Fitch Affirms San Jose, CA's GOs at 'AA+'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has affirmed the rating on San Jose, California's (the city) bonds as follows:

--$401.7 million outstanding general obligation bonds (GOs) at 'AA+'.

Fitch also affirms the 'AA' rating on the following bonds issued by the San Jose Financing Authority, California:

--$531.5 million lease revenue bonds (LRBs), series 2001F, 2003A, 2006A, 2007A, 2013A, and 2013B.

--$46.4 million lease revenue commercial paper bank notes series 1, 2, 1-T, and 2-T.

The Rating Outlook is Stable.

SECURITY

The GOs are payable from an unlimited property tax levied on all taxable properties in the city.

The LRBs and bank notes are payable by rental payments to the authority from the city for various leased assets. The LRBs additionally are backed by cash-funded debt service reserve funds.

KEY RATING DRIVERS

SOUND FINANCIAL POSITION: The city's general fund benefits from high reserve levels, a third consecutive audited year of operational surplus and solid revenue growth. Although multi-year projections point to mostly small structural surpluses, elected officials will have to contend with wage, service level, and deferred maintenance pressures.

STRONG ECONOMIC PERFORMANCE: The city's robust economic recovery, including strong tax base and employment growth, has driven above average revenue performance. High concentration in the technology industry has fueled robust income levels and low poverty rates while leaving the city exposed to fluctuations in sector performance.

WEAK DEBT PROFILE: The city's overall debt burden is high. Pension and other post-employment benefit (OPEB) liabilities are also quite high; however, the city instituted aggressive policies to address them and recent years' high contribution rate hikes are projected to level off soon. The city's capital needs are dominated by a large and growing backlog of street maintenance and it remains to be seen how it will be addressed.

GOOD MANAGEMENT TEAM: The city benefits from a sophisticated and tenured financial management team that publishes multi-year projections, mid-year budget reviews, and a multitude of other reporting practices that Fitch considers to be strong. Although there has been recent and significant turnover among key elected officials and some managerial positions, there has been no apparent shift in major financial policies.

LEASE REFLECTS GO RATING: The rating on the LRBs is based on the city's overall credit quality; a one-notch distinction from the GO rating reflects weaker security provisions than the GO, such as leased asset abatement risks. Some of the leased assets are non-essential but Fitch has applied its minimum one-notch rating distinction from the GO due to a cross default provision that would substantially hike interest costs across the city's portfolio of variable rate LRBs in the event of a default on any one of its LRBs.

RATING SENSITIVITIES

MAINTENANCE OF STRUCTURAL BALANCE: Material and unexpected financial deterioration from current levels could lead to negative rating action. Fitch will pay close attention to the city's ability to maintain structural balance in the context of significant spending pressures, diminished expenditure flexibility, and very limited revenue raising abilities per California constitutional provisions.

CREDIT PROFILE

San Jose covers over 178 square miles at the southern end of the San Francisco Bay. Serving a population of about 1 million residents, the city is the largest in the Bay Area and the third largest in the state. Its economy, like that of the region, continues to be tied to the high-technology sector, although the focus has shifted somewhat from manufacturing to design, R&D, information, and software. The city benefits from its proximity to several universities, an abundance of venture capital companies, and a highly educated, affluent workforce.

WEALTHY, EXPANDING TECHNOLOGY BASED ECONOMY

The city's relatively high concentration in technology companies has led to strong average income and educational attainment levels, but also leaves the city subject to the volatility of the high tech sector. The impact of the housing-led recession was somewhat muted compared to the bursting of the tech bubble in the early 2000's, though employment still declined significantly in 2009.

San Jose's economic recovery has been robust with five years of mostly solid employment growth, lowering the city's December 2014 unemployment rate to a somewhat low 5%. Robust economic growth has translated into high total revenue growth, ranging from 4.3%-6% annually from fiscal 2011-2014. The city's well diversified tax base also staged a solid recovery due to rapidly rising home values and in-fill development. Assessed value (AV) increased a cumulative 18% from its recessionary low in fiscal 2011 to 2015 compared to a peak to trough AV decline of 4.9% during the recession. Poverty rates are below average and median household incomes are high at 134% and 154% of state and national levels, respectively.

STRONG FINANCIAL PERFORMANCE, THOUGH VULNERABILITIES PERSIST

The city has a solid financial position that stems largely from aggressive cost-cutting and benefit reforms following the housing-led recession. The city's general fund produced an impressive $77.1 million (or 10.4% of spending) operating surplus after transfers in fiscal 2014, raising the total and unrestricted reserves to high levels of $304 million (41% of expenditures and transfers out) and $284 million (38.4%), respectively. Fiscal 2014 was the third consecutive year of operating surpluses.

