Fitch Rates Rhode Island's $196.5MM GOs 'AA'; Outlook Stable

NEW YORK--()--Fitch Ratings assigns an 'AA' rating to the following State of Rhode Island and Providence Plantations general obligation (GO) bonds:

--$34 million consolidated capital improvement loan of 2014, series B (tax-exempt);

--$12.5 million consolidated capital improvement loan of 2014, series C (federally taxable);

--$150 million consolidated capital improvement loan of 2014, refunding series D (tax-exempt).

The bonds are expected to sell via negotiation on or about Oct. 15, 2014.

In addition, Fitch affirms the following ratings:

--$1.075 billion in outstanding state GO bonds at 'AA';

--$556.6 million in outstanding state appropriation-backed debt at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The state's GO bonds are secured by a pledge of the state's full faith and credit. Appropriation-backed debt of the state is secured by payments from the state subject to annual legislative appropriation.

KEY RATING DRIVERS

STRONG FISCAL MANAGEMENT: The state's financial operations are conservatively managed and the state acts proactively to close budget gaps. The constitutionally mandated limit on budget appropriations to 97% of estimated revenue and 5% budget reserve contribute to fiscal stability.

FINANCIAL PERFORMANCE STABILIZING: Following a period of persistent weakening during the recession, the state's fiscal performance has steadily recovered. Preliminary fiscal 2014 general results indicate a fifth consecutive year with general revenue operating surplus and tax revenue growth.

Moderated Liability Position: The state's debt position has moderated, with more disciplined debt issuance policies and cash funding of capital projects. While the state's combined burden of debt and unfunded pension liabilities is well above average, comprehensive 2011 pension reform significantly improved funded ratios while lowering annual required contributions.

LAGGING ECONOMIC INDICES: Rhode Island's economic performance continues to trail national trends but the gap narrowed somewhat in recent months. The state's economic decline was among the worst of the states during the downturn and the pace of recovery has lagged. Fitch anticipates continued below-average economic growth.

APPROPRIATION SECURITY: Bond payments for appropriation-backed debt rely on annual legislative appropriations, resulting in a rating one notch below the state's GO rating.

RATING SENSITIVITIES

FUNDAMENTAL CHARACTERISTICS: The rating is sensitive to changes in the state's fundamental credit characteristics, particularly its fiscal discipline.

PENSION REFORM LEGAL CHALLENGE: Litigation around recent pension reforms is ongoing and a resolution that substantively reduces the enacted savings for the state could trigger rating concern.

MORAL OBLIGATION COMMITMENT: The enacted fiscal 2015 budget includes an appropriation for state moral obligation debt previously issued for a now-bankrupt video game company. The rating incorporates Fitch's expectation that the state will sustain its full support of these bonds through final maturity. Failure to meet that commitment going forward would exert negative rating pressure.

CREDIT PROFILE

The state's 'AA' GO bond rating is based on conservative fiscal management, improved financial performance, and a manageable debt position, offset by below-average economic growth. A deep recession and fragile recovery severely strained the state's financial position. But since fiscal 2011, Rhode Island's general revenue taxes increased every year, allowing the state to add to its rainy day fund and meet a higher statutory requirement. Preliminary fiscal 2014 results and the enacted fiscal 2015 budget forecast continued growth and maintenance of the rainy day fund at the statutory 5% of revenues. While Fitch anticipates modest revenue growth, Rhode Island's budget outlook assumes manageable structural gaps in the out-years that will require continued fiscal discipline.

SLUGGISH ECONOMIC PERFORMANCE

Current economic indicators point to an economy that will be very slow to recapture employment lost in the recession. Rhode Island's annual nonfarm employment losses during the recession of 8% exceeded the national decline of 6.3%. The state's employment recovery has been weak as well as through August 2014 Rhode Island had regained just 55.3% of the lost jobs, while national employment fully recovered several months ago.

