Fitch Rates Philadelphia Municipal Auth, PA's $83MM Lease Rev Rfdg Bonds 'A-'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned an 'A-' rating to the Philadelphia Municipal Authority's $82.72 million lease revenue refunding bonds, series 2016.

The bonds are expected to sell through a negotiated sale on Dec. 7, 2016.

Fitch has also affirmed the following ratings at 'A-':

--Philadelphia Municipal Authority (PMA) bonds;

--Philadelphia Authority for Industrial Development (PAID) bonds;

--Philadelphia Redevelopment Authority (PRA) bonds;

--Philadelphia Parking Authority (PPA) parking system revenue bonds, series 1999;

--Philadelphia Issuer Default Rating (IDR);

--Philadelphia general obligation (GO) bonds.

The Rating Outlook is Stable.

SECURITY

Bonds issued by the PMA, PAID, and PRA are payable from annual rental or service fee payments payable by the city under noncancellable agreements. Series 1999 revenue bonds issued by the PPA are similarly backstopped by a noncancellable city agreement to restore a debt service reserve fund (DSRF). The city's obligations to make payments required by the agreements are absolute and unconditional. State law and the city charter obligate the city council to appropriate annual payments through final maturity.

GO bonds are backed by the city's full faith and credit and are payable from an ad valorem tax without limitation as to rate or amount.

KEY RATING DRIVERS

The 'A-' rating on lease and service fee agreement bonds issued by various authorities for the city of Philadelphia, and the Philadelphia Parking Authority's series 1999A parking system revenue bonds, reflects the city's credit quality and the lack of optionality for appropriation embedded in these commitments by city ordinance, the city's charter, and state law. The rating is equivalent to Philadelphia's IDR and the rating on its GO debt.

Philadelphia's 'A-' IDR reflects the strength of the city's economic base and revenue growth prospects, somewhat offset by risks related to expenditure constraints and a limited reserve cushion. The city's long-term liability burden is somewhat elevated but well within the capacity of its resource base to absorb. Philadelphia continues to take modest but prudent steps to limit growth in the pension liability in particular, and eventually reduce it. Fitch expects the city's long-term liabilities to remain close to current levels, as the city has fully funded or exceeded annual pension contribution requirements. Philadelphia's comparatively constrained expenditure framework will pressure the budget, but expectations for solid revenue growth from a steadily growing economy should support these spending pressures. Long-term budget forecasting, active budgetary management, and close oversight from a state fiscal board help mitigate the risk of reserve levels that are well below those of most local tax-supported governments.

Economic Resource Base

Philadelphia serves as a regional economic center in the northeast, with a stable employment base weighted toward the higher education and healthcare sectors. Jobs expansion since the recession has been steady and strong, but low wealth levels and weak population increases persist and limit growth prospects. The population is estimated at 1.5 million.

Revenue Framework: 'aa' factor assessment

The income, property, and sales taxes that are Philadelphia's primary revenue sources will likely grow ahead of inflation but below national GDP given economic prospects. Philadelphia retains ample legal ability to raise revenues without specific commonwealth authorization.

Expenditure Framework: 'a' factor assessment

Philadelphia's recent expenditure growth has been measured reflecting active budgetary management efforts. The city faces manageable but persistent fixed-cost growth pressures and has limited flexibility regarding labor expenses given a highly unionized workforce and statutory collective bargaining framework. The future trajectory of spending growth will likely exceed baseline revenue growth, requiring active budgetary management.

Long-Term Liability Burden: 'a' factor assessment

Long-term liabilities are somewhat elevated but still in the moderate range relative to Philadelphia's resource base due to both comparatively elevated debt levels and unfunded pension obligations.

Operating Performance: 'bbb' factor assessment

Budgetary management practices are strong, offsetting Philadelphia's very modest reserve levels and supporting the city's adequate ability to respond to changing economic and fiscal circumstances. Fiscal stress is likely in the event of a downturn, but the city has the tools and demonstrated ability to manage through and restore financial flexibility.

RATING SENSITIVITIES

LINKED TO IDR: The ratings on the various authority service and lease agreement bonds, and on the PPA's series 1999A parking system revenue bonds, are sensitive to shifts in the city's IDR to which they are linked.

