Fitch Rates Texas Water Development Board's $150 Million GO Bonds 'AAA'; Outlook Stable

AUSTIN, Texas--()--Fitch Ratings has assigned a 'AAA' rating to approximately $149,800,000 in general obligation (GO) bonds of the State of Texas issued by the Texas Water Development Board, as follows:

--$60,345,000 water financial assistance and refunding bonds, subseries 2016B-1;

--$28,125,000 water financial assistance and refunding bonds, subseries 2016B-2 (variable rate);

--$18,950,000 water financial assistance and refunding bonds, subseries 2016B-3 (taxable);

--$29,225,000 water financial assistance refunding bonds (economically distressed areas program) subseries 2016C-1;

--$1,310,000 water financial assistance refunding bonds (economically distressed areas program) subseries 2016C-2 (taxable);

--$11,845,000 water financial assistance refunding bonds, series 2016D (state participation program).

The par amounts are approximate and subject to change upon final sale.

The bonds are expected to sell via negotiated sale on or about June 28, 2016.

The subseries 2016B-2 bonds are variable rate and have no external liquidity support. In the event of a failed remarketing, the bonds would remain outstanding and would bear interest at a stepped rate, up to a maximum rate, pending successful remarketing or conversion to another interest rate mode.

The Rating Outlook is Stable.

SECURITY

The bonds are general obligations to which the state pledges its full faith and credit.

KEY RATING DRIVERS

Texas' Long-Term 'AAA' IDR reflects an economy that continues to grow despite the severe contraction in the state's globally important energy sector, its conservative financial operations and manageable liability burden. The oil price plunge that began in late 2014 interrupted a long period of economic and revenue growth, but diversification over time leaves the state better positioned relative to past cycles to weather the energy sector downturn.

Economic Resource Base:

Texas' economic resource base is large and diverse, although oil and gas remain significant and are subject to volatility. The state has been a population magnet and economic growth leader for decades, resulting in a degree of diversification well beyond the resource sectors that were dominant during the last severe oil price shock in the 1980s. Service sectors in particular have grown in size and importance. The current energy sector downturn has slowed, but not halted, economic momentum; and Fitch views the state's longer-term economic prospects as strong. Overall employment gains continue, albeit now below national averages, and the unemployment rate remains well below U.S. levels.

Revenue Framework: 'aaa' factor assessment

Texas' revenue growth is expected to be in line with or above the level of U.S. economic growth, driven by rapid population and economic growth over time. Like most states, Texas retains nearly unlimited ability to raise operating revenues. Sales tax is the dominant source of revenue, although transportation, energy and other levies are also important.

Expenditure Framework: 'aa' factor assessment

Consistent with other states, Texas retains ample flexibility to cut spending throughout the economic cycle, an attribute that the state relies on if needed to maintain fiscal equilibrium. Spending pressures from education, Medicaid, transportation, water and other growth-related needs are notable, and litigation, particularly related to education funding, is a source of uncertainty.

Long-Term Liability Burden: 'aaa' factor assessment

The combined burden of Texas' debt and unfunded liabilities is low relative to its resource base. A reluctance to borrow results in a low burden of net tax-supported debt. Unfunded pensions are a larger, but manageable burden. Progress in lowering pension liabilities is unlikely given several factors, which include higher than average discount rates and contributions that are statutorily fixed instead of shifting with actuarially-calculated needs.

Operating Performance: 'aaa' factor assessment

Financial resilience is strong, with exceptional gap-closing capacity stemming from a willingness to cut even high priority spending and a very well-funded budgetary reserve that receives constitutionally dedicated oil and gas tax revenues. The state has a high level of fundamental financial flexibility despite a historical reluctance to raise operating revenues. To a limited degree, there is some deferral of required spending, notably pension contributions.

RATING SENSITIVITIES

Economic Growth and Ample Flexibility: Texas' 'AAA' Long-Term IDR and Stable Outlook assume continued strong prospects for economic gains and the maintenance of ample fiscal flexibility both in its conservative approach to budget management and its high reserve balances. The rating could be pressured in the event of the state's unwillingness to address potential fiscal challenges in an effective and timely manner.

CREDIT PROFILE

Fitch believes that the state has ample fiscal flexibility to absorb near-term economic and revenue volatility, both in the form of its very large budgetary reserve -- the economic stabilization fund (ESF) -- and a practice of taking budgetary actions to maintain balance. Although sales tax collections -- the state's primary source of revenues -- are now trending below prior year figures, liquidity remains ample. In fiscal 2016, for the first time in decades, it was unnecessary for the state to undertake cash flow borrowing for intra-year cash needs. However, rapid growth and the concomitant demand for public services, including transportation, education and water, continue to pressure spending, and unresolved litigation poses further uncertainty.

Fitch expects the downturn in the state's oil and gas sector to continue to weigh on overall state economic performance, but to what degree is not yet clear. Job gains continue, albeit now at levels below U.S. averages, while the unemployment rate remains well under national averages. Employment losses to date are concentrated in natural resources and manufacturing, as well as in geographic regions of the state with significant energy sector concentration.

