NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'AA-' rating for the following Commonwealth of Pennsylvania's general obligation (GO) bonds:
--$355 million first series of 2016;
--$635.55 million first refunding series of 2016.
The bonds are expected to sell on or about June 1, 2016 through competitive bid.
In addition, Fitch has affirmed the commonwealth's 'AA-' Issuer Default Rating (IDR), and the 'AA-' ratings on the commonwealth's outstanding GO bonds. Fitch has also affirmed and upgraded the ratings on bonds supported by commonwealth appropriations or otherwise capped at the commonwealth's IDR, which are listed at the end of this release. The ratings on these bonds are linked to the commonwealth's IDR.
The Rating Outlook is Stable.
SECURITY
The GO bonds are direct and general obligations of the commonwealth of Pennsylvania, with its full faith and credit pledged.
KEY RATING DRIVERS
Pennsylvania faces fiscal pressures in the form of a structurally unbalanced budget, brought on by a combination of rising fixed costs, modest baseline revenue growth, and a particularly contentious decision-making environment. The 'AA-' IDR reflects those limiting factors, as well as Fitch's expectation that the commonwealth will utilize the significant budgetary flexibility available to most states to respond to those pressures adequately, while also making progress toward structural budgetary balance. Pennsylvania benefits from a large, diversified and expanding, albeit slowly, economic base which is expected to provide adequate revenue capacity to match expenditure growth.
Economic Resource Base
Pennsylvania's broad-based economy is growing, but at a slower pace than the nation. While the commonwealth's non-farm payrolls grew every year since 2009, the year-over-year (YOY) change lagged national trends for the past five years. Manufacturing is a major employer, but services (particularly education and health) have become much larger components of Pennsylvania's economic profile. Below-average demographics represent a long-term drag on economic growth with a median age of 40.5 versus the national median of 37.4. State population growth has lagged the national trend for several decades, indicating the potential for a smaller future workforce. Ongoing development of Pennsylvania's significant natural gas reserves could mitigate that concern but a weakened market tempers that potential. Overall, the state's economy provides a solid base for future potential revenue growth to help manage ongoing expenditure pressures.
Revenue Framework: 'aa' factor assessment
Fitch expects Pennsylvania's revenues, primarily income and sales taxes, will continue to reflect
the depth and breadth of the economy, but also its slower pace of growth. The commonwealth has complete legal control over its revenues.
Expenditure Framework: 'aa' factor assessment
The commonwealth maintains solid expenditure flexibility with a moderate burden of carrying costs for liabilities and the broad expense-cutting ability common to most U.S. states. Also, as with most states, Medicaid remains a key expense driver but one that Fitch expects to remain manageable.
Long-Term Liability Burden: 'aa' factor assessment
Pennsylvania's long-term liability burden is moderate but above average for a state driven by unfunded pensions. Net tax-supported debt is low. Pension funded ratios have eroded with contributions long below actuarial levels, but the commonwealth is nearing full funding of its contributions following a multiyear ramp up, which may help stabilize ratios.
Operating Performance: 'aa' factor assessment
The commonwealth retains very strong gap-closing capacity to deal with a cyclical downturn given its general budgetary flexibility. Pennsylvania is somewhat less exposed to revenue volatility due to economic declines than most states. Pennsylvania continues to utilize material nonrecurring budgetary measures during the economic recovery, with recent efforts towards reducing the reliance stymied by as-yet unresolved differences between executive and legislative branch approaches.
RATING SENSITIVITIES
ADDRESSING FIXED-COST PRESSURES: The 'AA-' rating is sensitive to Pennsylvania's ability to continue addressing increasing fixed-cost pressures, particularly for pensions, without materially weakening its fiscal flexibility. Fitch anticipates the commonwealth will meet its statutory obligations through adequate funding in lieu of more discretionary budget items, structural expenditure reform, or revenue increases; any shift away from those commitments would be a credit negative.
MOVE TOWARD SUSTAINABLE BUDGETS: Given the magnitude of Pennsylvania's structural budget gap, Fitch anticipates some continued use of non-recurring items in upcoming budgets. Material growth in the structural gap beyond this expectation could trigger negative rating action.