CHANGES IN FINANCIAL FLEXIBILITY: Philadelphia's IDR is sensitive to sustained structural balance that improves reserve levels materially, aiding the city's financial flexibility, which could support upward rating movement. While Fitch anticipates some imbalance during an economic downturn, deficits well beyond current projections resulting in deeper reserve draws could trigger negative rating concern.

PENSION FUNDING IMPROVEMENT: Material reductions to the unfunded actuarial accrued liability or annual funding demands for the city's pension plan would be viewed positively for the city's IDR. Significant movement, which Fitch does not currently anticipate, could support positive rating action.

CREDIT PROFILE

Fitch considers the credit quality of Philadelphia's lease and service fee agreement bonds equivalent to the city's general credit quality as expressed in the IDR given the lack of optionality for the city in annually appropriating for payments used for debt service. Prior to the issuance of each series of bonds, the city enters into a noncancellable agreement with the issuing authority that has been approved by the city council by ordinance. The agreements, all substantially similar in legal terms, require the city to appropriate annual lease rental or service fee payments from current revenues of the city. The city council ordinance approving the agreement also requires the council to budget and appropriate these payments annually. The city's charter explicitly allows city council to authorize service agreements that extend beyond one year and are valid and binding commitments of the city. Commonwealth law (53 P.S. S.12557) also authorizes the city to make contracts for more than one year and states that it is "the duty of [City] council to make subsequent appropriations from year to year as required for the purposes of such contracts."

Fitch views the combination of the commonwealth statutory language, the city charter provision authorizing multi-year commitments, and the noncancellable nature of the absolute and unconditional obligations set forth in the agreement approved by local ordinance as eliminating any optionality on the part of the city to appropriate required annual payments.

Series 1999A PPA bonds similarly benefit from the city's noncancellable commitment to ensure timely debt service payment and the rating is on par with the city's IDR, reflecting the absence of optionality for the city. Prior to issuance of the bonds, the city entered into a contract with PPA that the council approved by ordinance. Instead of annual appropriations used directly for debt service, a noncancellable contract with PPA requires the city to restore any DSRF deficiency. The DSRF requirement is maximum annual debt service. There is no annual legislative appropriation required to restore deficiencies under the contract. PPA abandoned the financed project shortly after issuance of the bonds and Philadelphia has consistently provided sufficient funds to restore the DSRF.

Timely Mechanism for PPA Bonds

The mechanics of the city's commitment ensures that debt service on the series 1999A bonds will be covered by the city's promise to restore DSRF deficiencies. Every February 16 (the day after the principal payment date for the series 1999A bonds), the authority must certify any deficiency in the DSRF to the city for restoration. Under the contract, the city must fully fund the depleted DSRF, either from that year's revenue or via an appropriation in the following year's budget, which would begin on July 1. In either case, the city is absolutely and unconditionally obligated to pay to the bond trustee any debt reserve deficiencies by July 15. In a worst case scenario, whereby all debt service reserve funds were depleted to meet current debt service on February 15, the city's payment would assure that sufficient funds would be on hand by July 15, one month before scheduled interest (August 15) and seven months before the scheduled principal and interest payment on February 15.

Revenue Framework

Philadelphia has a diverse revenue base, with personal and business income and receipts taxes, property tax and sales tax each generating a significant portion of local revenues. The wage tax (essentially a personal income tax without a capital gains component) accounts for one third of general fund revenues, and the other key revenue sources noted above make up another third. An additional 10% of revenues are transfers in from the Pennsylvania Intergovernmental Cooperation Authority (PICA) and come from the wage tax, net of deductions for debt service on revenue bonds issued by PICA.

Historically the wage tax has proven relatively resilient with limited declines. Growth has been slow, partially reflecting low wealth levels but also steady rate reductions implemented to enhance economic competitiveness. Property taxes have been stable through economic cycles as well, with more robust growth attributable to the city's position as a regional economic center. Other tax revenues have been more volatile due mainly to policy changes at the city and commonwealth levels.

Historical general fund revenue growth, after adjusting for a significant accounting change, has been robust. However, the growth also reflects tax policy changes including both rate increases and decreases. The city shifted certain federal and commonwealth grants from the general fund to the grants revenue fund beginning in fiscal 2012; these grants averaged $469 million between fiscal years 1999 and 2011, or roughly 10%-15% of general fund revenues. Management provided Fitch with detailed breakouts of the revenues from prior years that allowed Fitch to adjust general fund revenues to a like-for-like basis by removing the affected revenues in earlier years.

