NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned an 'AAA' rating to the following general obligation (GO) bonds of the State of North Carolina:
--$200 million GO public improvement (Connect NC) bonds, series 2016B
The bonds are expected to be sold via competitive bid July 27, 2016.
In addition, Fitch has affirmed the following State of North Carolina ratings:
--Long-Term Issuer Default Rating (IDR) at 'AAA';
--$3.0 billion outstanding state GO bonds at 'AAA';
--$2.3 billion outstanding appropriation-backed bonds issued by the state and its Infrastructure Finance Corp. at 'AA+'.
The Rating Outlook is Stable.
The bonds are a general obligation, full faith and credit pledge of the state of North Carolina.
KEY RATING DRIVERS
North Carolina's 'AAA' GO bond rating reflects its low liabilities, conservative financial operations and long-term prospects for continued economic expansion and diversification. The governor is empowered to unilaterally reduce spending to maintain a balanced budget, after making provision for debt service. The state has rebuilt its rainy day fund, another source of financial flexibility.
Economic Resource Base
The economy's transition away from manufacturing toward services continues. However, manufacturing employment remains a larger part of North Carolina's economic base, more than the U.S. average, and has shown steady growth since 2011, but remains half of what it was in the 1990s. Professional and business service employment is one of the fastest growing sectors.
Revenue Framework: 'aaa' factor assessment
North Carolina's broad-based revenues will continue to reflect the depth and breadth of the economy and its solid growth potential. The state has complete control over its revenues, with an unlimited legal ability to raise operating revenue as needed.
Expenditure Framework: 'aaa' factor assessment
The state maintains ample expenditure flexibility with a low burden of carrying costs and the broad expense-cutting ability common to most states. Medicaid and education remain key expense drivers, but Fitch expects them to remain manageable.
Long-Term Liability Burden: 'aaa' factor assessment
The state has low liabilities and strong debt management practices, including an affordability planning process. Pension funding is strong compared to other states.
Operating Performance: 'aaa' factor assessment
The state is well-positioned to address economic downturns, and has strong gap closing capacity due to its broad control over revenues and spending and a rebuilt rainy day fund. North Carolina has demonstrated its ability to take prompt action when necessary to maintain budget balance, which will remain important as the state continues to address the impact of a revised tax structure that is expected to lower tax revenues and absorb some near-term revenue growth associated with economic expansion.
The rating is sensitive to a fundamental change in expectations for economic and related revenue growth and to changes in the state's approach to maintaining operational flexibility to address a cyclical downturn and rebuild resilience during periods of economic expansion.
After an initial slow emergence from the recession, recent economic growth in North Carolina has accelerated and future growth is expected to be stronger as the now smaller manufacturing sector begins to recover and business and professional service sectors grow with the overall economy. Employment growth began to match the U.S. rate in 2011 and has been growing faster since. Measured by per capita personal income, North Carolina is below average at 85.1% of the U.S. level, ranking 39th among the states, although it does benefit from a lower cost of living.
North Carolina relies on broad-based income and sales taxes to fund operations. The state replaced a multi-tiered progressive personal income tax system with a flat rate in 2014. Additional tax code adjustments have further lowered the flat rate, currently 5.75% and scheduled to fall to 5.499% on Jan. 1, 2017, and have expanded the sales tax base. Revenue performance was very weak during the most recent recession. Growth emerging from the recession was weaker than expected.
Historical growth in the state's revenues, after adjusting for the estimated impact of tax policy changes, has generally been above inflation for the 10-year period ending in 2014, and just shy of national GDP growth. Given the expectation of solid economic growth, which is now stronger than the regional average, North Carolina's revenues are expected to continue to experience real growth, although perhaps tempered by the implementation of the flat income tax rate.
North Carolina has no significant legal limitation on its ability to raise revenues. The state legislature is considering putting a proposal before voters to lower the income tax cap in the state constitution. If approved, Fitch would assess the extent to which a lower hard limit on revenue raising limits the state's financial flexibility.