CREDIT PROFILE
Revenue Framework
Pennsylvania's income tax and sales and use tax serve as the primary revenue sources, accounting for nearly three-quarters of general fund revenues.
Historical revenue growth, adjusted for the estimated effect of policy changes, has been slightly positive on a real basis over the last 10 years. Year-over-year growth was robust leading into the recession but moderated considerably after recessionary declines in fiscals 2009 and 2010. Fitch anticipates the long-term trend for revenue growth will be moderately above inflation but trail the pace of national economic growth given Pennsylvania's slowly growing economic trajectory.
Pennsylvania has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
Expenditure Framework
As in most states, education and health and human services spending are Pennsylvania's largest
operating expenses. Considering just spending from state funds, education spending is the largest expense as the commonwealth provides significant funding for local school districts and the public university and college system but health and human services growth is likely to outpace it going forward. Medicaid is the largest component of health and human services spending.
While pension contributions have grown considerably in recent years as the commonwealth ramped up spending in line with a statutory plan enacted in 2010, they are not a material driver of overall expenditure growth.
Spending growth in the commonwealth, absent policy actions, will likely be in line with marginally above revenue growth driven primarily by Medicaid. The fiscal challenge of Medicaid is common to all U.S. states, and the nature of the program as well as federal government rules limit the states' options in managing the pace of spending growth.
Pennsylvania retains solid expenditure flexibility. While Medicaid costs are somewhat beyond the commonwealth's ability to materially change given federal requirements for the program, the state's carrying costs are moderate and likely to remain so given increased pension contributions under a statutory ramp-up plan with full funding anticipated by fiscal 2017. Like most states, Pennsylvania's operating budget (outside of Medicaid) goes largely towards funding of services rather than direct service delivery, allowing the commonwealth to shift costs to lower levels of government in times of fiscal stress.
Long-Term Liability Burden
Pennsylvania maintains a moderate long-term liability burden that should remain manageable. Per Fitch's October 2015 State Pension Update report, the commonwealth's total net tax-supported debt and unfunded pension liabilities of $56 billion covered 9.3% of 2014 personal income compared to the 50-state median of 5.8%. Fitch anticipates the pension liability burden will increase gradually at least until the commonwealth reaches full actuarial contributions, anticipated for next fiscal year based on the current statutory schedule.
Debt levels reflect borrowing for various capital needs including facilities, transportation, and water and sewer infrastructure. The commonwealth uses a mix of GO (legislatively or electorate approved) and appropriation-backed bonds. Approximately two-thirds of outstanding net tax-supported debt is GO. The state has used multiple entities and mechanisms to issue appropriation debt, which is used primarily for water and sewer needs and economic development projects.
Pennsylvania's pension obligations are for the State Employees' Retirement System (SERS) and the Public Schools Employees' Retirement System (PSERS). SERS includes state employees and employees of certain state-related organizations and the liability is essentially fully borne by the commonwealth. PSERS includes public school employees and the liability is shared between the commonwealth and local school districts. Pennsylvania makes its PSERS contributions through appropriations to school districts which make the only direct employer contributions to the system. The commonwealth has been consistently short of its actuarially calculated annual contribution for both systems for many years, but the percentage paid has been steadily increasing in line with legislation enacted in 2010.
Pension reform enacted in 2010 (Act 120 of 2010) made substantive changes for new employees but did not materially affect the liability, as current employee and retiree benefits were largely unchanged. More importantly, it established a ramp-up of commonwealth and local school district contributions. Under that schedule, the commonwealth will make full contributions to both systems beginning in fiscal 2017.
Operating Performance
Pennsylvania's ability to respond to cyclical downturns relies on the superior budget flexibility common to most states, but is hampered by slow growth prospects for revenues. The commonwealth retains broad capabilities to adjust expenditures and revenues on an annual basis to deal with a cyclical economic downturn. The Fitch Analytical Sensitivity Tool (FAST v.2.0.1) indicates such a downturn would likely have a more moderate effect on the commonwealth's revenues relative to other states, somewhat limiting the extent of fiscal challenge Pennsylvania could face. Pennsylvania's economy and revenue base have proven less cyclical than the national economy. Fitch anticipates the commonwealth would maintain an adequate level of financial flexibility in a moderate downturn. Failure to stem the growth in the structural budget gap in the coming years could materially weaken Pennsylvania's financial resilience in the event of a downturn and raise negative rating concern.
