Fitch Rates Michigan’s $185MM GO Bonds ‘AA’; Outlook Stable
By Business Wire News
By Business Wire News
Fitch Ratings has assigned ‘AA’ ratings to approximately $184,740,000 in State of Michigan general obligation (GO) bonds, as follows:
–$126,130,000 GO school loan refunding bonds, series 2016A (taxable);
–$58,610,000 GO environmental program refunding bonds, series 2016B (tax-exempt).
The bonds are expected to sell via negotiation on or about June 21.
In addition, Fitch has affirmed Michigan’s ‘AA’ Long-Term Issuer Default Rating (IDR) and the following ratings that are directly linked to Michigan’s long-term IDR:
–State of Michigan general obligation bonds at ‘AA’;
–Michigan State Building Authority (SBA) revenue bonds at ‘AA-‘;
–Michigan ‘Michigan School Bond Qualification and Loan Program’ (SBQLP) program rating at ‘AA’.
The Rating Outlook is Stable.
The bonds are general obligations of the state, with full faith and credit pledged.
KEY RATING DRIVERS
Michigan’s ‘AA’ bond rating reflects the state’s solid economic performance, low direct liabilities for debt and retirement obligations, and conservative approach to fiscal management. Despite the economy’s growing diversity, Michigan’s globally important manufacturing sector, particularly automotive manufacturing, is central to economic performance and subject to volatility. The state manages the consequent revenue cyclicality by an emphasis on maintaining fiscal flexibility, including in recent years a rebuilt budget stabilization fund (BSF), the state’s rainy day fund.
In addition to the economic and revenue cyclicality, the state faces other notable fiscal uncertainties, including contingent needs arising from distressed local governments and school districts, as well as remediation costs and potential litigation exposure arising from the water crisis in Flint, Michigan. The state’s ‘AA’ GO bond rating assumes that the state’s financial exposure to these challenges will remain within manageable parameters in the future.
Economic Resource Base
Michigan’s economy is diverse and growing, although longstanding strengths in automotive manufacturing and affiliated sectors remain central to its economic resource base. A decade of persistent economic weakness led into the last recession, the result of restructuring in the manufacturing sector and the near-collapse of the domestic auto industry. Michigan’s economy has stabilized during the current expansion, and structural changes in the automotive sector have improved its longer-term viability. Service sector growth has been particularly notable, and recent economic performance has approximated or exceeded the nation’s across a range of indicators. Fitch assumes that manufacturing generally, and the automotive sector specifically, will remain key but cyclical components of the economy going forward.
Revenue Framework: ‘a’ factor assessment
Tax revenues are very diverse and dominated by income and consumption taxes, although other revenue sources are also significant. They are deposited either to the general fund for general purpose needs or to special purpose funds as designated by constitutional or statutory provisions. Tax revenues are economically sensitive, and Fitch expects revenue growth to generally remain at or below the level of inflation over time. There are no material limits on the state’s ability to impose tax revenues.
Expenditure Framework: ‘aa’ factor assessment
The natural pace of spending growth in Michigan is expected to be ahead of expected revenue growth over time, requiring ongoing cost control. The state has an ample ability to reduce spending throughout the economic cycle.
Long-Term Liability Burden: ‘aaa’ factor assessment
Michigan’s direct liabilities for tax-supported debt and retirement obligations are low and represent only a limited burden on resources. Direct net tax-supported debt has fallen given low issuance. Long-implemented pension reforms that shifted the state’s obligation to a defined contribution from a defined benefit, limit the state’s pension liabilities.
Operating Performance: ‘aa’ factor assessment
Michigan has very strong gap-closing capacity stemming from a consistent willingness to implement budgetary changes, including deep spending cuts, to maintain fiscal equilibrium. The state’s BSF, which it rebuilds during sustained periods of economic and revenue expansion, adds a material degree of flexibility. Risks arising from fiscal challenges at local levels of government are present and may have a negative impact on operations but appear manageable within the state’s existing level of financial flexibility.
