NEW YORK--(BUSINESS WIRE)--Fitch Ratings assigns an 'A+' rating to the following Turnpike Authority of Kentucky's (TAK) bonds:
--$65.965 million economic development road revenue bonds 2015 series A;
--$122.235 million economic revenue road revenue refunding bonds 2015 series B.
The bonds are expected to be offered through negotiated sale on or about the week of Jun. 15, 2015.
The Rating Outlook is Stable.
SECURITY
The bonds are a special and limited obligation of TAK, payable solely from revenues derived under a financing/lease agreement between TAK, as lessor, and the commonwealth's transportation cabinet, as lessee. The bonds are paid from appropriations made to the transportation cabinet, primarily from the Road Fund, which receives various transportation-related fees and taxes.
KEY RATING DRIVERS
APPROPRIATION RISK LIMITS RATING: Road fund revenues, which are the primary sources of revenues for debt service, are constitutionally dedicated to highway purposes, though not necessarily for debt service on road revenue bonds. Biennial legislative appropriation is required for the transportation cabinet to have sufficient resources to make lease payments, and therefore, for TAK to make debt service payments. Accordingly, the rating on TAK's road fund revenue bonds is equivalent to the commonwealth's general-fund supported appropriation debt.
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. The last biennium ended with an unexpected revenue shortfall, but current year performance is 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. 2013 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 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 pose long-term demographic challenges for the commonwealth.
RATING SENSITIVITIES
LINKED TO IMPLIED GO RATING: The rating on TAK's road revenue bonds is linked to changes in the commonwealth's implied GO rating.
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
TAK road revenue bonds are rated equivalent to general fund-supported appropriation debt of the commonwealth due to appropriation risk. While road fund revenues are constitutionally dedicated to transportation uses, there is no lien on road fund revenues in favor of bondholders. In the event of non-appropriation, statute dedicates a portion of motor fuel taxes and surtaxes to repayment of road fund revenue bonds. But these dedicated revenues are not anticipated to be sufficient to pay debt service on outstanding road revenue bonds. Further, neither the indenture nor the lease agreement includes non-impairment language requiring the commonwealth to maintain motor fuel tax rates at levels sufficient to pay debt service.
Road revenue bonds are paid with lease payments from the transportation cabinet to the authority, with revenues derived from biennial legislative appropriations. Resources of the road fund, principally motor fuel and vehicle usage taxes, are the main source of lease payments. Total available road fund revenues equaled $1.1 billion in fiscal 2014, after adjustments for various statutory deductions, up 4% from the prior year. These revenues covered lease rentals for debt service on bonds supported by the transportation cabinet (including TAK road revenue bonds) by nearly eight times.
The motor fuel tax (38.2% of FY 2014 available road fund revenues) includes a fixed component (5 cents) and a variable rate component equal to 9% of the average wholesale price, subject to a floor. The tax is levied on gasoline, liquefied petroleum gas and special fuels (e.g. diesel). The vehicle usage tax (42% of fiscal 2014 revenues) is a 6% tax levied on the sale or transfer of motor vehicles. Prior to statutory deductions, FY 2014 road fund revenues were up 4.6% yoy to $1.6 billion and 1.4% ($22 million) below the commonwealth Consensus Forecasting Group's (CFG) budgeted estimate.
For the current fiscal year, total road fund receipts (inclusive of statutory allocations not available for these bonds) were down 1.2% yoy through April. The state budget director's third quarter economic and revenue report forecasts continued declines in road fund receipts over the next several months, including an 11.7% decline in the last quarter of fiscal 2015. The decline partially reflects the effect of lower gas prices on the variable component of Kentucky's motor fuel tax.
In response, the legislature enacted HB299 (effective April 1, 2015) which raised the motor fuels tax floor and revised the overall process for calculating the motor fuel tax to limit future collections declines. Fitch anticipates the changes will mitigate effects of lower gas prices on motor fuel tax collections, but the budget director's projection of a 10.3% decline in the first six months of fiscal 2016 incorporates HB299's changes.
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 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.
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 April is well ahead of the official forecast. Kentucky's revenue forecast is for general fund revenue growth of 3.6% in fiscal 2015 (versus actual fiscal 2014) and 2.7% in 2016. The budget, enacted before the fiscal 2014 shortfall was recognized, relies on 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 April 2015 are up a robust 6.2% 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 and bringing the commonwealth ahead of the budgeted forecast for the entire fiscal year. Fitch notes monthly tax revenues in the last few months of the fiscal year can be somewhat volatile given timing issues and anticipates yoy growth will move lower in the final two months. 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. Kentucky reports Medicaid savings were 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 million (or less than 1% of annual general fund revenues) at the end of the biennium. Strong revenue performance this fiscal year could allow the commonwealth to rebuild its BRTF and limit any drawdowns in fiscal 2016.
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.
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, the three month moving average durable goods manufacturing employment was up 5.3% yoy in March while non-durables declined 3%. Overall, the commonwealth's three-month moving average non-farm employment is up 2.1% yoy as of April, just below the national rate (2.3%). Kentucky's April 2015 unemployment rate of 5% is down sharply from 7% a year earlier, and is now below the 5.4% U.S. rate. Labor force contraction continued at 0.6% yoy in April, but at a slower pace than last year (2%).
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 (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 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 position 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. 2013 legislation 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. 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. 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 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 Fitch's 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
Additional Disclosures
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=985912
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https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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