The city's five-year financial projections point to mostly small operating surpluses. Fitch views the city's financial projections as realistic, though there are a number of financial susceptibilities that could negatively affect out-year performance as noted below. Despite these vulnerabilities, the city has tended to well out-perform its financial projections in recent years. San Jose produces optimistic, base case, and pessimistic projections, which Fitch views as prudent planning exercises.

Most of the city's reserves reflect committed and assigned fund balances designed to be spent on numerous policy initiatives. The intent behind the accumulation of these balances is to guarantee service delivery over a multi-year period even if projected revenue gains don't transpire. Because the timing of these initiatives varies and new initiatives may be created requiring their own reserve accumulations, it is unclear to what extent, if any, these dedicated reserves may fall moving forward. Given the city's historical propensity to maintain high fund balances, Fitch expects such balances will remain sound.

Continued solid financial performance will require elected officials to contend with three significant vulnerabilities moving forward. First, the city spends roughly two-thirds of its resources on public safety, which is beginning to show signs of diminishing expenditure flexibility and pent-up compensation pressures following years of cost reductions. Second, a recent internal report on the city's roads suggests there is a large and growing backlog of deferred maintenance to contend with that would require an additional annual investment of $38 million to $85 million annually from recent historical levels. Third, it has been the goal of policymakers to restore major services to Jan. 1, 2011 levels and to significantly increase the police force from current levels. The city will need to maintain a measured approach to these pressures to ensure continued sound financial operations.

STRONG MANAGEMENT PRACTICES

Fitch views city management practices as strong overall. Financial operations are sophisticated, including multi-year forecasting, mid-year budget reviews and adjustments, comprehensive annual debt reports, and multiple other financial reports. Management is well tenured overall, and the political environment has been good, with a stronger than average voter approval history for GO authorizations and overwhelming support for Measure B in 2012. Elected officials prudently implemented major expenditure reductions during the downturn and implemented strong mitigating measures to deal with the city's challenged debt profile.

Labor relations are strained with substantial and continuing pushback over Measure B. Pension reform played a key role in the city's November 2014 mayoral election, with the labor-backed candidate narrowly losing to Sam Liccardo, who supported Measure B as a city councilman and campaigned to maintain the reforms. In addition to a new mayor, there are five new councilmembers and there has been significant turnover among some key managers in the City Manager's Office. To date, these changes have not resulted in an apparent shift in major financial policies.

WEAK DEBT PROFILE DESPITE RECENT REFORMS

The city's overall net debt burden is high at $6,762 per capita, or 4.9% of AV based on fiscal year end 2014 debt levels. Amortization is moderate, with 47% of principal retiring over a 10-year period. The city has no plans for new money debt issuances, so direct debt levels may fall over the intermediate term.

The city's public safety pension system is adequately funded at 76% (Fitch-adjusted, reflecting a standardized 7% investment return rate). The federated pension system (non-sworn workforce) Fitch-adjusted funded position is somewhat weaker at 58%. On a combined basis, the city's Fitch-adjusted unfunded pension liabilities total a considerable $2.2 billion or 1.7% of AV.

The risks related to the city's large pension and OPEB liabilities have been moderately mitigated by Measure B, which is subject to ongoing litigation and administrative proceedings. Some provisions, such as certain benefit eliminations and a second tier pension system for newer employees, have already taken effect. Other provisions have not yet taken effect, such as increased pension contributions for existing employees. The city has excluded any potential savings in its financial projections from measures that have not yet been implemented, should Measure B be upheld in its entirety.

The city entered into agreements with all bargaining units in fiscal 2009 and 2012 to raise city and employee OPEB contribution rates significantly over a multi-year period with the intent of eventually achieving full funding of the annual required contribution (ARC). The city has not yet reached 100% funding of the ARC, but has made substantial progress to date and Fitch views as a credit positive the city's proactive approach to pre-funding its large OPEB liability.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

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

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685314

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=981092

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Contacts

Fitch Ratings
Primary Analyst
Scott Monroe
Director
+1-415-732-5618
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94108
or
Secondary Analyst
Karen Ribble
Senior Director
+1-415-732-5611
or
Committee Chairperson
Michael Rinaldi
Senior Director
+1-212-908-0833
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Scott Monroe
Director
+1-415-732-5618
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94108
or
Secondary Analyst
Karen Ribble
Senior Director
+1-415-732-5611
or
Committee Chairperson
Michael Rinaldi
Senior Director
+1-212-908-0833
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com