In recent months, the state's pace of jobs growth has moved closer to the national trend - in August 2014, Rhode Island's year-over-year (yoy) payrolls growth rate of 1.7% was nearly equivalent to the national rate of 1.8%, and the three-month moving average of 1.6% is close to the national average of 1.9%. Similarly, the gap between Rhode Island's and the nation's unemployment rate is narrowing. Rhode Island's August 2014 unemployment rate of 7.7% improved notably from 9.6% the prior year, and is now 126% of the national level versus 133% in August 2013.

The state's consensus economic forecast (last updated in early May 2014) forecasts modest employment growth of 1.5% for fiscal 2014, with the recovery accelerating in fiscal 2015 (1.9% employment growth). The fiscal 2014 estimates was revised upwards from the November 2013 estimates of 0.9% growth, reflecting some recent improvement in employment growth. Fitch anticipates the state's growth will remain below national levels over at least the medium term.

IMPROVED FINANCIAL POSITION

Despite the weak economic performance, general revenues increased for the fifth consecutive year in fiscal 2014 (preliminary results), signaling a modest fiscal recovery and allowing Rhode Island to maintain its budget reserve at the full 5% requirement of general revenues ($177 million at June 30, 2014). On a preliminary basis, fiscal 2014 ended with a general revenue fund free surplus of $68 million (inclusive of all transfers and adjustments). Revenue from the personal income tax (PIT, 32.8% of general revenues) increased 2.7% yoy, while sales tax revenue (26.2% of general revenues) increased 4.2%. The PIT growth came despite the lingering effects of income acceleration in the prior year which held back PIT growth in other states. Overall, general revenue fund (GRF) tax revenues increased 4% and total GRF revenues increased 3.4% yoy, essentially in line with the final forecast. The $3.4 billion in total revenues was the first time GRF revenues exceeded the pre-recession peak.

Fitch anticipates continued revenue growth in fiscal 2015, but at a lesser pace, with continued full funding of the statutory reserve. The enacted fiscal 2015 budget, using the May 2014 revenue estimating conference forecast, relies on 2.2% GRF tax revenues (and 1.7% total GRF revenues) growth. A projected $575 thousand GRF free surplus at the end of fiscal 2015 would be a sharp decline from the prior year, but Fitch anticipates the state will likely manage to a higher surplus as it historically has. For fiscal 2014, the enacted budget GRF free surplus of $428 thousand compared to the preliminary actual result of $68 million.

Rhode Island's fiscal 2015 budget is balanced but utilizes some one-time items and is subject to downside risk, and Fitch expects the state will take appropriate and timely actions to maintain budgetary balance through the year. As in prior years, the enacted budget utilizes the projected ending balance from the prior year of $59 million (projected at the time of budget adoption). Downside risks in the budget include $5 million from a proposed refinancing of tobacco settlement bonds that is tied up in litigation, and $25 million from negotiated wage increases the legislature did not include in the enacted budget. The preliminary ending balance for fiscal 2014, reported after budget enactment, is $68 million versus the $59 million assumed in the budget, providing some cushion (though the amount is subject to revision).

Rhode Island's multiyear budget outlook shows challenges, but structural budgetary protections mitigate associated risks. Based on the May 2014 revenue estimating conference forecast, the state's budget office forecasts current services general revenue fund deficits of $172.9 million and $296.3 million in fiscal years 2016 and 2017. Notably, these projected deficits are down from the May 2013 estimates. In addition to lackluster economic growth, a key driver of the shortfalls is a reduction in lottery and gaming-related revenues due to the anticipated opening of gaming facilities in adjacent southeastern Massachusetts. The constitutional funding formula that calculates contributions to the budget reserve account (capped at 5% of general revenues) limits annual appropriations to 97% of estimated revenues, providing an important fiscal cushion. With the rainy day fund at its statutory cap, excess revenues flow to a capital projects fund thereby reducing debt issuance.

