's judicial branch, operating through the AOC, is Kentucky's court system consisting of more than 400 elected justices, judges and circuit court clerks and various non-elected court personnel. Lease payments used to pay debt service on this obligation are subject to biennial appropriation, warranting the one-notch distinction from Fitch's implied GO rating on the commonwealth.
Kentucky's 'AA-' implied GO rating reflects the commonwealth's limited fund balances following depletion amid 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 economic recovery, indicating a structural problem that goes beyond the impact of economic cyclicality on its financial operations. Each of the past five biennial budgets relied on one-time solutions to achieve balance, including use of reserves, debt restructuring, or borrowing for operations.
BROAD APPROPRIATIONS PLEDGE
This is the commonwealth's first issuance of revenue bonds through the SPBC for the judicial branch, or AOC - most financings related to judicial branch projects are for courthouses and done by county-level conduit issuers. SPBC's project 109 bonds will finance a statewide AOC information technology project, warranting a commonwealth-level issuer.
Like all of SPBC's issues, this transaction rests on a lease between SPBC as lessor and a leasing agency. As lessee, AOC's covenant to seek biennial appropriations for amounts sufficient to make rental payments used for debt service parallels the covenant found in other SPBC transactions. AOC's pledge is to use all funds appropriated to the commonwealth's judicial branch. The vast majority of AOC's funds are appropriated from the general fund, with the remainder from restricted and federal funds. Fitch views this as a broad pool of available funds and accordingly rates these bonds equivalent to the commonwealth's general fund-backed appropriation debt, one notch below Kentucky's implied GO rating.
Unlike general fund appropriation bonds, the commonwealth's Finance and Administration cabinet (FAC, its key fiscal and budget management agency) is not a direct party to the transaction. FAC is an executive branch agency with no fiscal and budget oversight role in the judicial branch. AOC serves that function and is the lessee, and Fitch recognizes the broad responsibility of AOC for managing the state's court system. Fitch notes the secretary of FAC serves as executive director of the SPBC, which is the lessor.
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 attributed the shortfall to lingering effects of the 2013 federal income tax increase. To address the fiscal 2014 gap, the governor enacted various non-recurring measures including $50 million in fund sweeps and a $21 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 June is well ahead of the official forecast. General fund revenue growth for fiscal 2015 was 1.7% more than the official revenue estimate which projected 3.6% growth (versus actual fiscal 2014). Fiscal 2016 revenue growth is projected to be 2.7%. The fiscal 2016 budget relies on annual PIT and sales tax revenue growth of 4% and 2.1%, respectively.
Positively, general fund revenues ended the first half of the biennium (June 30, 2015) up a robust 5.3% yoy versus the 3.6% budgeted forecast with both PIT and sales tax revenues exceeding their targets. April collections were particularly strong, exceeding $1 billion for the first time ever, up 23.3% over the prior year. The strong revenue performance offsets some of the structural weakness of the enacted budget.
The current biennial budget includes a substantial $302 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. 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) revenue sources. 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. A second major system remains underfunded.
Fiscal 2015's strong revenue performance allowed Kentucky to generate a reported $165.4 million general fund surplus, and to bolster its reserve position. The commonwealth deposited $82.5 million into the budget reserve trust fund (BRTF), bringing the balance to an improved but still modest $209.4 million or 2.1% of fiscal 2015 general fund revenues. The enacted budget envisions a $13.7 million drawdown in fiscal 2016, which Fitch no longer anticipates given the general fund surplus in fiscal 2015.
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 recovered strongly after bottoming out in early 2010, and growth is now in line with national trends.
Overall, the commonwealth's quarterly moving average non-farm employment is up 2.1% yoy as of July, in line with the national rate. Kentucky's July 2015 unemployment rate of 5.2% is down from 6.2% a year earlier, and is just below the 5.3% U.S. rate. Labor force contraction continued at 1.4% yoy in July, but at a slower pace than last year's annual decline of 2.5%.
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 bachelor's 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 2014 per capita personal income of $37,654 was just 81.6% of the U.S. average, ranking 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. This is among the highest ratios for a U.S. state.
Net tax-supported debt alone (as of Dec. 31, 2014) was a moderately high 5.1% of 2014 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 entirely 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.
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 litigation to terminate their participation in KERS. 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 actuarial funding commitment for KTRS. Kentucky's contribution to KTRS has been short of the full actuarially determined employer contribution (ADEC, formerly the ARC) for seven of the past eight years. The fiscal positions of Kentucky's pension systems have deteriorated, partially due to investment losses and the failure to fully fund the ADEC.
Recent pension reforms address some of the commonwealth's pension-related problems, but challenges remain. Legislation in 2013 established a statutory full ARC funding commitment for KERS; 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.
The 2015 legislative session included active discussion around KTRS' funding challenges, most prominently a proposal for a pension obligation bond offering. The proposal failed and Fitch anticipates next year's budgetary session, which will include a new governor to be elected this fall, will focus on several key fiscal issues including KTRS funding. In June 2015, the current governor appointed a 23-member working group to develop recommendations to address the funding challenges with a report due on December 1. Fitch 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. According to the governor's executive order establishing the working group, Kentucky's fiscal 2016 KTRS pension contribution would need to increase by $487 million, or 4.8% of budgeted fiscal 2016 revenues. In the context of a stable-to-improving economic and revenue environment, Fitch anticipates the commonwealth could address that gap in a sustainable manner as it recently did with KERS and the KTRS other post-employment benefit liability.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from IHS.
Applicable Criteria
Tax-Supported Rating Criteria (pub. 14 Aug 2012)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015
U.S. State Government Tax-Supported Rating Criteria (pub. 14 Aug 2012)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033
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