During the economic recovery, Pennsylvania has restored some financial flexibility but continues to rely on substantial non-recurring budgetary measures. The commonwealth utilized fund transfers, changes in timing of state expenditures, cuts in education spending, and one-time revenue sources to achieve annual budgetary balance in the past several years. Pension contribution deferrals have been another key non-recurring budgetary measure as the commonwealth has been consistently short of the actuarially determined contributions. Positively, Pennsylvania has steadily increased its contributions since fiscal 2010. The demonstrated commitment to the Act 120 statutory ramp-up schedule indicates Pennsylvania's intent to eliminate the deferrals, but the use of substantial one-time revenues to accommodate the funding growth indicates sizable structural gaps remain several years into the economic recovery.
The commonwealth's difficulty in reaching political agreement on fiscal measures hinders its ability to fully address its structural budget challenges and limits Fitch's assessment of Pennsylvania's operating performance. In fiscal 2016, Pennsylvania's newly elected governor and state legislature were unable to reach a full-year budget agreement. In December, the governor signed into law a partial budget with substantial line-item vetoes and in March he allowed a legislatively approved full-year budget to become effective without his signature. The commonwealth has a long history of contentious budget negotiations, but the commitment to timely debt service has never been in question, even for appropriation-back debt. But continued discord on basic issues of revenues and expenditures hinders the commonwealth's ability to fully utilize its fiscal flexibility to manage through downturns and recoveries.
Current Developments
Through the first nine months of fiscal 2016 (which began on July 1), general fund revenues were tracking essentially in-line with the estimate used in the governor's fiscal 2017 executive budget proposal and in the enacted fiscal 2016 full-year budget. Fitch notes some underlying risk because above-budgeted growth in more non-recurring and volatile revenue streams such as unclaimed property, inheritance taxes, and corporate income taxes are offsetting modest weakness in personal income tax withholding.
The commonwealth's independent Fiscal Office (IFO) projects a modest $150 million revenue surplus for fiscal 2016, which the administration expects will be fully consumed by an estimated $209 million in estimated supplemental appropriations primarily for Medicaid and corrections. Overall the administration currently projects a nearly $200 million negative ending budgetary general fund balance for the year. This would be the second negative balance in three years and adds to the structural challenge for fiscal 2017.
In January, IFO estimated a $1.9 billion structural, or current services, general fund budget gap for fiscal 2017. Revenue performance has improved since then, but expenditure trends have arguably weakened for the commonwealth as demonstrated by the supplemental appropriations the administration believes will be required this year. Regardless, the structural budget challenge remains significant for a roughly $30 billion overall general fund budget. The governor's fiscal 2017 executive budget proposes broad-based revenue measures similar to the ones ultimately rejected by the legislature last year. Pennsylvania's current 'AA-' IDR incorporates an expectation of continued challenges in reaching political consensus on final fiscal measures. But the rating also anticipates the commonwealth will halt the growth in the fundamental mismatch between recurring revenues and recurring expenditures.
UPGRADE FOR CONVENTION CENTER BONDS
The upgrade to the ratings for Pennsylvania Economic Development Financing Authority (convention center project) revenue bonds to 'A+'/Stable from 'A'/Stable reflects application of Fitch's updated criteria for appropriation-backed debt. Essentiality of the financed project is no longer a key driver of notching for appropriation-backed debt.
Fitch has affirmed and upgraded the following ratings that are supported by commonwealth appropriations and therefore linked to the commonwealth's IDR, or otherwise capped at the IDR:
--Pennsylvania Turnpike Commission motor license fund-enhanced turnpike subordinate special revenue bonds affirmed at 'AA-' ;
--Pennsylvania Commonwealth Financing Authority appropriation-backed debt affirmed at 'A+'
--Pennsylvania Economic Development Financing Authority revenue bonds (Convention Center Project) bonds upgraded to 'A+' from 'A'.
The Outlook on all of the ratings is Stable.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
Applicable Criteria
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879478
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