Fitch Rates Kentucky ALCo's $153MM Funding Notes 'A+'; Outlook Stable

NEW YORK--()--Fitch Ratings assigns an 'A+' rating to $153.5 million of Kentucky Asset/Liability Commission (ALCo) funding notes, 2013 General Fund First Series (Taxable).

The bonds are expected to be offered through negotiation as early as Feb. 7, 2013.

Fitch also affirms Kentucky's appropriation-backed debt as follows:

--Approximately $6.4 billion in appropriation backed debt issued by the State Property and Buildings Commission (SPBC), the Kentucky Infrastructure Authority, the Kentucky Turnpike Authority, ALCo, and the Lexington-Fayette Urban County Government Public Facilities Corp. at 'A+';

--SPBC Agency Fund Revenue Bonds, Project 91 at 'A';

--Agency Fund Revenue Refunding Bonds, Project 104 at 'A';

--State Property and Buildings Commission (SPBC) taxable agency fund revenue bonds, Proj. 92 at 'A';

--Asset Liability Commission (ALCo) project notes, 2005 agency fund taxable first series at 'A';

--SPBC taxable agency fund revenue bonds, project 97 at 'A'.

The Rating Outlook is Stable.

SECURITY

The funding notes are special and limited obligations of ALCo, payable solely from revenues derived under financing/lease agreements between the commission and the commonwealth's finance and administration cabinet and teachers retirement system (KTRS).

SENSITIVITY/RATING DRIVERS

COMMONWEALTH APPROPRIATION OBLIGATION: Debt service derives from commonwealth appropriations, linking the rating to the general credit quality of the commonwealth. 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.

LIMITED OPERATING FLEXIBILITY: The commonwealth's operating flexibility has been reduced as is indicated by the depletion of reserves and a continuing reliance on nonrecurring budget items, including issuance for operating purposes, despite evidence of economic and revenue recovery.

HIGH LONG-TERM LIABILITIES: Commonwealth debt levels are at the higher end of the moderate range and other long-term liabilities are significant and well above average for a U.S. state.

ECONOMY REBOUNDING: Kentucky's economy is rebounding from the recession but remains exposed to an outsized and generally contracting manufacturing presence. Income levels are low.

CREDIT PROFILE

The commonwealth primarily issues debt through lease rental bonds, requiring appropriation. Proceeds of the bonds will be used to fund Kentucky's annual contributions to KTRS' state medical insurance fund. This is the third such issuance by the commonwealth since August 2010.

Kentucky's 'A+' lease 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 high liabilities, including for the poorly funded pension system.

Kentucky continues to face budget balancing challenges despite recovery in the economy, indicating a structural problem that goes beyond the impact of cyclical recession and recovery on its financial operations. In each of the past four biennial budgets, beginning in fiscal 2007 and including the biennium that began July 1, 2012, the commonwealth has relied on one-time solutions to balance its budget, including depletion of reserves, debt restructuring, and borrowing for operations, specifically to pay non-pension retirement benefits (OPEB), as in the current transaction. Although the structural gap and use of one-time items has been reduced in the current biennium, this practice continues despite economic recovery and growing revenues.

The fiscal 2011-2012 biennial budget for the general fund appropriated funds for fiscal 2011 at approximately fiscal 2010 levels, followed by an 11% increase in fiscal 2012 as the benefits of the federal fiscal stimulus program rolled off and spending shifted back to state generated resources. To balance, the budget called for 3.5% and 4.5% budget reductions for fiscal 2011 and fiscal 2012, respectively, $226 million in fund transfers, and $300 million in contract and operating efficiencies.

The budget included savings from debt restructuring of $203 million over the biennium and two borrowings related to OPEB financing of retiree health benefits. Revenue performance during the biennium was positive, with 6.5% year-over-year growth in fiscal 2011 and 3.8% growth in fiscal 2012, higher than forecast. Sales tax revenues grew 5.2% over the prior biennium and personal income tax 7.1%. Coal severance taxes also showed healthy increases and exceeded estimate.

