Rates PA Commonwealth Financing Auth’s $198MM Rev Bonds ‘A+’; Outlook Stable
By Business Wire News
By Business Wire News
MUMBAI, India & TOKYO & SINGAPORE
Fitch Ratings has assigned an ‘A+’ rating to the following Pennsylvania Commonwealth Financing Authority (CFA) bonds:
–$96 million CFA revenue bonds (tax-exempt) series A of 2015;
–$98.05 million CFA revenue refunding bonds (tax-exempt) series B-1 of 2015;
–$3.565 million CFA revenue refunding bonds (taxable) series B-2 of 2015.
The bonds are expected to be offered through negotiation the week of April 6, 2015.
The Rating Outlook is Stable.
Concurrently, Fitch has withdrawn the ‘A+’ rating for the following Pennsylvania CFA bonds as they were not sold:
–$96 million CFA revenue bonds (tax-exempt) series A of 2014;
–$96.865 million CFA revenue refunding bonds (tax-exempt) series B-1 of 2014;
–$6.94 million CFA revenue refunding bonds (federally taxable) series B-2 of 2014.
The bonds are paid from payments made by the commonwealth of Pennsylvania pursuant to service agreements between the authority and the commonwealth, subject to annual appropriation by the Pennsylvania General Assembly.
KEY RATING DRIVERS
APPROPRIATION SECURITY: Bond payments require annual legislative appropriation, resulting in a rating one-notch below Pennsylvania’s ‘AA-‘ GO rating.
FISCAL CHALLENGES: Pennsylvania’s ‘AA-‘ GO rating, below the level of most states, reflects the commonwealth’s continued inability to address its fiscal challenges with structural and recurring measures. After an unexpected revenue shortfall in fiscal 2014, the current year budget includes a substantial amount of one-time revenue and expense items to achieve balance and continues the deferral of statutory requirements to replenish reserves which were utilized during the recession. The commonwealth’s rapid growth in fixed costs, particularly the escalating pension burden, poses a key ongoing challenge, although Fitch expects budgetary planning and management to mitigate these pressures in a manner consistent with the ‘AA-‘ rating.
PENSION FUNDING DEMANDS: The funding levels of the commonwealth’s pension systems have materially weakened as a result of annual contribution levels that have been well below actuarially determined annual required contribution (ARC) levels. Under current law, contributions are projected to rise to the ARC for the two primary pension systems by as soon as fiscal 2017, increasing the budgetary burden and potentially crowding out other funding priorities.
INCREASING BUT STILL MODERATE LONG-TERM LIABILITIES: The commonwealth’s debt ratios are in line with the median for U.S. states. However, the commonwealth’s combined debt plus Fitch-adjusted pension liabilities is above average, and could continue growing given the current statutory schedule of pension underfunding for at least the next few years. Fitch views Pennsylvania’s long-term liability burden as manageable at the ‘AA-‘ rating so long as the commonwealth adheres to its funding schedule, or enacts reforms that do not materially increase its liability or annual funding pressure.
SOLID ECONOMIC PROFILE: Employment growth continues for the state’s broad-based economy, but at a slower pace than the nation. Below-average demographics represent a long-term drag on economic growth, though potential development of the significant natural gas reserves could mitigate that concern. Overall, the state’s economy provides a solid base for future potential revenue growth to help manage ongoing expenditure pressures.
ADDRESSING FIXED-COST PRESSURES: The ‘AA-‘ rating is sensitive to the commonwealth’s continued ability to address increasing fixed-cost pressures, particularly for pensions. Fitch anticipates the commonwealth will meet at least its statutory obligations through adequate funding in lieu of more discretionary budget items, structural expenditure reform, or revenue increases; any shift away from those commitments would be a credit negative.
MOVE TOWARD SUSTAINABLE BUDGETS: Given the magnitude of Pennsylvania’s structural budget gap, Fitch anticipates some continued use of non-recurring items in upcoming budgets, but at a declining rate. Failure to make progress toward structural balance could trigger negative rating action.