Fitch anticipates solid general fund revenue growth, absent future policy actions, ahead of inflation but somewhat below national economic growth. Significant policy changes implemented by the city include small but regular rate reductions in the wage tax, and business income and receipts tax (except for three years around the Great Recession, when the city held rates steady) and sales tax rate changes authorized by the commonwealth.

Philadelphia maintains ample legal authority to adjust revenues, other than the sales tax, under provisions of Pennsylvania's Sterling Act. The city has regularly utilized that ability to adjust wage and business income and receipts taxes to improve Philadelphia's economic competitiveness or provide additional budgetary flexibility.

Expenditure Framework

Philadelphia pays for a wide range of public services but public safety represents the largest expenditure category (about half of spending), like many local governments. The city does not directly pay for education but does support the contiguous School District of Philadelphia (SDP) with direct appropriations and through other policy measures such as statutory allocations of specific taxes. In recent years, the city issued bonds to finance an SDP operating deficit and the commonwealth legislature permanently redirected part of the city's local sales tax levy to the district.

Spending growth absent policy actions will likely exceed projected revenue growth due to both a high demand for services given the city's low wealth levels, and moderating, but still persistent, growth in pension costs. The newly implemented sweetened-beverage tax will fund new policy initiatives including expanded pre-kindergarten. Fitch anticipates the city would scale back spending if revenues fell short of projections.

Philadelphia has solid expenditure flexibility with a moderate carrying cost burden of 14% in fiscal 2015, but a constraining workforce environment. Pension costs escalated sharply in recent years due partially to actuarial adjustments to revise down the investment return assumption (to a still somewhat aggressive 7.75%) and apply findings from the most recent experience study. Growth should moderate and remain in line with to marginally ahead of revenue growth, if actuarial assumptions are met. The city consistently directs any new and otherwise unallocated revenues to the pension fund, including in the current five-year plan through fiscal 2021. This could reduce the long-term liability burden and carrying cost over time.

The vast majority of city employees are unionized with most work terms established in multi-year contracts. Labor relations have been somewhat contentious historically, with multiple recent contract negotiations ending in binding arbitration. Management retains very limited ability to alter contracts, though current wage and benefit terms are not a threat to fiscal stability. All contracts either ended this past fiscal year or will end this year. A recent agreement with the largest blue-collar union reflects positively on the administration's ability to maintain stable labor relations on reasonable financial terms. Salary increases are well within the city's fiscal capacity and the contract includes a stacked hybrid pension plan that is mandatory for new hires and could reduce costs over the long term if implemented with other unions.

The city's commitment to the school district represents an ongoing expenditure pressure point. SDP faces its own significant challenges (IDR of 'BB-'/Stable Outlook) and relies heavily on the city for fiscal support. Philadelphia has historically contributed to the school district via both direct appropriations and imposition of new taxes or allocations of existing taxes. Unlike all other Pennsylvania school districts, SDP has no ability to set its own local tax policy.

Long-Term Liability Burden

Philadelphia's long-term liability burden of approximately 21% of 2015 personal income is somewhat elevated but still in the moderate range relative to its resource base with roughly equivalent levels of net tax-supported debt and Fitch-adjusted unfunded pension liabilities for its primary single employer plan (the city maintains a separate single employer plan for Philadelphia Gas Works, an independently operated enterprise unit, revenue bonds rated 'BBB+'/ Stable Outlook).

For the city's pension fund, market performance below recently reduced but still somewhat aggressive assumptions, and recent actuarial changes to revise down the return assumption and implement findings from an experience study were the primary contributors to growth in the unfunded liability in recent years. The burden could moderate over the long term if actuarial assumptions are met and the city successfully rolls out plan changes across its labor bargaining units; however, Fitch anticipates the burden will remain sizable. The city has contributed at least the actuarially determined employer contribution for many years, though Philadelphia did defer (and repay within five years) a portion of the statutorily required minimum municipal obligation in fiscal 2010 and 2011. The pension liability was re-amortized several years ago over a closed 30-year term, which reduced the annual cost. Positively, as noted above, the city typically adds any otherwise unallocated revenue to the pension fund to help reduce the liability.

