Fitch Rates Washington’s $530MM GO Bonds ‘AA+’; Outlook Stable
By Business Wire News
Fitch Ratings has assigned an ‘AA+’ rating to the following state of Washington general obligation (GO) bonds:
–$321,580,000 various purpose GO bonds, series 2016C;
–$200,525,000 motor vehicle fuel tax GO bonds, series 2016D.
The bonds are expected to be sold through competitive bid on Feb. 9, 2016.
The Rating Outlook is Stable.
The bonds are GOs of the state to which its full faith, credit, and taxing power are pledged. Motor vehicle fuel tax GO bonds are first payable from state excise taxes on motor vehicle and special fuels.
KEY RATING DRIVERS
SOLID ECONOMY: Washington’s economy is characterized by generally sound performance and increased diversification. Aerospace, technology, and construction remain significant to the state economy. The manufacturing sector is concentrated in the cyclical aerospace industry, although this concentration is sharply reduced.
RESPONSIVE FINANCIAL MANAGEMENT: Frequent reviews of economic and financial forecasts allow the state to react to changing conditions. As the economy and revenues repeatedly underperformed estimates in the last recession, the state demonstrated its willingness and ability to take actions to maintain budget balance. The state has since experienced steady improvement in its economic and revenue results and replenished its cushion against future underperformance. Fitch anticipates the state will address near-term budgetary challenges, primarily related to K-12 education funding requirements, in a sustainable manner consistent with historical practice.
CONCENTRATED REVENUE SYSTEM: The state, with no income tax, relies on consumption-based revenues. This makes Washington particularly vulnerable to reductions in consumer spending.
ABOVE-AVERAGE LIABILITY BURDEN: Debt ratios are in the upper moderate range and expected to remain so. This reflects funding of substantial capital needs, particularly for transportation. Although the state’s unfunded pension liability is below average, the combined burden of debt plus pensions is above the median for U.S. states.
INITIATIVES AND REFERENDA – A LIMITED RISK: Washington’s initiative and referendum environment creates a level of operating and financial uncertainty. However, it is significant that any law approved by voters in this manner can be amended or repealed by the legislature by a two-thirds vote in the first two years after approval and by a simple majority thereafter.
Washington’s ‘AA+’ rating and Stable Outlook assume the state’s continued ability to maintain budget balance and an adequate reserve position in the face of funding demands presented by an education-funding court decision and for transportation needs.
Washington’s ‘AA+’ GO bond rating reflects a generally solid economy and a demonstrated commitment to fiscal balance despite economic and revenue cyclicality. Credit strengths are offset by a concentrated revenue system that is reliant on the sales tax, as well as above-average debt levels.
Economic and revenue growth in the recovery has allowed the state to replenish its financial cushion, and the state ended the fiscal 2013-2015 biennium on June 30, 2015 with substantially increased reserves of $1.5 billion (including the general fund ending balance and the budget stabilization fund). The enacted budget for the current 2015-2017 biennium projected a net decline in total reserves by the end of fiscal 2017 to $1.2 billion.
The September 2015 revenue forecast increased the general fund revenue estimate for the biennium by $333 million, and the November quarterly forecast update added another $113 million. Total revenues for the biennium are now forecast at $37.2 billion. However, expenditure projections have increased by more than revenues have since budget enactment.
In December 2015, the governor released a supplemental budget proposal that would fund the increased projected expenditures resulting from updated cost and caseload forecasts as well as 2015 wildfire-related costs of $178 million that were well above historical averages on which the budget was based. The proposal would also raise the minimum salary for beginning teachers statewide and fund a raise for other teachers, in response to a reported teacher shortage. If enacted in its current form, the supplemental budget would reduce the projected ending reserve and balance for the biennium to $941 million. The legislature is currently considering this proposal in a 60-day session.
