Fitch Rates Michigan’s $130MM GO Bonds ‘AA’; Outlook Stable

NEW YORK

Fitch Ratings assigns ‘AA’ ratings to the following State of Michigan general obligation (GO) bonds:

–$130,000,000 GO environmental program refunding bonds, series 2015A (tax-exempt).

The bonds are expected to sell via negotiation on or about Aug. 11.

The Rating Outlook is Stable.

SECURITY

The bonds are general obligations of the state, with full faith and credit pledged.

KEY RATING DRIVERS

ECONOMIC AND FISCAL STABILITY: Michigan’s GO rating reflects the state’s improved economic and fiscal performance, with structurally balanced budgeting, growing reserves and higher liquidity.

MANUFACTURING DOMINANCE: The state’s economy is dominated by manufacturing. Although the competitive posture of its large automotive sector has improved since its restructuring in recent years, the state is likely to remain exposed to the economic and fiscal impacts of manufacturing cyclicality over the long-term.

MANAGEABLE LIABILITIES: Net tax-supported debt is low given the state’s infrequent debt issuance. Obligations for retiree pensions and health care are manageable given state reforms and the state continues to pursue additional savings.

RATING SENSITIVITIES

Michigan’s GO rating is sensitive to changes in the state’s economic outlook, particularly from the manufacturing sector. Exposure to manufacturing-related concentration and cyclicality is a limiting credit factor. The Stable Outlook assumes the continuation of conservative fiscal management and an ongoing commitment to replenishing and sustaining reserve balances that has marked recent years.

CREDIT PROFILE

Michigan’s GO bond rating reflects the state’s solid economic and fiscal recovery over the last several years and conservative approach to state fiscal management. After a decade of persistent economic weakness, the result of manufacturing cyclicality and the near-collapse of the domestic auto sector, the state’s economy is growing again and structural changes in the automotive sector have improved its longer-term viability. Fitch assumes that Michigan’s automotive manufacturing sector will remain a sizable and cyclical component of the economy even as services grow in size and importance to the state’s economic profile.

Michigan has used the economic and revenue momentum of recent years to stabilize state finances, with structurally balanced budgets, annual surpluses, higher liquidity and annual deposits to the budget stabilization fund (BSF), the state’s rainy day fund. Despite a one-time BSF draw during fiscal 2014 of $194.8 million for the state’s contribution to the Detroit bankruptcy settlement, continued BSF deposits remain a priority, with annual appropriations in both fiscal 2015 and 2016 as well as funds deposited to repay the draw for the Detroit settlement. The state’s ‘AA’ GO bond rating assumes that the state’s financial exposure to distressed local governments and school districts will remain within manageable parameters in the future.

The state’s longstanding conservative fiscal management, combined with the actions taken in recent years, leaves it better positioned to address future economic and revenue uncertainty, in Fitch’s opinion. Tax-supported debt has been falling gradually and state’s exposure to retiree obligations is manageable, in part given recent benefit reforms.

ECONOMIC RECOVERY CONTINUES

Michigan’s economy lost jobs on an annual basis between 2001 and 2010, with the 2009 decline particularly steep at 7% year-over-year reflecting the combined impact of the national recession and the domestic automotive sector’s weakness and associated restructuring. Employment turned around thereafter, with employment rising faster than the national rate in the 2011-2013 period, and with growth of 1.6% in 2014, below the 2.3% national rate. June 2015 employment is up 2.3% from a year earlier, ahead of the 2.1% national rate.

Despite recent improvement, automotive retrenchment has been difficult for the state, with roughly two-thirds of automotive manufacturing and parts employment lost over a decade. Both sectors have logged sizable gains since 2010, although Fitch notes that production has rebounded faster than employment reflecting productivity improvements. Manufacturing jobs represent 13.9% of total jobs in Michigan as of June 2015, well ahead of the 8.7% U.S. level, exposing the state to future cyclicality. However, the economy also benefits from a diverse and growing service sector, which has seen particularly strong gains in professional and business services, education and health, and leisure and hospitality.

The unemployment rate has historically been higher than the national average, although has declined steadily since peaking at 13.7% in 2009 (147% of the nation.) The 5.5% unemployment rate in June 2015 was only slightly higher than the nation’s 5.3% level. The state’s May 2015 consensus forecast assumes an unemployment rate at 5.8% during 2015, falling to 5.4% by 2017.

Consistent with the state’s significant employment losses, personal income growth consistently lagged the nation’s throughout the last decade through 2013. Michigan’s personal income in 2014 grew faster than the nation’s, up 4% vs. 3.9% nationwide. Measured by per capita personal income, Michigan ranked 36th among the states in 2014, at 88% of the national average. The May 2015 consensus forecast assumes solid personal income growth going forward, ranging from 4.6% in 2015 to 4.2% in 2017.

CONSERVATIVE FINANCES AND GROWING RESERVES

Michigan has long taken a conservative approach to fiscal management, although a decade of economic and revenue weakness starting with the 2001 recession eroded the state’s financial standing. During that time, the state took repeated remedial action to maintain budgetary balance, including revenue increases, spending austerity and the use of one-time resources. The latter included debt restructuring, depletion of the BSF, and reliance on federal stimulus funding. Economic improvement beginning in 2010 was matched by revenue stabilization, with higher liquidity and sizable surplus balances. Improved liquidity has meant the state has not borrowed for cash flow purposes since fiscal 2011.

