Fitch Rates Oregon's $53MM GO Bonds 'AA+'; Outlook Stable
--$53.042 million 2016 series I (Article XI-P school district capital projects).
The bonds are expected to price via negotiation the week of Oct. 3, 2016.
The Rating Outlook is Stable.
The bonds are general obligations of the state of Oregon, with the full faith and credit of the state pledged to bond repayment.
KEY RATING DRIVERS
Oregon's 'AA+' rating reflects the state's strong control over revenues and spending, low liabilities, and record of prompt actions to maintain financial flexibility in challenging revenue periods. Strong financial management is critical to the rating given a revenue structure largely dependent on the cyclical personal income tax (PIT), exposure to voter initiatives that can have negative fiscal impacts, and constitutional 'kicker' provisions that require the return of surplus revenues to taxpayers. There is no statewide sales tax. The state's operating performance is sustained by a diverse economy with strong growth prospects.
Economic Resource Base
Oregon's economy tends to be more cyclical than the nation's due to its large high-tech sector and international trade activities that expose the state to global economic cycles. The economy has retained its large agriculture and natural resource sectors although those sectors now represent a smaller proportion of the economy due to the strong growth in the computer and manufacturing sectors. Fitch expects the state's population and labor force growth to continue, propelled by strong employment opportunities.
Revenue Framework: 'aaa' factor assessment
Fitch expects Oregon's revenues, with a heavy dependence on the PIT, to continue to reflect the strength of the economy, as well as its volatility. The state has complete control over its revenues, with an unlimited legal ability to raise operating revenues as needed.
Expenditure Framework: 'aaa' factor assessment
The state maintains ample expenditure flexibility with a low burden of carrying costs for liabilities and the broad expense-cutting ability common to most U. S. states. As with most states, Medicaid remains a key expense driver but one that Fitch expects to remain manageable.
Long-Term Liability Burden: 'aaa' factor assessment
Debt levels are above average for a U. S. state but are a low burden on resources. On a combined basis, the burden of the state's net tax-supported debt and unfunded pension obligations approximates the median for U. S. states. Other post-employment benefit (OPEB) obligations are small.
Operating Performance: 'aa' factor assessment
The state's strong management of its financial operations offsets volatility in its revenue sources, leaving it well-positioned to deal with economic downturns. The state has very strong gap-closing capacity in the form of its control over revenue and spending. State balancing measures in downturns include reserve draws and there is a consistent history of rebuilding reserves as the economy strengthens. Voter initiatives have periodically affected state finances.
The rating is sensitive to shifts in the state's fundamental credit characteristics, including its proactive financial management and low liability profile.
Oregon's general fund (GF) is largely dependent on the PIT, which generally accounts for about 90% of biennial general fund (GF) revenues. There is some volatility to PIT collections and increases more than 2% above the state's close of session (COS) forecast are subject to "kicker" requirements, whereby excess revenue is returned to taxpayers. Corporate income taxes (CIT) that are above the 2% forecast threshold are also subject to kicker requirements; however, excess CIT collections are directed to education in the following biennium and have no impact on the state's GF revenues.
Historical growth in the state's revenues, after adjusting for the estimated impact of tax policy changes, has generally been above inflation over the past ten years, with robust growth in most years more than compensating for recessionary declines. Fitch believes this growth trend will continue, supported by employment and wage expansion across the state and across all major industries. Employment growth in 2015 registered 3.3% compared to 2.1% for the nation and as of July 2016, the state essentially matched the nation in jobs regained since the recession, at 167%. Unemployment rates are ahead of the nation; 5.2% in July for the state compared with 4.9% for the nation; but the rate continues to reflect strong growth in the state's labor force; up 4.6% year over year compared with 1.4% for the U. S.
In tangent with strong economic growth, the state is forecasting 12.6% growth in the PIT from the prior biennium. The constitutional "kicker" provisions for the PIT and CIT were triggered under both taxes at the end of the 2013-2015 biennium following stronger growth than forecast coming out of the recession. The state's September 2016 revenue forecast projects GF revenues just slightly ahead of the forecast used to enact the current biennial budget.
