Fitch Rates Minnesota's $12MM State Appropriation Bonds 'AA+'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned a 'AA+' rating to the following State of Minnesota bonds:

--$11,805,000 state general fund appropriation bonds taxable series 2016A (Lewis and Clark Regional Water System Project).

The bonds are expected to sell through competitive bid on Oct. 19, 2016.

In addition, Fitch has affirmed the following ratings:

--The state's Issuer Default Rating (IDR) at 'AAA';

--$7 billion in outstanding state general obligation (GO) bonds at 'AAA';

--$1 billion in state general fund appropriation bonds series 2012B, 2014A and 2014B at 'AA+';

--$79 million in State of Minnesota certificates of participation (COPs), series 2014 (legislative office facility project) at 'AA+';

--$95 million in St. Paul Port Authority (State of Minnesota Office Building) lease revenue bonds at 'AA+'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a legislative general fund appropriation for debt service.

KEY RATING DRIVERS

The 'AA+' rating, one notch below the state's IDR, reflects the slightly higher degree of optionality associated with payments that are subject to appropriation.

The state's 'AAA' IDR reflects Minnesota's solid and broad-based economy, a revenue structure well designed to capture economic growth, a low liability burden, and strong control over revenues and spending that, in conjunction with a sophisticated approach to reserve funding, leaves the state exceptionally well positioned to manage throughout the economic cycle while maintaining a high level of financial flexibility.

Economic Resource Base

Minnesota's economy is broad based and resembles that of the nation, although the manufacturing, education and health services, and financial activities sectors are somewhat more important than the national average. The state's population of about 5.5 million is well educated and wealth levels are above average. Population growth is moderately slower than the U.S. pace.

Revenue Framework: 'aaa' factor assessment

Minnesota's revenues have shown solid growth even after adjusting for the impact of tax increases. Fitch believes that revenue growth prospects continue to be strong. The state has complete independent legal control over revenues.

Expenditure Framework: 'aaa' factor assessment

Fitch expects that the natural pace of Minnesota's spending growth, driven by education and Medicaid funding demands, will be generally in line with to marginally above revenue growth and require ongoing budget management. The state has ample flexibility to control spending.

Long-Term Liability Burden: 'aaa' factor assessment

Minnesota's combined debt and unfunded pension liability is a low burden on resources, in line with the state median as measured against personal income. GO debt amortization is rapid and other post-employment benefit obligations are minimal.

Operating Performance: 'aaa' factor assessment

Minnesota has shown significant financial resilience through downturns and a strong commitment to bolstering its financial position as conditions improve. The state historically has relied on non-recurring budget-balancing measures at times of recessionary weakness, with positive performance during recoveries allowing for timely replenishment of reserves and repayment of deferred school aid. Although revenue volatility has increased as capital gains have become a larger part of the state's tax receipts, the state has materially strengthened its approach to reserve funding in response.

RATING SENSITIVITIES

The rating is sensitive to changes in the state's IDR, to which it is linked. The IDR is sensitive to the state's ongoing strong budget management, including adherence to well-developed reserve funding policies, as well as Fitch's expectations for continued strong economic and revenue growth prospects and a low long-term liability burden.

CREDIT PROFILE

The bonds are secured by a continuous general fund appropriation for debt service; the appropriation will remain in place for the life of the bonds unless the legislature affirmatively chooses to repeal it. Debt service is also subject to the governor's unallotment powers. In the event of such repeal or unallotment, the bonds would be cancelled. The risk of legislative repeal of the appropriation is inherent in appropriation-backed debt and reflected in the rating below that of the state's IDR. In addition, despite historical use of executive unallotment powers by the state, debt service has not been affected. Fitch would expect an issuer of the strong credit quality of Minnesota to continue to protect its debt service obligations.

Bond proceeds will fund costs related to the Lewis and Clark Regional Water System project. The state legislature approved the issuance of state general fund appropriation-backed bonds for the project up to $19 million of net proceeds. As is the case for the state's series 2014 and 2012 state general fund appropriation bonds, which funded the Vikings football stadium and refunded tobacco securitization bonds issued for deficit financing in the downturn, the state's commissioner of management and budget was authorized to issue general fund appropriation bonds for this project under statutes that include a standing general fund appropriation for debt service.

State's General Credit Quality

Minnesota's economy is balanced, with positive wealth indicators and demographic strengths. The Minneapolis-Saint Paul area serves as a major regional center, and robust growth in the educational and health services sector has made that an increasingly significant part of the state economy.

The state experienced job losses less severe than those of the U.S. in the Great Recession, while the state's employment recovery has been generally consistent with that of the U.S. The unemployment rate remains well below that of the nation; the state believes that Minnesota is currently essentially at its full employment potential, which could serve to moderate growth.

Revenue Framework

Minnesota's general fund revenues are diverse, consisting of individual and corporate income, sales, and property taxes. Personal income tax revenues make up about 54% of all general fund tax revenues, and sales tax revenues another 27%.

The state's income and sales taxes respond quickly to changes in economic conditions. On average, tax revenues have grown at a pace about the rate of national economic growth. Fitch expects this trend to continue.

Like most states, Minnesota has the independent legal ability to raise operating revenues without any external approval required. The state's comparatively high taxation levels appear to be well balanced by high services.

Budget forecasting and management mechanisms are strong, with reviews of economic and revenue forecasts in February and November of each year.

Expenditure Framework

Minnesota's general fund spending is primarily for K-12 education (about 42% of expenditures), higher education (7%), and health and human services (30%).