The ‘A+’ rating on the CFA revenue bonds reflects the credit of the commonwealth (GOs rated ‘AA-‘ with a Stable Outlook by Fitch) and covenants to seek state appropriations. The bonds are special obligations of the CFA, which was created in 2004 to stimulate and diversify the state’s economy through the use of appropriation-backed debt. Debt service is derived from payments from the commonwealth to the CFA under multiple service agreements, subject to appropriation. The secretary of the Department of Community and Economic Development (DCED) and the secretary of the budget have covenanted to seek such appropriations. The CFA is staffed through DCED and is governed by a seven-member board including both executive and legislative appointees. The CFA and DCED have regularly met their covenants to request full appropriation of debt service from the general fund in annual budget requests. Partially as a budget management tool in fiscal 2015 (and also in fiscal 2011), Pennsylvania’s enacted budget relies on the CFA’s use of available interest earnings, in addition to state appropriations. Interest earnings are pledged to bondholders.
CFA was granted bonding authority for up to $1.135 billion in debt, of which $500 million is for alternative energy projects and the remainder for other programs including economic development initiatives (the original programs authorization). The series 2015A bonds are being issued under the alternative energy authorization, and the 2015B bonds are being issued under the original programs authorization. Following these issuances, Fitch estimates CFA will have issued $461 million of the $500 million in authorized alternative energy programs debt.
Pennsylvania faces fiscal pressures in the form of a structurally unbalanced budget, depleted reserves, and a rapidly growing pension contribution burden following years of contribution underfunding and market-driven investment declines. The ‘AA-‘ rating reflects those issues, as well as Fitch’s expectation that the commonwealth will respond to those pressures adequately, while also beginning to make progress toward structural budgetary balance. Pennsylvania benefits from a large, diversified and expanding, albeit slowly, economic base and moderate tax burden which provides some capacity to match expenditure growth.
STRUCTURAL IMBALANCE; ONGOING BUDGETARY RISK
The commonwealth’s tax revenues continue their slow recovery, though fiscal 2014 ended well short of budgeted expectations (0.1% actual growth versus 2% budgeted), adding to the state’s fiscal pressures. As in several other states, Pennsylvania’s fiscal 2014 personal income tax revenues grew at a much slower rate than anticipated, largely due to the acceleration of income into fiscal 2013 attributable to a federal income tax increase. Sales tax revenues also came in below the enacted budget, but to a lesser degree. The revenue shortfall totaled just over $500 million, which the commonwealth responded to primarily through broad-based expenditure reductions, reflecting positively on Pennsylvania’s proactive budgetary management.
Pennsylvania’s enacted budget for fiscal 2015, which ends on June 30, relies heavily on one-time items to achieve balance. In total, the budget includes a significant $2 billion in one-time items on a $29 billion budget, or approximately 7%. Through the first eight months of fiscal 2015, general fund revenues were tracking ahead (2.2%) of the budgeted estimate. Fitch notes the enacted budget includes $2 billion in one-time, non-recurring items to achieve balance creating a substantial budget challenge for fiscal 2016. In November, the state legislature’s independent fiscal office (IFO) projected a significant structural budget gap of $1.7 billion for fiscal 2016, escalating steadily in the years thereafter. Fitch anticipates Pennsylvania will take necessary budgetary actions to move towards structural balance over the next several years.
Several one-time sources included in the current budget may not be realized, but revenue over-performance to date appears sufficient to offset the loss of these items. Fitch does not currently anticipate any need for intra-year balancing actions in order to maintain balance, a notable improvement from last year. However, budgetary pressure for future years remains substantial, evidenced by the extensive use of one-time items in the current year and ongoing statutory increases in pension contributions noted earlier. The potential for a moderate level of added budgetary stress and continued, though declining, use of one-time items in upcoming budgets is incorporated into the ‘AA-‘ rating.