ABOVE AVERAGE, BUT STABILIZED LIABILITIES

2011 pension reforms mitigated the ongoing credit pressure from the state's long-term liability levels which Fitch views as manageable for the state. The state's debt ratios are moderate, with pro forma net tax-supported debt (inclusive of the series 2014 B and C new money bonds) of $2.1 billion equal to 4.3% of 2013 personal income. This is down from 5.3% of personal income at the end of fiscal 2009. The state continues to moderate debt levels through increased cash funding of capital projects. In November 2014, voters will decide on several GO bond referenda approved by the legislature - if accepted, the state could issue up to $248 million in additional GO bonds in the next several years.

On a combined basis, the burden of the state's net tax-supported debt and Fitch-adjusted unfunded pension obligations equals 11% of personal income, well above the median of 6.1% for U.S. states. The calculations include 100% of the liability for state employees in the employees' retirement system (ERS), 40% of teachers' liability in ERS (the state share), and 100% of the liability for the judicial retirement benefit trusts and the state police retirement benefits trust. The ERS liabilities encompass over 97% of the unfunded liabilities attributed to the state by Fitch.

Prior to significant recent reforms, the state's liability position was characterized by notably low funding levels (48.4% for ERS as of June 30, 2010). The state undertook two rounds of pension reform in 2011; in the first round, the state made a variety of adjustments, including reducing the return assumption to 7.5% from 8.25%, reducing the rate of inflation, and increasing the life expectancy of retirees, which raised the state's unfunded actuarial accrued liability (UAAL). In late 2011, a second round of reform (Rhode Island Retirement Security Act, or RIRSA) included establishing a hybrid defined benefit-defined contribution system and making future cost-of-living adjustments (COLAs) contingent on investment performance and the funded level of the plan. For fiscal 2013, the state reported system-wide funded ratios for the state employees' and teachers' portion of ERS of 54.7% and 56.6%, respectively. On a consolidated basis, the total state-reported ERS funded ratio was 57.3%. The Fitch-adjusted system-wide funded ratio for ERS is 54.4% for 2013. Under current actuarial assumptions, the state's actuary projects ERS to reach full funding in 2035.

Fitch's rating on the state incorporates the benefits of RIRSA and other recently enacted pension reforms, therefore, legal challenges to the reforms pose a downside credit risk. There are several lawsuits currently outstanding challenging the pension reforms in 2011, as well as reforms promulgated in 2009 and 2010. The judicial system did not stay the implementation of the reforms so if the cases result in unfavorable outcomes for the state, Fitch believes there could be considerable financial loss if retroactive payments to employees and retirees were to be required. Additionally, Rhode Island's liability position would likely weaken and additional budgetary allocations would be required to maintain pension funding levels.

EXPECTATION OF COMMITMENT TO MORAL OBLIGATION

The state's willingness to continue paying debt service on bonds issued in 2010, with a moral obligation commitment from the state, on behalf of a now bankrupt video game company are an important credit consideration for Fitch. While there has been significant public debate about the state's commitment, the fiscal 2014 and 2015 enacted budgets included the full debt service appropriations. Failure to fully appropriate for debt service on moral obligation bonds that were originally issued by a state agency would lead Fitch to reassess the state's commitment to bondholders and likely trigger negative rating action on the state's GO and appropriation-backed debt ratings. Consistent with our criteria for moral obligation pledges, Fitch does not anticipate moving those ratings below investment-grade as these moral obligation bonds were a project-specific commitment with limited direct state involvement in the company.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from IHS.

Applicable Criteria and Related Research:

--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'Rating Guidelines for Moral Obligations' (April 18, 2013);

--Fitch: Rhode Island's 38 Studios Moral Obligation Bonds Represent Limited Risk to State's Rating' (June 24, 2014).

Applicable Criteria and Related Research:

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Rating Guidelines for Moral Obligations

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=704882

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=890534

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Contacts

Fitch Ratings
Primary Analyst
Eric Kim, +1-212-908-0241
Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block, +1-212-908-0239
Senior Director
or
Committee Chairperson
Laura Porter, +1-212-908-0575
Managing Director
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Eric Kim, +1-212-908-0241
Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Marcy Block, +1-212-908-0239
Senior Director
or
Committee Chairperson
Laura Porter, +1-212-908-0575
Managing Director
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com