The rating is sensitive to the state’s ability to maintain operating performance over time consistent with the current rating level despite economic and revenue cyclicality and the risks arising from fiscally challenged local governments. The Stable Outlook assumes the continuation of conservative fiscal management and an ongoing commitment to maintaining fiscal flexibility, including through replenishing and sustaining reserves.
Michigan’s economy is diverse, although anchored by a large manufacturing sector, particularly its globally-important automotive industry. Manufacturing underwent a severe restructuring in the decade leading up to 2010, weakening overall state economic and fiscal performance. The state lost jobs on an annual basis between 2001 and 2010.
Economic performance has strengthened markedly since 2010, most notably in manufacturing. Despite losing two-thirds of automotive manufacturing and parts employment prior to and during the last recession, employment has rebounded since then. However, automation and labor agreement changes have driven productivity increases faster than employment. Manufacturing employment remains more than 60% higher in Michigan than in the nation, a factor that could expose the state to future cyclical or structural weakness. The state’s diverse and growing service sector has become increasingly important.
Unemployment in the state historically has exceeded the nation’s, but this recently reversed. Similarly, personal income gains, while steady, have historically underperformed national averages, a situation that has also reversed. Measured by per capita personal income, Michigan ranks 33rd among the states in 2015, at 89% of the national average.
Michigan’s tax revenues are very diverse, with the state relying on personal income tax (PIT) and sales and use taxes for the majority of needs. Individual levies are frequently subject to constitutional or statutory designations to specified needs, leaving remaining receipts for general purposes. The general fund receives PIT, portions of sales and use taxes, business income, insurance and other taxes not otherwise dedicated to special funds.
Consistent with other states levying a PIT, Michigan’s PIT is economically sensitive. Taxation of businesses has undergone multiple reforms over the last two decades; since 2012 the state has levied a corporate income tax at a flat rate based on federal taxable income. Business tax collections continue to be affected by credits granted under the prior tax system (the Michigan business tax, MBT) that can still be claimed; credits claimed in recent years have approached or exceeded corporate income taxes received.
Under various constitutional and statutory provisions, the school aid fund (SAF) receives the majority of sales and use taxes, cigarette and tobacco taxes, a 6-mill statewide property tax, and an earmarked transfer of PIT from the general fund. Most transportation receipts are deposited to the Michigan transportation fund or the comprehensive transportation fund to support highways and public transportation, respectively.
Michigan’s revenue growth over the last 10 years, adjusted for policy changes, has been negative and well under benchmarks of national economic growth, including GDP and CPI, in contrast to the vast majority of states. The state’s past experience reflected in part the severe economic dislocations it faced in the decade leading into the last recession. Going forward, Fitch expects Michigan’s revenue growth absent policy changes to be stronger than in the recent past, broadly reflecting its stabilized economic performance and structural changes in its economy, although revenue growth is still likely to trail the average for states.
The state has only limited legal constraints on its ability to raise revenues. A constitutional limit restricts total state revenues to a fixed amount based on a formula incorporating recent personal income experience; recent state revenues have been well under the limit. The limit excludes revenues for payment of GO bond debt service, and the state can exceed the limit with a supermajority legislative vote.
Education funding and social services are Michigan’s largest spending commitments. Education is supported not only by appropriations from the SAF but also by additional general fund support for K-12 and for higher education. Carrying costs for liabilities are not a significant burden on Michigan’s resources given the relatively low level of the state’s liabilities. School funding, notably, includes additional formula resources to offset a portion of the pension contribution of local school districts to MPSERS, although contributions and the associated liabilities are ultimately the responsibility of the districts, rather than the state.
Absent policy actions the pace of spending growth is likely to be above revenue growth in Michigan, requiring ongoing budget action to ensure balance. Rising costs are driven by ongoing spending needs for schools and social services. Adding to potential spending growth are the demands for state resources that arise periodically from local governments and school districts, including to address fiscal distress, litigation or emergency needs. Generally, Fitch views the state as having sufficient near-term flexibility to absorb unexpected demands on state resources in a manner consistent with the state’s ‘AA’ IDR.
The state retains ample expenditure flexibility. During the decade leading into the last recession, the state was able to repeatedly implement spending cuts and other actions to ensure budgetary balance. Given that a significant share of state spending is for transfers to lower levels of government to support service delivery, the state has often shifted the burden of service cuts to local governments and schools via reduced transfers.