The state has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees and the state has a strong track record of adjusting revenues to accomplish programmatic goals.
As in most states, education and health and human services spending are Oregon's largest operating expenses. Education is the larger line item, as the state provides significant funding for local school districts and an extensive public university and college system. Health and human services spending is the second largest area of spending, with Medicaid being the primary driver.
Spending growth, absent policy actions, will likely be slightly ahead of revenue growth driven primarily by Medicaid, requiring regular budget measures to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U. S. states and the nature of the program limits the states' options in managing the pace of spending growth. In other major areas of spending such as education, Oregon is able to more easily adjust the trajectory of growth since it does not retain responsibility for direct service delivery, although the state has demonstrated strong support for education programs, a fundamental state responsibility. A voter initiative, approved in 2012, now directs CIT revenue in excess of the revenue forecast to elementary and secondary education, providing an additional source of funds for this expense.
While Medicaid remains a notable cost pressure, spending requirements for debt service, pension, and other post-employment expense (OPEB) are manageable; carrying costs total only 3.6% of expenditures. A 2015 state Supreme Court decision found against some of the state's 2013 pension reforms, restoring cost of living (COLA) increases to retirees and current employees. Together with the adoption of more conservative actuarial assumptions, this is expected to lead to higher employer contributions beginning in the 2017-2019 biennium. The decision allowed the COLA reduction for service performed after the reform law. The state's actuary estimates that system-wide average, uncollared employer contribution rates would increase by 8.7% of covered payroll beginning in fiscal 2018; however, employer contributions are subject to an annual rate collar, which limits and stretches out increases, resulting in lower annual growth in this expense. Overall, Oregon retains ample ability to adjust expenditures to meet changing fiscal circumstances.
Long-Term Liability Burden
As of June 30, 2016, the state's debt burden at 4.4% of 2015 personal income is above U. S. state averages but remains a low burden on resources. Per Fitch's October 2015 State Pension Update report, which was issued prior to the receipt of updated pension system information following the 2015 COLA ruling and the adjustments made by the Oregon Public Employees Retirement System (PERS) board, the state's total net tax-supported debt and unfunded pension liabilities (UAAL) at 5.7% of 2014 personal income was just below the 50-state median of 5.8%. Based on PERS' current estimates, which account for the COLA ruling and the actuarial assumption changes, the system UAAL increased from $2.6 billion as of December 31, 2013 to $12.1 billion as of December 31, 2014. The state's share of the UAAL increased from $487.6 million to $3.1 billion, respectively, increasing the state's ratio of net tax-supported debt and unfunded pension liabilities to a still moderate 6.3% of 2015 personal income.
The state consistently funds its actuarially calculated annual required contributions (ARC) for the pension system, subject to any applicable rate collars. The state's OPEB obligations are modest and the state made 76.1% of the OPEB ARC payment in fiscal 2015.
The state issues debt for a variety of programs, including seismic rehabilitation, higher education, and to support mortgage loans for veterans' housing. As of June 30, 2016, there was $1.8 billion in outstanding GO pension obligation bonds; total GO bonds represent 60% of the state's outstanding debt. The next largest share of debt has been issued for transportation purposes and is funded by highway user taxes, including gasoline taxes.
Oregon's ability to respond to cyclical downturns rests with its superior budget flexibility. The state's recessionary dips in the economy are above that of the nation; the state recorded 7.6% employment loss during the recent recession compared to 5.6% for the nation, with revenues responding quickly to changing economic conditions, but the declines are generally offset by subsequent robust growth that brings steady restoration of reserves if they have been tapped. The state typically takes a multi-prong approach to solving budget gaps during times of budgetary stress; tax rates are adjusted, expenditures are reduced, and the state applies reserves from its rainy day fund (RDF) and education stability fund (ESF) to attain balance.