Fitch believes spending growth, absent policy actions, will likely be in line with to marginally above revenue growth over time, requiring regular budget management. The ongoing fiscal challenge of Medicaid is common to all U.S. states, and Minnesota has shown a strong commitment to education funding.

The state has substantial flexibility to cut spending as needed, with the broad expense-cutting authority common to most U.S. states. Fixed carrying costs for debt and retiree benefits are low. Although federal rules place limits on the ability to control the Medicaid program, Minnesota has seen health care costs come in below expected levels in recent years.

Long-Term Liability Burden

Minnesota's combined debt and unfunded pension liability is low and at the median for U.S. states - 5.8% of personal income as of Fitch's 2015 state pension update. The state has well-established debt policies that control issuance and require rapid amortization of GO debt, which equals about 80% of net tax-supported debt. Seventy percent of outstanding GO debt matures in 10 years and, per the state constitution, debt must mature within 20 years.

Minnesota's use of appropriation-backed debt has increased in recent years. In 2012 the state issued $656 million in appropriation-backed debt to refund the tobacco securitization debt that was issued in 2011 for budget relief through debt service savings. In addition, in 2014 the state issued $462 million in appropriation-backed debt to fund its $348 million commitment to a new stadium for the Minnesota Vikings as well as the local share. The increased debt service cost to the general fund associated with the stadium bonds is expected to be offset by increased gaming revenues, among other revenues.

The state participates in multiple defined benefit pension plans, with its obligation for state employees constituting the largest share of its obligations. In aggregate, the state's unfunded pension liability is below average as a percent of personal income; however, annual pension contributions are determined by statute rather than actuarial calculation and the state's contributions have been consistently below the actuarial level. This comparative credit weakness has been offset to date by the relatively small size of overall obligations and by meaningful reforms to lower benefits, including the court-validated authority to reduce cost of living adjustments. Discussions of additional measures to bolster sustainability are ongoing. Retiree health benefits are very limited.

Operating Performance

Minnesota's historical record for budget management is very consistent, with a reliance on one-time solutions in downturns (particularly school aid deferrals and, in the Great Recession, bonding for deficits) and financial flexibility then quickly rebuilt in recoveries. The governor has the power to reduce appropriations (unallot) if the budget reserve is not sufficient to close a projected deficit that emerges over the course of a biennium; unallotments are one-time (i.e., not carried over into the next biennium).

Historically, budget negotiations have often been contentious at times of split government. Following the November 2014 elections, and after two years of single-party control, control is once again divided between the two political parties. Budget negotiations for the current biennium were more contentious than the prior budget session, during which the legislature enacted significant tax increases to provide funding for education and property tax relief. However, the process was significantly smoother than in some earlier years - disagreements surrounding the budget for the fiscal 2012 -2013 biennium resulted in delayed budget adoption and a 21-day partial state government shutdown.

Fitch believes it is significant that in the current recovery the state has materially enhanced reserve funding, making volatility the focus of the policy and introducing automatic funding mechanisms. The reserve target is sized to provide a 95% level of confidence that a biennial deficit will not exceed budget reserves, and 33% of the ending balance projected in each November forecast is transferred to the budget reserve until the reserve reaches the annually established target level ($2 billion for the current biennium).

Given the availability of increased reserve resources, Fitch believes that in a future moderate economic downturn the state would be unlikely to need to take extraordinary measures to maintain balance. The comprehensive and dynamic approach to reserve funding offsets the likely increase in the economic sensitivity of the state's revenue system following a 2013 increase in the income tax to a top rate of 9.85%.

In addition to the new focus on reserves, the state has repeatedly demonstrated its ability and willingness to rapidly rebuild financial flexibility at times of economic and revenue growth. Pursuant to state law, revenue overperformance in recoveries is first applied to fund reserves to their policy targets and reverse payment deferrals.

Recent Operating Performance

The state is currently in the middle of the fiscal 2016-2017 biennium. Although estimated spending is largely unchanged from the enacted budget and the biennial revenue estimate has been modestly reduced, the projection for reserves and ending balance is improved due to significant revenue overperformance in fiscal 2015 that was carried over.

With an automatic triggered deposit from fiscal 2015 surplus, the budget reserve now holds $1.6 billion (8% of fiscal 2016 spending). Including other reserves and the projected ending fund balance, the most recent forecast (from February) anticipated the biennium ending with total reserves and balance of $2.7 billion, about 12.5% of annual general fund expenditures. The state reports that revenue overperformance in fiscal 2016 compared to estimates increased this figure by $220 million; however, general fund revenue results are $97 million (2%) below forecast for the first three months of fiscal 2017, with underperformance in all of the major taxes. The forecast will be updated next month.

At the start of fiscal 2017, the state had been discussing a special session that could result in use of balance for capital and other spending ($379 million) and tax cuts ($174 million). If all such measures were to pass, the estimated ending result would have been reserves and balance at a still robust 10% of expenditures. Other reported possible special session topics were pension sustainability and an additional $1 billion in bonding authorization. No special session is currently planned.

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/site/re/879478

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Fitch Ratings
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+1-212-908-0575
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block
Senior Director
+1-212-908-0239
or
Committee Chairperson
Karen Krop
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+1-212-908-0661
or
Media Relations
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Laura Porter
Managing Director
+1-212-908-0575
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block
Senior Director
+1-212-908-0239
or
Committee Chairperson
Karen Krop
Senior Director
+1-212-908-0661
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com