Long-Term Liability Burden
Michigan’s debt and retiree obligations are low for a state and as such represent a low burden on resources. As of Fitch’s 2015 state pension update, net tax-supported debt and unfunded pensions attributable to the state measured 4.1% of personal income, below the 5.8% median for states.
The state’s debt level has fallen gradually in recent years given limited new issuance. As of Sept. 30, 2015, net tax-supported debt of $7.1 billion represents a low 1.7% of 2015 personal income. GO debt amortization is rapid with 81% 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 provides a contingent guarantee to certain school district borrowing through its school bond qualification and loan program; $13.2 billion in borrowing is covered by the state’s guarantee.
Multiple pension plans are sponsored by the state, although the State Employees Retirement System (MSERS) is the largest plan for which the state has direct responsibility. Retiree obligations are low. In 1997 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 separate state-sponsored system whose liability is not carried by the state.
The state has eliminated other post-employment benefits for new hires and undertook various other reforms to curb the growth of obligations or limit the state’s exposure to rising costs. Ongoing litigation has left the ultimate outcome of some of these reforms uncertain.
As of Sept. 30, 2015, the most recent actuarial valuation date, the reported funded ratios of MSERS was 61.6% (based on an 8% investment return assumption), or 55.5% (based on Fitch’s more conservative 7% assumption). Under GASB 67, the system’s Sept. 30, 2015 ratio of assets to liabilities was 66.1%, reflecting in part the full recognition of market gains through the measurement date.
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, the state continuously took 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 operating surpluses. Improved liquidity has meant the state has not borrowed for cash flow purposes since fiscal 2011. The state has made replenishing its BSF a priority, with deposits beginning at $363 million in fiscal 2012. 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 directed $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. Including tobacco settlement revenues and an additional $95 million deposit in fiscal 2016, the BSF is estimated to total $611 million as of Sept. 30, 2016.
Recent Operating Performance
Fiscal 2016 performance has generally been steady, despite budgetary uncertainties arising from revenue performance and local needs, including the Flint water crisis and Detroit Public Schools. The adopted budget reflected the May 2015 consensus revenue forecast, which assumed net general fund-general purpose (GF/GP) revenues rising 1.6% (to $9.9 billion), and net SAF revenues rising 3% (to $12.2 billion). The plan continued BSF deposits, with $95 million appropriated in addition to the tobacco settlement funds deposit noted earlier. The state also allocated $400 million in GF/GP resources on a one-time basis for transportation needs.
Year-to-date through April, net GF/GP receipts are down 1% from the prior year, while net SAF receipts are up 2.5%. Factors affecting collections include unusually strong fiscal 2015 capital gains, lower corporate income receipts, higher MBT credits, and weaker sales tax receipts including due to low gasoline prices. The May 2016 consensus forecast has incorporated these trends, with fiscal 2016 net GF/GP revenues expected to fall 3% (to $9.7 billion) from fiscal 2015 and net SAF revenues rising 2.7% (to $12.1 billion).
The fiscal 2017 budget has not yet been finalized. The May 2016 consensus forecast assumes fiscal 2017 net GF/GP revenues rising 4.2% (to $10.1 billion) and net SAF revenues rising 2.8% (to $12.4 billion); baseline economic growth and a decline in MBT credits helps propel revenue growth. However, the diminished revenue growth expectations relative to the previous consensus forecast, in January 2016, required adjustments to proposed spending, including lowering resources directed to infrastructure.
In response to the Flint water crisis, the legislature has or is considering appropriations totaling $233 million, including fiscal 2016 supplementals and additional funding in the fiscal 2017 budget. To date, funding is primarily for immediate response needs and ongoing services; the timing and magnitude of exposure to Flint-related litigation remains unknown. The legislature is also finalizing a reported $617 million package that restructures Detroit Public Schools, to which the state would direct $72 million in tobacco settlement receipts annually over 10 years for debt paydown.
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.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
Dodd-Frank Rating Information Disclosure Form
Fitch Ratings, Inc.
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