A recent superior court ruling removes the need for the legislature to act in the near term on an initiative that was approved by voters at the November 2015 election. The court found Initiative 1366 to be unconstitutional. The state’s attorney general filed an appeal to the state supreme court on Jan. 25; state law requires the attorney general to defend all enacted statutes, including voter-approved initiatives. Under the terms of the initiative, the state’s sales tax rate would have dropped to 5.5% from 6.5% on April 15, 2016 unless the legislature had referred to voters a constitutional amendment requiring two-thirds legislative approval or voter approval to raise taxes, and a majority legislative approval for fee increases. The state estimates reducing the sales tax rate to 5.5% would have reduced sales tax revenue by approximately $163 million in the remainder of fiscal 2016 and $1.4 billion in fiscal 2017.
Given the fiscal pressures related to education funding that currently face the state, in the event the initiative were ultimately to be upheld, Fitch would expect the legislature to take action to avoid the reduction, either by amending or repealing the initiative or referring the required amendment to voters.
The pressure that education funding currently places on Washington’s budget is due mainly to the McCleary court decision of 2012 and Initiative 1351 of 2014, which set class-size reduction targets. The current biennial budget made progress towards addressing the demands with increased K-12 spending, but sizable challenges remain, and the state supreme court is actively fining the state for underfunding education pursuant to the terms of the court decision. The fines are insignificant compared to the size of the state’s budget and the accumulated funds support education spending. As such, Fitch sees this as mainly a policy rather than credit issue for the state.
IMPROVING FISCAL POSITION
Washington’s reliance on a broad-based sales tax makes it particularly vulnerable to reductions in consumer spending. State general fund revenue declines of 9.6% in fiscal 2009 and 4.1% in fiscal 2010 were followed by growth of 7.9% in fiscal 2011, reflecting in part tax increases enacted in April 2010, 1.5% in fiscal 2012, 6.1% in fiscal 2013, 3.8% in fiscal 2014, and 5.5% in fiscal 2015. The most recent forecast, from November 2015, projects revenues up 5.8% in the current fiscal year 2016, and up 3.5% in the second half of the biennium (fiscal 2017).
The state reviews its general fund revenue forecast quarterly. Actual revenue performance underperformed revised estimates in the last recession repeatedly and significantly. Budget balance was maintained through a combination of ongoing and one-time actions, including a drawdown of reserves. Performance since has been positive, with regular modest upward forecast changes.
Despite continued revenue growth, budgeting for the fiscal 2013-2015 biennium was challenging. Washington had already taken extensive spending control action in the downturn, and there was not sufficient support for significant revenue increases to support new spending demands. Adding to the challenge, a new statutory requirement mandated that the budget show projected balance over a four-year period rather than just the biennium; Fitch viewed the requirement as a positive credit factor.
The enacted budget was passed unusually close to the start of the new biennium and following preparation for a possible partial government shutdown. A key source of debate was the amount of additional money necessary to address K-12 funding adequacy based on the McCleary decision, noted earlier. The court decision provided the state flexibility in terms of the timing and amount of supplemental funding. The state calculated that $1 billion in additional funding was provided towards the McCleary decision goals with the 2013-2015 budget, although that included the continued suspension of a scheduled raise for teachers that was passed by voter initiative.
Budgeting for the 2015-2017 biennium proved equally challenging with the governor signing the budget on the last day of the fiscal year. Once again, education funding played a key role in the debate. The enacted budget includes $1.3 billion in additional basic education funding, and $618 million to support K-12 staff compensation increases. The legislature delayed implementation of class-size requirements passed by voters under Initiative 1351 until the 2019-2021 biennium.
In August 2015, the state’s supreme court acknowledged the additional education funding support in the enacted budget, but determined the state had still not addressed several important aspects of the McCleary decision and issued an order instituting a nominal $100,000 daily fine until the legislature adopts a complete plan. The state currently estimates meeting the remaining McCleary decision obligations could require as much as $3.5 billion per biennium above currently budgeted K-12 spending levels. Fitch anticipates this will continue to be a key source of budgetary pressure.
The ending balance and reserves for the biennium that closed on June 30, 2015 totaled $1.5 billion, 8.8% of fiscal 2015 general fund tax revenues. This is up significantly from the previous biennium, which ended on June 30, 2013 with a much more modest $438 million in reserves, or 2.7% of general fund tax revenues.