The commonwealth began to rebuild its rainy day fund at the end of the last biennium with a deposit of approximately $122 million; however, the enacted budget for the current biennium again draws upon the budget stabilization fund to achieve balance, using $49 million of the balance in fiscal 2014. The budget, which assumed modest revenue growth of 2.4% in fiscal 2013 and 2.3% in fiscal 2014, required aggressive measures to close an estimated gap of $742 million. Priority areas such as education and Medicaid were protected from budget reductions but most areas of the budget were reduced.

The budget authorized continued borrowing to pay a portion of retiree health benefits, albeit in a smaller amount than in the prior biennium. Legislation passed in 2010 phases in additional contributions by both employees and the state and newly requires contributions from teachers.

Through the first six months of fiscal 2013 (ending June 30), the commonwealth reports solid general fund revenue growth of 3.8% year-over-year, ahead of the budgeted 2.4% growth. Sales and use tax revenues are essentially flat (up 0.1%) versus fiscal 2012, while personal income tax revenues show more robust growth of 4.9%.

Despite a decade of contraction, Kentucky continues to have an oversized manufacturing sector relative to the national economy. This sector is recovering since bottoming out in early 2010, with 0.6% year-over-year growth as of December 2012. Overall, non-farm employment is up 1.5% as of December, slightly higher than the national rate of growth of 1.4%. Kentucky's unemployment rate remains above the 7.8% U.S. rate at 8.1% in September 2012. Kentucky's per capita personal income for more than three decades has approximated 80% of the U.S. average and currently ranks the commonwealth 47th among the states for this measure.

Kentucky's liabilities are high with the combined ratio of debt and unfunded pension liabilities representing 20.3% of 2011 personal income. This ranks it among the highest of U.S. states rated by Fitch and is significantly higher than the median. Net tax supported debt of approximately $8.9 billion, represents an above-average 6.0% of 2011 personal income. The funding level for the Kentucky Employees Retirement System (KERS) non-hazardous sector was only 27.3% as of June 30, 2012, down from 97.3% funded as of June 30, 2003. Using Fitch's more conservative 7% discount rate assumption, funding of the pension plan would decline to 25.2%. Funding levels for the commonwealth's other retirement systems are better but have deteriorated as well due to investment losses and the failure to fully fund annually required contributions.

Some pension reforms have been enacted requiring more years of service and higher retirement age for certain workers, with the goal of reducing the future liabilities of the state's pension systems. The reform legislation also mandates increased annual pension funding but allows 15 years to reach full funding of the ARC, in the case of KERS, and slightly shorter ramp-up periods for the other systems. As a result, the funded status of the pension system is likely to decline significantly before it begins to improve and future pension payment requirements will place a greater demand on budgetary resources than would have otherwise been the case. The statutorily commissioned Kentucky Public Pensions Taskforce (KPPT) released a set of recommendations for additional pension reforms to the legislature in early December 2012.

Kentucky has long used state agencies for its financings which, for capital purposes 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 future legislative biennial budget appropriations, the securing financing agreement is automatically renewable.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria', dated Aug. 14, 2012.

--'U.S. State Government Tax-Supported Rating Criteria', dated Aug. 14, 2012.

Applicable Criteria and Related Research:

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

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Contacts

Fitch Ratings
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Eric Kim, +1-212-908-0241
Director
Fitch, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Karen Krop, +1-212-908-0661
Senior Director
Karen.Krop@fitchratings.com
or
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Senior Director
or
Media Relations
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elizabeth.fogerty@fitchratings.com

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Contacts

Fitch Ratings
Primary Analyst
Eric Kim, +1-212-908-0241
Director
Fitch, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Karen Krop, +1-212-908-0661
Senior Director
Karen.Krop@fitchratings.com
or
Committee Chair
Marcy Block, +1-212-908-0239
Senior Director
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com