Pennsylvania’s newly inaugurated governor introduced his first executive budget, for fiscal 2016, several weeks ago, focusing on several substantial revenue changes and a multi-year plan to restore education funding cuts made in recent years. Revenue highlights include a severance tax on natural gas, increases in the personal income and sales tax rates, broadening of the sales tax base, and reduction in corporate tax rates and local school district property taxes through increased state offsets for property owners. The most significant spending growth is in K-12 education, particularly beyond the next fiscal year when full-year effects of the proposed tax changes are realized. Pennsylvania has a history of late budgets, particularly in situations where political control is split between parties, and thus Fitch expects that achieving consensus on a final fiscal 2016 budget may be challenging. Importantly, debt service for GO and appropriation debt has consistently been paid even when final budget enactment was delayed several months.
PENSIONS PRESSURING FINANCIAL PROFILE
Growing statutory pension funding obligations are a main driver of the structural imbalance in the state’s budget and will require either a growing commitment of state fiscal resources, or a structural reform to drive down costs. Under the current statutory framework, Fitch expects commonwealth general fund pension contributions will increase significantly in fiscals 2016 and 2017 before growth rates ratchet down thereafter. Both of the state’s primary pension systems project Pennsylvania will contribute the full ARC by fiscal 2017 following over a decade of underfunding. At that point, Fitch expects growth in annual contribution increases will slow to a level more in line with overall budgetary growth. Similarly, projections provided by each of the systems for their respective funded ratios (a proxy for unfunded liabilities) weaken moderately over the next several years but begin improving by fiscal 2019.
Without structural expense reform or broad revenue increases, pension contributions will consume a larger share of state resources and limit the commonwealth’s overall fiscal flexibility. In fiscal 2015, commonwealth contributions are increasing over $600 million from the prior year, to $2.7 billion on a $30 billion general fund budget (9.1%). Based on the statutory framework and the pension systems’ historical data and actuarial projections for contributions, Fitch anticipates increases for fiscal 2016 and 2017 will be similar though somewhat lower. While substantial, Fitch views the anticipated contribution increases and unfunded liabilities laid out in the current statutory framework as within the commonwealth’s capacity to absorb at the ‘AA-‘ rating level.
The governor’s fiscal 2016 executive budget includes pension-related measures focused on issuing a pension obligation bond to reduce the unfunded liability, dedicating revenues to ensure adequate annual contributions, and reducing investment management fees. Several alternative legislative proposals appear to focus instead on benefit reform, largely through switching to a defined contribution plan for new employees. Fitch will evaluate any enacted pension changes on their ability to improve the commonwealth’s fiscal capacity and long-term liability profile.
LONG-TERM LIABILITIES ABOVE AVERAGE
Pennsylvania’s debt burden is moderate and at the median for U.S. states rated by Fitch. The state issues primarily GO debt, with over 60% retired within 10 years. Pro forma net tax-supported debt (NTSD) ratios have risen but remain very manageable at approximately 3% of 2014 personal income. Fitch’s NTSD calculation for Pennsylvania includes availability and milestone payment (AP and MP) commitments for its rapid bridges replacement public private partnership transportation project (P3), which Fitch views as a long-term state obligation. Under terms of the AP and MP agreements and related contracts, Pennsylvania pays a private developer fees based on the successful completion and continued operation of the bridge projects. The commonwealth anticipates funding the payments largely from its Motor License Fund, though Pennsylvania remains committed even if such revenues are insufficient.
Unfunded pension obligations now represent the dominant share of the state’s long-term liabilities. Annual contributions have been below actuarially required levels for many years and investment performance lagged expectations during the recession, triggering growth in unfunded liabilities. Pursuant to statute, sharp jumps in required contributions began in fiscal 2011, with the goal of phasing in full ARC funding over several years. Funded level ratios for the primary pension systems, the State Employees’ Retirement System (SERS) and the Public School Employees’ Retirement Systems (PSERS), have declined in recent years, and continued declines are likely at least for PSERS given that even the increased statutory contributions will be below the ARC for several more years.
