Fitch Affirms the City of Frederick, MD's GOs and IDR at 'AA+'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed the following Frederick, MD ratings:

--$248.9 million general obligation (GO) bonds at 'AA+';

--Issuer Default Rating (IDR) at 'AA+'.

SECURITY

The bonds are a general obligation of the city backed by its full faith and credit and unlimited taxing power.

KEY RATING DRIVERS

The city's stable economic base, historically strong operating performance and solid revenue framework support the 'AA+' IDR.

Economic Resource Base

The city of Frederick occupies a land area of more than 23 square miles in Frederick County, for which the city serves as the county seat. Frederick is situated along I-70 and I-270 approximately 50 miles distance from both Washington, D.C. and Baltimore. The city is the second largest in Maryland by population, which is estimated at 69,479 in 2015, a 1.25% average annual increase since 2010.

Revenue Framework: 'aaa' factor assessment

Revenues have been rising at a pace above the rate of U.S. GDP growth. The city has the independent legal ability to raise property tax revenues in an unlimited amount.

Expenditure Framework: 'a' factor assessment

The natural pace of spending growth is expected to be close to or marginally above that of revenue. Carrying costs associated with debt service and retiree benefits are high, but control over staffing, wages, and benefits is satisfactory.

Long-Term Liability Burden: 'aa' factor assessment

The combined burden of long-term debt and pension liabilities is moderate as a percentage of personal income. Fitch expects the liability burden to remain stable given expected annual debt issuances at the county level despite rapid amortization and limited future debt issuance plans from the city.

Operating Performance: 'aaa' factor assessment

The maintenance of high reserves, moderate inherent budget flexibility, and strong revenue control provide the city with exceptional financial resilience and gap-closing ability in the event of an economic downturn.

RATING SENSITIVITIES

OPERATING STABILITY: The rating is sensitive to significant growth in the city's high cost of debt and pension liabilities relative to spending. However, the Stable Outlook reflects the city's favorable financial management track record, good revenue flexibility that would allow it to respond to unforeseen budgetary pressures, and a current economic environment exhibiting moderate growth.

CREDIT PROFILE

The city's economy is fueled by its proximity to the region's key governmental, technological, and biomedical economic assets. Frederick is home to the U.S. Army's Fort Detrick, site of the U.S. Army Medical Research Institute of Infectious Diseases, the National Cancer Institute, and the National Interagency Biodefense Campus. The fort has grown steadily in size and now employs 9,100 or the equivalent of 7.5% of total resident employment in Frederick County. However, economic development extends beyond activities related to Fort Detrick. Flying Dog Brewery is planning a $40 million expansion, adding 150 new jobs. Regent Education (a software company) is leasing the Union Knitting Mill building which recently completed a $7 million renovation. Other large employers include Frederick County Board of Education (5,650), Frederick Memorial Healthcare (2,232), Frederick County (1,937), Ledios Biomedical Research (1,836) and Wells Fargo Home Mortgage (1,742). The city's employment base has increased in each of the past five years. As of August 2016, the unemployment rate of 4% was below the rate of 4.5% a year prior.

Revenue Framework

Property taxes are the largest revenue source for the city at over 70% of general fund revenues. Homes values are approximately 77% of the pre-recession peak of fiscal 2006 according to Zillow; however, taxable assessed value has increased for five consecutive years. The fiscal 2017 budget projects a 1.3% increase over 2016 to $7.28 billion based on the rolling three-year reassessment cycle and new construction.

The city's natural pace of general fund revenue growth has trended above U.S. GDP without any tax policy changes. Given ongoing economic development as well as positive housing trends, growth prospects are positive.

Lack of a legal cap on the property tax rate or levy provides the city with significant independent legal revenue-raising flexibility.

Expenditure Framework

The city's largest spending area is public safety, which makes up slightly less than half of general fund spending, followed by public works at 19%.

