Fitch Affirms Alabama at ‘AA+’; Outlook Stable

NEW YORK

Fitch Ratings affirms the following ratings of the State of Alabama:

–State Issuer Default Rating (IDR) at ‘AA+’;
–$678.4 million in outstanding general obligation (GO) bonds of the state at ‘AA+’;
–$19.1 million of series 2010 appropriation backed bonds issued by the Building Renovation Finance Authority (BRFA) at ‘AA’.

The Rating Outlook is Stable.

SECURITY
The GO bonds are full faith and credit obligations of the State of Alabama.

The appropriation backed bonds are a special obligation of the Alabama Building Renovation Finance Authority, payable solely from rental payments to be received by the Authority from the state of Alabama, pursuant to a master lease agreement. Rental payments are subject to annual appropriation.

KEY RATING DRIVERS

Alabama’s ‘AA+’ GO rating and IDR reflect the longer-term trend toward a more diversified economy even with continued reliance on manufacturing, strong spending controls that contribute to balanced operations, and manageable debt levels.

Economic Resource Base
The trend in Alabama’s economy is toward greater economic diversification although the state retains a sizeable manufacturing base. There is an ongoing positive shift from low paying textile and apparel jobs to higher paying durable subsectors including automobile and aerospace manufacturing.

Revenue Framework: ‘aa’ factor assessment
Alabama maintains unlimited ability to raise operating revenues. Its revenue base is diverse, including broad based income and sales taxes. Fitch anticipates growth prospects for revenues to be in lines with historical performance.

Expenditure Framework: ‘aaa’ factor assessment
Strong spending controls include a statutory requirement to make across-the-board appropriation reductions to maintain budgetary balance. Carrying costs for debt service and pensions are low.

Long-Term Liability Burden: ‘aaa’ factor assessment
Debt levels are moderate with most debt issued by a variety of authorities. However, pension funded ratios have weakened in recent years.

Operating Performance: ‘aa’ factor assessment
Alabama has a strong ability to address economic downturns through expenditure controls and access to extensive reserves. Despite slow growing revenues and the need to take continued budget balancing actions during the recovery period, the state has rebuilt flexibility by restoring reserves and eliminating the use of non-recurring budget solutions.

RATING SENSITIVITIES
FUNDAMENTAL CREDIT QUALITY: The IDR is sensitive to material deviation from historically prudent financial practices, a change in policy or statute regarding use of the Alabama Trust Fund, significant weakness in the economy that deviates from national economic trends.

CREDIT PROFILE

Alabama’s economy was historically dominated by agriculture, natural resource extraction, and manufacturing, including textiles and iron and steel production. Today, the state still depends more heavily on manufacturing relative to the national average, but manufacturing has shifted away from textiles and apparel to the automotive sector. Aerospace manufacturing is also growing in the state with Airbus investing $600 million in an assembly plant in Mobile that began operation in 2015 and is expected to employ 1,000 as well as a $200 million investment by GE Aviation in Huntsville.

Alabama’s labor market has been slowly expanding since the recession and, even with the positive investments noted above, has been lagging the nation in job creation. Wealth indicators have typically been well below national averages but show improvement in recent years. Personal income per capita is just 82% of the U.S. average, ranking it 44th among the states. The poverty level is still among the highest of the states.

Revenue Framework
State financial operations are dispersed among a variety of funds, supported by a diverse revenue stream. General fund operations are relatively small and supported by a variety of taxes and fees, including a portion of the sales and use tax and earnings on the Alabama Trust Fund. The largest fund is the Education Trust Fund (ETF), which receives the state income tax, sales and use tax, and utility taxes.

Historical tax revenue growth, adjusted for the estimated impact of policy changes, has been essentially flat on a real basis over the last 10 years, lagging GDP growth and below median growth for states. Year-over-year changes vary widely, indicating some volatility in the revenue stream and a revenue system that responds fairly quickly to economic changes. Fitch anticipates the long-term trend for revenue growth will be in line with historical performance.

Alabama has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.