The state's quarterly economic and revenue forecasts are an important tool that the state applies to ensure budgetary balance, particularly given the extensive reliance on the economically sensitive PIT to fund operations. State agency spending is monitored by the department of administrative services (DAS) with monies allotted over the eight quarters of the biennium based on departmental needs. If DAS declares a projected budget deficit due to insufficient revenues, with the governor's approval, DAS may reduce allotments to prevent the deficit. There is also a state emergency board comprised of legislative leadership that can reallocate appropriations when the legislature is not in session. The legislature also applies holdbacks of appropriations, only releasing expenditure authority when supported by updated revenue forecasts.
Accurate revenue forecasting is also critical for the state's financial goals given constitutional kicker provisions. For the recently ended 2013- 2015 biennium, kickers were triggered for both the PIT and the CIT following stronger than forecast economic and revenue growth. Due to actions undertaken by the 2011 legislature, a $402 million PIT kicker was applied as a credit on 2015 tax returns, reducing revenue in the current 2015 - 2017 biennium. A CIT kicker payment of $59 million will be dedicated to K-12 funding in the 2017 - 2019 biennium due to a 2012 ballot measure that reallocated these funds.
The state historically makes a robust recovery post-recession, allowing it to restore programmatic cuts and bolster aid to education. Conservative fiscal management is reflected in its commitment to rebuilding reserves if they have been tapped during times of revenue weakness. Reserves in the RDF and ESF were reduced to $15.5 million at the close of the 2009-2011 biennium and the state has committed to restoring and growing these balances in each subsequent biennial year subject to applicable caps: the RDF is capped at 7.5% of GF revenues in the prior biennium and the ESF is capped at 5% of GF revenue received in the prior biennium. Total reserves at the conclusion of the 2013-2015 biennium totaled $391.2 million, equal to 4.6% of fiscal 2015 revenue alone. Following the recession, the state also sought to reduce the pension system UAAL as a means to reduce annual employer contributions, for both itself and other participating employers in the state. Two rounds of pension reform in 2013 only partly achieved that target as the aforementioned COLA reforms were only partly upheld.
The enacted budget for the 2015-2017 biennium included almost $18 billion in GF expenditures, supported by 12% growth in projected revenues at COS to $17.96 billion. The forecast was inclusive of 12.6% expected growth in the PIT over the biennium. An update to the revenue forecast on September 14, 2016 modestly improved on the state's revenue expectations from COS, tied to stronger growth expectations for the PIT. The September CIT forecast, however, reverted back to COS expectations following a modest boost in early 2016 forecasts that the state ascribed to some slowing national economic trends. The revenue forecast remains supported by the healthy state economy, with rapid job and income growth. The state's reserve funds are expected to increase to a combined $770 million, up from $391 million at the conclusion of the 2015 biennium, and equal to 8.4% of revenue in fiscal 2017 alone.
The forecast does not include four voter initiatives with fiscal impacts that are appearing on the November ballot. The most significant of the four is Measure 97, which would impose a new tax rate of 2.5% on C-corporations with sales above $25 million, on those sales above the $25 million threshold. The measure would take effect for the 2017 corporate tax year and is expected to result in $548 million in new CIT revenue between January 1, 2017 and June 30, 2017, if approved. Revenue from Measure 97 would be used to provide additional funding for early childhood through twelfth grade education and healthcare and services for senior citizens.
Two additional voter initiatives; Measures 98 and 99; are also related to school funding and would require $147 million in additional, annual GF expenditures for education (Measure 98) and $22 million in additional, annual net lottery proceeds dedicated to education (Measure 99). If approved, a fourth fiscal initiative, Measure 96, would re-allocate net lottery proceeds by dedicating 1.5% of these proceeds to a fund for veterans' services. The fiscal impact for this measure is estimated at $9.3 million annually. It is uncertain at this time if any of these voter initiatives will be approved by the electorate.