As with most local governments, Fitch expects spending growth will be near to slightly ahead of revenue growth. Fitch expects that modest population growth will not place undue demands on expenditures.

The city maintains adequate expenditure flexibility. The city's police department, which represents approximately a quarter of total employees, is unionized. However, management does have the ability to impose terms unilaterally if no agreement is reached, affording some flexibility in salaries. Carrying costs (debt service, pension and OPEB annual costs) are high at nearly 30% of total governmental spending, which generally limits the extent to which the city may enact broader expenditure saving measures. The actuarial determined pension contribution is the largest component of the carrying cost metric, and was equal to 12% of governmental spending in fiscal 2015. The pension contribution has declined as a percentage of spending in recent years reflecting various reform actions implemented by the city; however, the annual obligation is based on a somewhat high 7.5% investment rate of return assumption, which could pressure future contribution levels if not consistently achieved. Debt service, pegged at about 9% of governmental spending, should remain stable or decline marginally going forward based on the rapid pace of principal payout and manageable borrowing needs.

The city makes annual contributions for capital projects which in fiscal 2016 totaled approximately $2 million or 3% of general fund spending, adding additional budgetary flexibility.

Long-Term Liability Burden

Long-term liabilities for debt and pensions represent a moderate 12% of personal income. The debt ratio includes airport and golf course debt issued by the city for which the general fund provides debt service and at times, operational support. The city retires governmental fund debt at a rapid pace of 74.5% in 10 years. Fitch expects the debt ratio to remain stable.

The city administers three separate defined benefit pension plans which have an estimated combined net pension liability (NPL) of $104.9 million in fiscal 2015 or 3.6% of personal income, when adjusted by Fitch to assume a 7% investment rate of return in place of the plans' 7.5% rate. The Fitch adjusted ratio of assets-to-liabilities is an estimated 56.6%. The pension NPL has declined slightly from $108.7 million in fiscal 2013 following pension reform and the city's payments to the plan have equaled or exceeded 100% of the actuarial required payment. Pension reforms impact new hires after June 30, 2012 and include a reduction in cost-of-living-adjustments and benefit multiplier, an increase in employee contributions, change in vesting periods, normal and early retirement age, and pensionable salary. The UAAL for OPEB is $98.9 million or 3.4% of personal income.

Operating Performance

Fitch views the city as having exceptionally strong gap-closing capacity given its midrange inherent budget flexibility, legal ability to raise property tax revenues in an unlimited amount and demonstrated commitment to generally maintaining reserves at its 12% policy level. Fitch considers the city's reserve policy level as more than sufficient for a 'aaa' financial resilience assessment.

The city proved its financial resilience and strong budget management through the most recent recession by eliminating several positions due to retirements or natural turnover and postponing capital spending and equipment replacement. Fitch expects the city to make similar operational changes as needed during an economic downturn.

The unrestricted general fund balance of $14.7 million in fiscal 2015 was a healthy 20.3% of spending. The city is projecting to add $2.8 million to reserves at the close of fiscal 2016 as a result of positive revenue trends and conservative expenditures. The city had budgeted a $10.25 million draw on reserves which included a $1.1 million transfer to the capital improvement fund. The fiscal 2017 general fund budget is a 4.86% increase over fiscal 2016. The budget keeps the tax rate stable for the fourth year and includes a $10.76 million (15% of fiscal 2017 budgeted spending) fund balance appropriation which is in line with prior years.

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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https://www.fitchratings.com/regulatory

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Contacts

Fitch Ratings
Primary Analyst
Evette Caze
Director
+1-212-908-0376
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Michael Rinaldi
Senior Director
+1-212-908-0833
or
Committee Chairperson
Amy Laskey
Managing Director
+1-212-908-0568
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Evette Caze
Director
+1-212-908-0376
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Michael Rinaldi
Senior Director
+1-212-908-0833
or
Committee Chairperson
Amy Laskey
Managing Director
+1-212-908-0568
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com