Long-term debt is issued for capital needs and has been managed particularly closely in recent years as evidenced by the gradual decline in outstanding amounts. More significant issuance is likely under the current administration to finance new initiatives but will be funded with revenues from a recently enacted sweetened-beverage tax.

The city does have variable-rate debt and swap exposure, but Fitch does not view it as a material rating concern. Approximately 15% of outstanding direct debt is swapped to a fixed rate with various counterparties. Philadelphia is required to post collateral if its GO rating falls below investment grade. A swap policy outlines when swaps can be entered into and sets stringent guidelines around counterparty credit exposure with swap agreements required to include a provision allowing the city to terminate if counterparties fall below 'A' category ratings. Philadelphia also has modest exposure to variable-debt put risk with 6% of outstanding direct debt supported with letters of credit. If the letters are triggered, amortization would accelerate, and Fitch anticipates the city would consider refinancing the debt given its solid market access.

Operating Performance

Philadelphia's reserve levels are relatively modest and would likely be drawn down during a downturn, but would be expected to recover. To address budget gaps, Fitch anticipates the city would rely primarily on its high budget flexibility. Likely budget measures include halting currently planned reductions in wage and business income and receipts tax rates, and headcount reductions and furloughs. Philadelphia took such steps during the Great Recession.

Close monitoring of fiscal performance by PICA, the state-appointed oversight board, provides further assurance the city would quickly address economic downturns. The mayor submits annual five-year financial plans and quarterly intra-year updates to PICA. PICA must certify that the plans resolve any projected deficits while quarterly reports assess the city's ongoing compliance. If PICA certifies non-compliance, the city forfeits commonwealth funding including a large share of state-authorized tax revenues, providing strong incentive for the city to maintain long-term fiscal balance.

Philadelphia has an extensive statutory and policy-based framework for timely and proactive budget management throughout the economic cycle, revolving around PICA's reporting and certification requirements. But Philadelphia's efforts to rebuild flexibility during periods of economic recovery remain somewhat inconsistent. Fund balances improved in the years following the Great Recession, but have been drawn down in recent years to meet recurring needs, despite economic and revenue growth. The current five-year plan anticipates additional reserve drawdowns through fiscal 2018.

Philadelphia's liquidity is comparatively limited, but stable and adequate for its fiscal needs given the superior level of budget flexibility and close monitoring from PICA. The city, or a related entity, has demonstrated clear and consistent market access, having issued tax and revenue anticipation notes virtually every year since fiscal 1972.

CURRENT DEVELOPMENTS

Philadelphia ended fiscal 2016 on June 30 with estimated revenues 2% ahead of the enacted budget, with growth across all major tax categories reflecting the city's solid economic performance. On an unaudited basis the city reports an available general fund balance of $148.3 million (3.7% of general fund revenues), which is ahead of the $106 million (2.7% of general fund revenues) assumed in the current five-year financial plan. PICA approved the plan this summer.

While the plan includes steady draws on an already limited fund balance for several years, it also includes scheduled gradual reductions in wage and business taxes that the city could slow, halt or even reverse depending on economic circumstances. Philadelphia also tends toward conservative revenue and expenditure forecasts. The projected fiscal 2016 available general fund balance in last year's five-year plan was just $70 million (versus the actual $148.3 million).

The fiscal 2017 budget includes a sweetened-beverage tax (an administration priority) to finance a range of new initiatives including expanded pre-kindergarten and community infrastructure investment. At full implementation, the city estimates the tax will generate $90 million-$100 million annually. The budget, and five-year financial plan, also reflects the new labor contract signed with the largest blue collar union, DC 33 (representing approximately one-fourth of the city's workforce). The contract includes a mix of notable wage increases (2.5% - 3% annually) and pension changes to increase employee contributions and bring new employees into a mandatory stacked hybrid plan that limits the city's exposure to defined benefits by capping the eligible salary.

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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Director
+1-212-908-0593
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Contacts

Fitch Ratings
Primary Analyst
Eric Kim
Director
+1-212-908-0241
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Shannon McCue
Director
+1-212-908-0593
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