Fitch views positively the state’s solid funding provisions for its budget stabilization account. In November 2007, voters approved a constitutional budget stabilization account that receives 1% of revenues off the top every year, capped at 10% of annual general revenues. Although there are restrictions on use, these monies were depleted during the recession. In 2011, voters approved another constitutional amendment that requires any extraordinary growth in state revenue (defined as growth in general state revenues that exceeds by one-third the average biennial growth of the prior five biennia) be transferred to the budget stabilization account on top of the 1%.
SOLID ECONOMIC PROFILE
Washington State’s economy, historically reliant on manufacturing supplemented by regional and international trade and tourism, has broadened. Areas of concentration (Boeing and Microsoft) offer relatively high-wage employment, and the population is well educated. In addition, population growth has far exceeded that of the U.S. as a whole.
Washington’s economy entered the last recession later than the U.S. overall following a period when it performed much more strongly than the nation. Peak-to-trough, the state’s non-farm employment decline was slightly lower than that of the nation and the recovery has been stronger. Washington’s year-over-year job growth of 2.8% in December 2015 compared favorably to 1.9% for the nation. The state’s unemployment rate in December was 5.5%, compared to the 5% U.S. rate.
Per capita personal income is above average, at 107.7% of the U.S. in 2014, 12th highest of the states. Recent personal income growth in Washington has been comparatively strong.
WELL-ABOVE-AVERAGE DEBT LEVELS; NEARER MEDIAN WHEN PENSIONS ADDED
Washington’s debt levels are in the upper moderate range and well above average for a U.S. state, with pro forma net tax-supported debt equal to 5.6% of 2014 personal income. Debt is primarily GO. Capital needs are substantial, particularly for transportation, and tolling is part of the funding solution. Positively, the state has increased its focus on debt affordability. In November 2012, voters approved a constitutional amendment that tightened the constitutional debt limit.
The state administers 13 defined benefit retirement plans, three of which have hybrid defined benefit/defined contribution options. The closed public employees and teachers plans (PERS1 and TRS1), which have been closed since 1977, are underfunded. However, Fitch believes that the unfunded liability is manageable. The state supreme court in 2014 upheld pension reforms that had been subject to longstanding legal challenge.
On a combined basis, Washington’s burden of net tax-supported debt and adjusted unfunded pension obligations, at 8.5%, is above the 5.8% median for U.S. states (per Fitch’s 2015 state pension update) even though the pension burden is below average. This is due to the debt burden being more than twice the median. Other post-employment benefits (OPEB) are limited and funded on a pay-as-you-go basis.
Date of Relevant Rating Committee: Sept. 17, 2015.
Additional information is available at ‘www.fitchratings.com‘.
Fitch recently published an exposure draft of state and local government tax-supported criteria (Exposure Draft: U.S. Tax-Supported Rating Criteria, dated Sept. 10, 2015). The draft includes a number of proposed revisions to existing criteria. If applied in the proposed form, Fitch estimates the revised criteria would result in changes to less than 10% of existing tax-supported ratings. Fitch expects that final criteria will be approved and published by the end of the first quarter of 2016. Once approved, the criteria will be applied immediately to any new issue and surveillance rating review. Fitch anticipates the criteria to be applied to all ratings that fall under the criteria within a 12-month period from the final approval date.
In addition to the sources of information identified in Fitch’s applicable criteria specified below, this action was informed by information from CreditScope, IHS, and Federal Reserve Bank of St. Louis Economic Data.
Exposure Draft: U.S. Tax-Supported Rating Criteria (pub. 10 Sep 2015)
Tax-Supported Rating Criteria (pub. 14 Aug 2012)
U.S. State Government Tax-Supported Rating Criteria (pub. 14 Aug 2012)
Laura Porter, +1-212-908-0575
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Douglas Offerman, +1-212-908-0889
Elizabeth Fogerty, New York, +1-212-908-0526