The state is currently in the first year of its fiscal 2016-2017 biennium. Total general revenue (GR) and GR dedicated appropriations in the adopted budget equal $106.6 billion through the biennium, after adjustments including vetoes. This figure is approximately 12% higher than the comparable figure for the fiscal 2014-2015 biennium, based on the legislative budget board (LBB) analysis of the joint senate-house budget bill.

Recent revenue collections show continued growth overall despite weakness in taxes affected by the oil and gas downturn. Year-to-date through April 2016, total revenues excluding federal funds were 2% over forecast and 1.4% over the prior year. Sales taxes are 4.3% below forecast and 1.9% below the prior year. The state's next revenue forecast is not expected until early 2017, before the next regular legislative session convenes.

Revenue Framework

Texas' main revenue source for funding expenditures is a statewide sales tax; there is no personal or corporate income tax. Other levies are important, including a franchise tax on businesses, various transportation taxes and fees, and oil and gas production taxes. The latter taxes in particular remain important, but volatile, and have fallen as a share of state revenues since the 1980s, the last time the state suffered through a severe energy sector downturn. Sales taxes are also affected by energy sector volatility, although to a lesser degree. The constitutional diversion of most oil and gas tax revenues into the budgetary reserve or for highways spares the general revenue fund from the most extreme energy sector volatility.

Texas' rapid population growth and generally strong labor market provide the basis for a revenue growth profile that Fitch expects to exceed the typical state's over time. This likely remains the case even as the state once again faces near-term economic disruptions from low energy prices and slowing revenue momentum. Dedication of revenues for specific needs (oil and gas production for budgetary reserves and highways, and sales taxes for highways beginning in the next biennium) may affect how closely economic trends align with revenue collection trends.

Texas has almost unlimited ability to raise revenues, with the exception of a constitutional restriction on levying a property tax.

The state has disclosed four lawsuits challenging application of state sales and franchise taxes to specific business situations. The comptroller does not believe that any of the cases, if decided individually against the state, would constitute a material risk, although if adverse decisions are applied across potentially affected taxpayers the impact could be material.

Expenditure Framework

Spending commitments are dominated by education and social services, particularly Medicaid. Education is the state's largest expenditure, and consists of formula spending for K-12 education distributed as intergovernmental aid to local school districts; public college and university funding are also significant line items.

Fitch has long noted the spending pressures arising from the state's rapid growth. Growth-related demands affect both operating and capital spending, including for education, transportation, water and social services. Education funding is provided through a combination of state resources and local property taxes, and has been a longstanding policy flashpoint given rapid growth, limits on local property taxes, and the state's demonstrated willingness to change education funding based on state fiscal conditions. Transportation needs are also considerable, particularly within and between cities, with the state devoting a larger share of both transportation and general revenues to address congestion.

The state has not hesitated to make deep cuts even to core services in the face of projected revenue weakness. These included, in the last downturn, deep cuts to education formula funding, deferrals of some education aid into later biennia, and underfunding of Medicaid. Texas' carrying cost for liabilities is low and only slightly above the median for states, driven primarily by pension contributions, which are statutorily set at a level that, of late, has been below the amount needed to make progress on amortizing the liability.

Adverse outcomes from litigation can affect state expenditures. At present, litigation in federal court related to the adequacy of foster care continues, although Fitch believes the state would have the ability to respond to an adverse court decision in a manner consistent with the current rating level. A long-running case challenging the adequacy/equity of the current state funding methodology for local school districts was recently decided by the state's Supreme Court in the state's favor, sparing the state from having to make potentially significant budget adjustments.

Long-Term Liability Burden

Texas' overall liability burden is just above the median for U.S. states but remains a low burden on resources. The net tax-supported debt burden is low, driven by a longstanding reluctance to pursue tax-supported borrowing, although self-supported borrowing is a significant source of capital spending and much of this debt carries a GO pledge. Pension liabilities are larger, given the state's responsibility both for its own retirees and for most of the cost of retired teachers. Despite some reforms, including partial cost-shifting to local schools and higher employer contributions, challenges for the pensions include higher than average discount rates and contributions that are statutorily fixed below actuarial levels. These factors suggest progress toward full prefunding is unlikely absent additional reforms.

The state has significant internal liquidity, which it has used to a limited degree to provide self-support for variable rate borrowing or CP programs. Liquidity is currently high enough that the state has not borrowed for annual cash flow needs in the current fiscal year, the first time this has been the case in more than two decades.

Operating Performance

The state's financial resilience is high, driven both by an exceptional budget reserve balance and by a willingness to make deep spending cuts, including to core services, in the event of a revenue shortfall. As of April 2016, the ESF balance of nearly $9.7 billion was equal to 18.6% of projected fiscal 2016 general revenues.

Constitutional provisions divert most oil and gas revenues to the ESF and more recently to highways; these provisions have both spared the GRF from energy revenue-related volatility and resulted in very high ESF balances. The state has not been reluctant to tap reserves for other needs, such as water development; recent decisions to divert portions of the ESF balance and revenues flowing to the ESF have generally been for functional spending needs that are urgent and growth-related.

Date of relevant rating committee: April 27, 2016.

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.

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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Contacts

Fitch Ratings
Primary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block
Senior Director
+1-(212)-908-0239
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Douglas Offerman
Senior Director
+1-212-908-0889
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block
Senior Director
+1-(212)-908-0239
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com