OREANDA-NEWS. Fitch Ratings has assigned an 'A+' rating to the commonwealth of Kentucky State Property and Building Commission's (SPBC) $111.475 million revenue and revenue refunding bonds, project 110.

The bonds are expected to be offered through negotiated sale on or about the week of Nov. 16, 2015.

The Rating Outlook is Stable.

SECURITY

The project 110 bonds are special and limited obligations of the SPBC, payable solely from revenues derived under financing/lease agreements between the commission, as lessor, and the commonwealth's finance and administration cabinet, as lessee. The project 110 bonds are backed by appropriations from the commonwealth's general fund.

KEY RATING DRIVERS

MOST STATE DEBT IS APPROPRIATION BACKED: Kentucky's debt is primarily in the form of lease rental bonds requiring appropriation for debt service. The commonwealth's lease financing mechanism is well established, highlighted by automatically renewable leases and covenants to seek appropriation for debt service. Fitch rates appropriation-backed debt supported by the general fund and road fund one notch below the commonwealth's implied GO rating of 'AA-'.

LIMITED OPERATING FLEXIBILITY: The commonwealth's operating flexibility is constrained compared with that of most states, with weak reserves and a continuing reliance on nonrecurring revenue sources. Fiscal 2014 ended with an unexpected revenue shortfall, but fiscal 2015 performance was $165.4 million ahead of the budgeted forecast.

COMPARATIVELY HIGH LONG-TERM LIABILITIES: The commonwealth's combined debt plus unfunded pension system liabilities are amongst the highest for U.S. states. Pension reform measures in 2013, including a commitment to full actuarial funding for one of Kentucky's systems, are a positive step, but significant challenges remain, including a consistently underfunded teachers' plan.

STEADY JOBS RECOVERY: Kentucky's economic recovery from the recession has been solid as the commonwealth returned to its pre-recession peak employment levels last summer. Other trends including labor force contraction, below-average population growth and low levels of educational attainment pose long-term demographic challenges.

RATING SENSITIVITIES

LINKED TO IMPLIED GO RATING: The rating on the commonwealth of Kentucky's appropriation-backed debt is linked to changes in the commonwealth's implied GO rating of 'AA-', on which the rating is based.

CREDIT PROFILE

Kentucky's 'AA-' implied GO rating reflects the commonwealth's limited fund balances following depletion amid recession-driven revenue shortfalls, continued reliance on one-time measures in the current biennial budget, and a high liability position, including unfunded liabilities for state-supported pension systems. Kentucky continues to face budget-balancing challenges despite economic recovery, indicating a structural problem that goes beyond the impact of economic cyclicality on its financial operations. Each of the past five biennial budgets relied on one-time solutions to achieve balance, including use of reserves, debt restructuring, or borrowing for operations.

ONGOING FISCAL CHALLENGES

Revenues fell short of the budgeted estimate by $91 million in fiscal 2014 (1% of revenues), largely due to weakness in the personal income tax (PIT) which only became clear in the final quarter of the year. The PIT is the largest general fund revenue source, generally comprising around 40% of revenues. As with several other states, the commonwealth attributed the weakness in the PIT to lingering effects of the 2013 federal income tax changes. To address the fiscal 2014 gap, the governor enacted various non-recurring measures including $50 million in fund sweeps and a $21 million draw on the budget reserve trust fund.

The fiscal 2015 - 2016 biennial budget includes a range of expenditure measures and fund transfers to achieve balance. General fund revenue growth for the fiscal year that ended June 30, 2015 (the first half of the biennium) was a robust 5.3% year over year (yoy), with both PIT and sales tax revenues exceeding their targets; growth was 1.7% ahead of the official revenue estimate which projected 3.6% yoy growth. April collections were particularly strong, exceeding $1 billion for the first time ever, up 23.3% over the prior year.

Given the better-than-expected fiscal 2015 revenue performance, the official revenue forecast used to enact the biennial budget calls for fiscal 2016 revenue growth at a very achievable 1% over actual fiscal 2015 collections. The forecast also projects fiscal 2016 annual PIT growth of 1.6% and a 1.5% decline in sales tax revenues from actual fiscal 2015 results. Positively, through the first quarter of fiscal 2016 (ended September 30), Kentucky's general fund collections have increased 4.5% yoy). PIT collections are up 6% yoy and sales tax collections were up 6.9%. Fitch believes the strong revenue performance through the first 15 months of the biennium offsets some of the structural weakness of the enacted budget.

The current biennial budget includes a substantial $302 million in fund sweeps, $98 million in general fund budget cuts across a broad range of agencies, and $166 million in estimated savings under federal ACA Medicaid expansion. The amount of fund-sweeps is in line with the amounts included in prior budgets going back for at least eight biennia indicating these are consistently available (and utilized) revenue sources. Positively, the budget also includes full actuarial funding for the state's contribution to one of its major pension systems, as required in reform legislation enacted in 2013. A second major system remains underfunded.

Fiscal 2015's strong revenue performance allowed Kentucky to generate a reported $165.4 million general fund surplus, and to bolster its reserve position. The commonwealth deposited $82.5 million into the budget reserve trust fund (BRTF), bringing the balance to an improved but still modest $209.4 million or 2.1% of fiscal 2015 general fund revenues. The enacted budget envisions a $13.7 million drawdown in fiscal 2016, which Fitch no longer anticipates given the general fund surplus in fiscal 2015.