The most recent reported funded ratio for SERS (as of Dec. 31, 2013) is 59.2%, dropping to 56.1% using Fitch’s more conservative 7% discount rate assumption – both ratios are actually up slightly from the 2012 valuation (58.8% reported and 55.7% Fitch-adjusted). SERS has not yet issued a fiscal 2014 comprehensive annual financial report. For PSERS, the reported funded ratio (as of June 30, 2013) is 63.8%, or a Fitch-adjusted 60.4% – PSERS reports 54.5% GASB 67 ratio of pension assets to liabilities as of June 30, 2013. The commonwealth is responsible for an estimated 59% of the PSERS liability and 100% of SERS. The burden of the commonwealth’s net tax-supported debt and adjusted unfunded pension obligations equals 9.8% of 2013 personal income, above the median for U.S. states, as reported by Fitch in its 2014 state pensions report.
Under current law, both pension systems project some weakening of funded ratios, and growth in unfunded liabilities, until commonwealth contributions reach the ARC. The ‘AA-‘ rating incorporates this projected growth, which Fitch anticipates will keep the total long-term liability burden at an above-average though manageable level for Pennsylvania.
Fitch notes that the state’s OPEB liabilities are relatively manageable, following several significant reforms in recent years. As of June 30, 2013, the state’s reported unfunded OPEB liability for its two largest plans (for state employees and teachers, and for state police) of $16.3 billion represented a moderate 2.8% of 2013 personal income. Those plans also have a modest amount of pre-funding, with $153 million in actuarially valued assets.
BROAD-BASED ECONOMY A CREDIT STRENGTH
Pennsylvania’s economy, historically dominated by manufacturing, has diversified and is growing slowly as the state recovers from the recession. Prior to the downturn, the economy posted consistent annual employment growth despite continued manufacturing losses. Employment in 2008 was flat as U.S. employment fell, and once the recession hit it was less severe and shorter in Pennsylvania than for the nation as a whole. The commonwealth’s peak-to-trough decline in seasonally adjusted monthly payrolls was just 4.4%, vs. a national decline of 6.3%.
While Pennsylvania’s non-farm payrolls grew every year since 2009, the trajectory has slowed. In 2014, non-farm employment grew just 0.8%, down from 1.1% in 2011 and half the U.S. rate of 1.8%. Pennsylvania’s January 2015 year-over-year (YOY) employment growth of 1.2% remains below the national YOY gain of 2.3%, but payrolls in the state do appear to be gaining some modest momentum. The three-month moving average for YOY employment growth in Pennsylvania reached 1.1% in January, up from 0.4% one year earlier.
Factors affecting the commonwealth’s longer term economic outlook include its relatively weak demographic profile as well as the boost that development of abundant natural gas resources could provide. The commonwealth is among the nation’s oldest states, with a median age of 40.5 versus the national median of 37.4. State population growth has lagged the national trend for several decades, indicating the potential for a smaller future workforce. Offsetting these trends, the state could benefit from continued development of the Marcellus Shale natural gas deposits, and eventual development of the Utica Shale, which may bring additional jobs in mining and related industries as well as attracting industries focused on low-cost energy such as manufacturing. While natural gas activity is subject to market-driven volatility, the abundance of supplies still presents a significant economic opportunity for the state.
Additional information is available at ‘www.fitchratings.com‘.
Applicable Criteria and Related Research:
–‘U.S. State Government Tax-Supported Rating Criteria’ (Aug. 14, 2012)
–‘Tax-Supported Rating Criteria’ (Aug. 14, 2012)
Applicable Criteria and Related Research:
Pension Pressures Continue (2014 State Pension Update)
Tax-Supported Rating Criteria
U.S. State Government Tax-Supported Rating Criteria
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Fitch Ratings, Inc.
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Douglas Offerman, +1-212-908-0889
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526