As in most states, education and health and human services spending are North Carolina's largest operating expenses. Education funding is centralized at the state level, is the larger line item and comprises more than half of state general fund expenditures. Health and human services spending is the second largest area of spending, with Medicaid being the primary driver.
Spending growth, absent policy actions, will likely be in line with to marginally above natural revenue growth and will require regular budget management to ensure ongoing balance. State funding for education is calculated on Average Daily Membership, which has been growing at a slow pace over the past five years, typically no more than 1% annually. The fiscal challenge of Medicaid is common to all U.S. states and the nature of the program as well as federal government rules limit the states' options in managing the pace of spending growth.
North Carolina retains ample expenditure flexibility. Spending pressure in two key areas, Medicaid and education, appears to be reduced. North Carolina's carrying costs for debt and retiree benefits, while above the state median, remain low.
The state is transitioning to a managed care model for Medicaid over the next three to four years, which is expected to stabilize Medicaid spending as a portion of the budget. Although North Carolina did not choose to expand Medicaid under the Affordable Care Act, it did experience a significant increase in new enrollments under preexisting eligibility guidelines. The fiscal 2015 - 2017 biennial budget included a $333 million increase in Medicaid spending over the biennium and funded a Medicaid Risk Reserve ($186 million) to address volatility in the program. Medicaid spending in the first year of the biennium was lower than expected, reflecting both lower enrollment as the economy improves and a lower utilization rate.
The state has primary responsibility for funding public schools rather than local ad valorem property taxes. General fund appropriations for public schools represents slightly more than one-third of the GF budget. The budget provided teacher salary increases but some budget flexibility may materialize as enrollment growth is lower than anticipated.
Long-Term Liability Burden
North Carolina's liabilities are low, with a combined ratio of debt and unfunded pension liabilities well below average at 3.3% of personal income. This compares favorably to the 5.8% median for U.S. states as of Fitch's pension update report, ranking North Carolina 11th among the states.
Tax-supported debt approximates $7.5 billion, as of June 30, 2015, about half of which is general obligation. Voters passed a $2 billion GO bond authorization in March 2016, of which the current offering is the first issuance. Given rapid amortization of outstanding debt (80% of GO and appropriation debt is retired within 10 years), debt levels are expected to remain low even with additional borrowing.
The state's pension systems are well funded. As reported under GASB 67, the fiduciary net position as a percentage of the total pension liability for the Teachers' and State Employees' system was 94.6% as of June 30, 2015. The state is responsible for the pension obligation of teachers as well as state employees.
North Carolina has a very strong ability to close budgetary gaps during a cyclical downturn, based on its demonstrated controls over spending and ability to raise revenues when necessary. During the most recent recession, the state took action to adjust to significant revenue under-performance with budget reductions, reduced capital expenditures, non-recurring actions such as fund sweeps and use of reserves, and temporary tax increases, some of which were eventually made permanent during the recovery period. Fitch's expects that the state would take similar action to balance its budget during a future cyclical downturn.
Financial performance was somewhat challenged as the state emerged slowly from the recession. The state contended with revenue underperformance during the fiscal 2013-2015 biennium, caused primarily by changes in its tax structure. Stronger economic growth has taken hold over the past two years, contributing to revenue growth that exceeded forecast in fiscal 2015 and 2016. This has allowed it to make steady progress rebuilding its rainy day fund, which it drew upon during the recession. The balance is budgeted to increase to $1.6 billion as of the end of fiscal 2016, or 7.1% of estimated general fund revenues.
The enacted budget for the fiscal 2015-2017 biennium is based on continued slow but steady economic growth and modest revenue growth. The forecast for fiscal 2016 was exceeded by an estimated $330 million, boosted by strong income tax collections and sales tax performance that exceeded forecast. The budget continues tax code adjustments, including lowering the PIT rate (to 5.499% from 5.75%) and further expanding the sales tax base. Additional changes made to the tax code in the 2016 legislative session are expected to reduce revenues by $132 million in fiscal 2017.
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.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
Dodd-Frank Rating Information Disclosure Form