With fiscal stabilization the state has made replenishing its BSF a priority. Beginning with a $363 million deposit in fiscal 2012, the BSF has benefitted from annual sizable deposits. The balance has grown rapidly as a result, with the exception of fiscal 2014, when the state withdrew $195 million under one provision of a nine-bill package related to Detroit’s Chapter 9 bankruptcy settlement. The package also directs $17.5 million to the BSF from the state’s receipt of tobacco settlement revenues annually for 21 years; the deposits are expected to total $368 million.

FISCAL 2015 BALANCED DESPITE TAX CREDITS

The fiscal 2015 adopted budget was based on the May 2014 consensus revenue forecast and projected revenues increasing by 4.1% ($864 million) from fiscal 2014; general fund-general purpose (GF/GP) revenue was forecast to increase 5.4% and school aid fund (SAF) revenue is projected to increase 3.1%. The budget included a $285 million shift of GF/GP resources for transportation, reflecting the state’s increasing focus on making additional resources available for transportation capital and maintenance. A package of tax and fee changes that would have raised revenues and shifted resources for transportation needs failed in a May 2015 voter referendum.

The fiscal 2015 outlook was affected mid-year by much higher than forecast business tax credit payments granted as part of past economic development packages. The January 2015 consensus forecast lowered fiscal 2015 and 2016 GF/GP revenues by $325 million and $532 million, respectively. Corrective action was taken immediately to return to forecast balance, with community college spending shifted to the SAF from the GF/GP, recognition of lower Medicaid caseload, and a range of spending cuts.

Beyond the challenge posed by the tax credits, the state’s overall performance has been steady. Year-to-date through May, GF/GP revenues are up 5.5% ($313 million), with SAF revenues up 8.1% ($602 million). At present, the fiscal agency for the state’s House of Representatives forecasts the year to end with a GF/GP balance of $170 million. Following the tobacco deposit and a general fund appropriation of $94 million in fiscal 2015, the BSF balance is forecast to be $499 million as of Sept. 30, 2015, the state’s fiscal year-end.

FISCAL 2016 CONTINUES RESERVE DEPOSITS

The fiscal 2016 adopted budget reflects the May 2015 consensus forecast, which assumes net GF/GP revenues rising 1.6% ($157 million), and net SAF revenues rising 3% ($360 million). The plan continues to prioritize BSF deposits, with $95 million appropriated in addition to the tobacco settlement funds deposit noted earlier. The state has also allocated $400 million in GF/GP resources for transportation purposes, of which $143 million is intended to be ongoing. Although the state’s budget for fiscal 2016 has been settled, deliberations in the legislature continue regarding options for providing more sustainable funding for transportation. Fitch will monitor legislative actions to assess their potential impact on the state’s ability to maintain structural balance going forward.

DEBT AND RETIREE OBLIGATIONS MANAGEABLE

The state’s debt and retiree obligations are manageable. As of Fitch’s 2014 state pension report, net tax-supported debt and unfunded pensions attributable to the state measured 4.3% of personal income, below the 6.1% median for the states.

Net tax-supported debt, at $7.6 billion as of Sept. 30, 2014 (the most recent reporting date), represents a low 1.9% of 2014 personal income. GO debt amortization is rapid with 80% to be retired over the next 10 years. Other sizable tax-supported programs include the SBA bonds issued for higher education and state facilities and several transportation revenue supported bond programs. The state’s debt level has fallen gradually in recent years given limited new issuance.

Retiree obligations are manageable. In 1997 the Michigan State Employees’ Retirement System (MSERS) converted to a defined contribution plan for newly-hired employees, and a similar change recently has been implemented for new hires in the Michigan Public School Employees’ Retirement System (MPSERS), a system managed by the state but for which the state carries no obligations.

The state has enacted various changes to state-administered retiree pension and health benefits in recent years to limit the growth of obligations, although some changes have been subject to litigation. Legislation passed in recent years also eliminated other post-employment benefits for new hires and lowered the state’s unfunded liability. For MPSERS, recent reforms include the state supplementing school funding to cover schools’ contributions over a certain share of payroll.

The systems’ funded ratios have been affected by past investment losses. As of Sept. 30, 2013, the most recent actuarial valuation date, the reported funded ratios of MSERS and MPSERS were 60.3% and 59.6%, respectively. Using Fitch’s more conservative 7% discount rate assumption (compared to the systems’ 8% level), the funded ratios would drop to 54.3% and 53.7%, respectively. Under GASB 67, the systems’ Sept. 30, 2014 ratios of assets to liabilities are 68.1% and 66.1%, respectively, reflecting in part the recognition of recent market gains that have yet to be smoothed in to the earlier actuarial figures.

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

Applicable Criteria

Tax-Supported Rating Criteria (pub. 14 Aug 2012)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. State Government Tax-Supported Rating Criteria (pub. 14 Aug 2012)

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

Additional Disclosures

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=988680

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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