Expenditure Framework
Financial operations benefit from strong spending controls, with a constitutional requirement to make across-the-board appropriation reductions, called ‘proration,’ when a deficit is projected in one of several funds; debt service is not subject to proration. This device has been implemented several times in recent years, especially in the ETF, but also in the general fund. Education funding, both for operations and capital, is centralized at the state level.

As with most states, spending growth, absent policy actions, is expected to be slightly ahead of revenue growth, driven primarily by education and Medicaid spending. Education spending growth is capped according to statute at the rolling 15-year average annual revenue growth rate in order to control spending and avoid proration. Excess revenues are transferred to a budget stabilization fund to be used only to avoid proration in the ETF.

Alabama retains ample expenditure flexibility. General fund operations are relatively small and limited to general government functions, health, and police/corrections. The state has significant responsibility for education with operations funded through the ETF. Carrying costs for debt service and pensions are slightly above the state median but still quite low.

Long-Term Liability Burden
Alabama’s long-term liability burden, including net tax-supported debt and unfunded pension liabilities attributable to the state, is slightly above the state median but still modest at 8.2% of 2015 personal income. With a prohibition against issuing debt, except by a constitutional amendment, state debt issuance is diffuse and issued by a variety of authorities, with less than 20% of debt in the form of general obligations. Approximately half of Alabama’s tax supported debt has been issued by the Public Schools and College Authority, which finances capital improvements to local school districts and institutions of higher education through both grants and loans.

A longer-term concern is the deterioration in pension funded ratios despite full actuarial contribution: the two largest systems, covering general employees and public education, were over-funded as recently as 2001 but are now funded on a reported basis at 67% and 67.5% respectively as of Sept. 30, 2014. These ratios, as adjusted by Fitch to a 7% return assumption, are 60.3% and 60.8% respectively. Both systems assume relatively high 8% discount rates, with annual contributions calculated on an open amortization basis. Reforms adopted in 2012 established a new tier with lower benefits and lower required contributions.

A constitutional amendment (from 1933) prohibits the issuance of debt except by constitutional amendment, which requires a three-fifths vote by each house of the legislature and voter approval. The authorization under which most GO debt is issued has a rolling $750 million limit, which allows the state to have outstanding at any time $750 million in GO bonds without an additional vote. Other constitutional amendments have authorized GO debt.

Operating Performance
Alabama’s ability to respond to cyclical downturns reflects its strong expenditure controls and significant reserves held in the Alabama Trust Fund (ATF). The ATF was initially capitalized with proceeds from off-shore lease sales in 1981 and still receives portions of oil and gas royalty payments to the state. Earnings from the fund, which has a balance of approximately $2.7 billion, support the general fund, a land trust, and a variety of state and local capital projects. The ATF is the source of the general fund and ETF rainy day funds up to specified capped amounts, which, when used, must be repaid over a specified time period. During the most recent recession, Alabama faced budget gaps in both the general and education trust funds due to revenue shortfalls. The gaps were closed with budget reductions including through proration (automatic spending cuts), use of one-time revenues, and draws on the rainy day fund. It is Fitch’s expectation that a reduction in revenues caused by a future cyclical downturn would also be met with proration and use of the now restored access to the rainy day fund.

During times of economic recovery, Alabama rebuilds its financial flexibility including restoring draws on its rainy day funds and reducing the use of non-recurring budget items. During this post-recessionary period, the state also passed the Rolling Reserve Act, which allows it to smooth spending for education and creates an additional budget stabilization fund specifically designed to reduce the occurrence of proration in education spending.

The adopted general fund budget for fiscal 2016, which began Oct. 1, 2015, assumed modest revenue growth and closed a $200 million forecast gap with an increase in the cigarette tax and modest budget cuts. With growth in recurring revenues, the budget relies only minimally on one-time revenues, an improvement over recent budgets. Through April, general fund revenues are 3.6% above forecast, reflecting stronger than anticipated sales tax collections.

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

In addition to the sources of information identified in Fitch’s 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/creditdesk/reports/report_frame.cfm?rpt_id=879478

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