SLOWLY RECOVERING ECONOMY

Economic growth in the commonwealth has been somewhat inconsistent coming out of the recession and is now at or near national performance. Despite a decade of contraction, Kentucky continues to have an oversized manufacturing sector relative to the national economy. This sector recovered strongly after bottoming out in early 2010, and growth is now below national trends but still well ahead of pre-recession levels.

Overall, the commonwealth's quarterly moving average non-farm employment is up 1.8% yoy as of September, below the national rate of 2.1%. Kentucky's September 2015 unemployment rate of 5% is down from 5.8% a year earlier, and remains just below the national rate (5.1%). The labor force contracted 2.5% yoy in September, consistent with the 2.5% decline in 2014

The labor force weakness, along with the commonwealth's below-average population growth (1.7% since 2010 versus 3.3% for the nation) and low educational attainment (among the lowest states for rate of adults with bachelor's degrees) limits the commonwealth's potential for future economic growth. Commonwealth wealth levels are also weaker than most other U.S. states as Kentucky's 2014 per capita personal income of $37,396 was just 81.2% of the U.S. average, ranking the commonwealth 46th among the states.

HIGH LONG-TERM LIABILITY LEVELS

Kentucky's liabilities are high for a U.S. state with the combined ratio of debt and unfunded pension liabilities (adjusted by Fitch) representing 21.4% of 2014 personal income (per Fitch's 2015 State Pension Update report). This is among the highest ratios for a U.S. state.

Net tax-supported debt alone (as of Dec. 31, 2014) was a moderately high 5.1% of 2014 personal income. This includes general-and road fund-supported appropriation debt, and debt paid from other state agency funds. Kentucky has long used state agencies for its capital financings, which depend on biennial legislative appropriations for security, and has well-established policies and procedures that recognize such obligations as debt. Although payment is subject to legislative biennial appropriations, the securing financing agreements are automatically renewable.

Under the new GASB 67 standard for pension systems, the Kentucky Employees Retirement Systems (KERS combined non-hazardous and hazardous) reported a 25.4% ratio of pension assets to liabilities in fiscal 2014 with a net pension liability of $9.2 billion borne essentially entirely by the commonwealth. While not directly comparable, the actuarially determined funded ratio was 23.9% in fiscal 2014 with an unfunded actuarial accrued liability of $9.4 billion.

KERS' parent, Kentucky Retirement Systems (KRS), is engaged in a legal dispute with a non-profit entity that has historically participated in KERS called Seven Counties Services (SCS) that could affect annual costs for the commonwealth. SCS is one of 14 community mental health centers (CMHCs) under contract with the commonwealth to provide certain mental health services. Last May, SCS won federal bankruptcy court approval to file for chapter 11 bankruptcy, rather than chapter 9, which would have required commonwealth approval. A primary reason for the bankruptcy filing was to discharge SCS' obligations to KERS. Several other CMHCs are engaged in litigation to terminate their participation in KERS. Fitch already incorporates the liabilities for all CMHCs in its calculation of KERS' pension liabilities, and funding for these organizations, including annual pension costs, already comes largely from the commonwealth.

The reported ratio of pension assets to liabilities for the commonwealth's other major state-supported retirement system, the Kentucky Teachers Retirement System (KTRS), was 45.6% in fiscal 2014 with a significant net pension liability of $21.6 billion. Per GASB 67, KTRS reports that under current policy pension system assets will be depleted in plan year 2036 and are therefore insufficient to fully cover liabilities. While concerning, Fitch notes disclosure of this depletion date is not surprising as it largely reflects the commonwealth's lack of a full actuarial funding commitment for KTRS. Kentucky's contribution to KTRS has been short of the full actuarially determined employer contribution (ADEC, formerly the ARC) for seven of the past eight years. The fiscal positions of Kentucky's pension systems have deteriorated, partially due to investment losses and the failure to fully fund the ADEC.

Recent pension reforms address some of the commonwealth's pension-related problems, but challenges remain. Legislation in 2013 established a statutory full ARC funding commitment for KERS; the current biennial budget follows through on that with full funding for both years and KERS does not report a GASB 67 depletion date. The reforms did not address KTRS and its significantly larger liability.

The 2015 legislative session included active discussion around KTRS' funding challenges, most prominently a proposal for a pension obligation bond offering. The proposal failed and Fitch anticipates next year's budgetary session, which will include the newly-elected governor, will focus on several key fiscal issues including KTRS funding. In June 2015, the current governor appointed a 23-member working group to develop recommendations to address the funding challenges with a report due on December 1. Fitch will monitor any enacted changes with a focus on how they affect the plan's liability position and commonwealth annual funding demands.

Fitch views the KTRS issues as a challenging but not insurmountable problem for the commonwealth. According to the governor's executive order establishing the working group, Kentucky's fiscal 2016 KTRS pension contribution would need to increase by $487 million, or 4.8% of budgeted fiscal 2016 revenues. In the context of a stable-to-improving economic and revenue environment, Fitch anticipates the commonwealth could address that gap in a sustainable manner as it recently did with KERS and the KTRS other post-employment benefit liability.