OREANDA-NEWS. Fitch Ratings has assigned an 'A+' rating to the following commonwealth of Kentucky State Property and Buildings Commission's (SPBC) bonds:

--$112.12 million revenue bonds, project no. 112 series A;
--$549.67 million revenue refunding bonds, project no. 112 series B.

The bonds are expected to be offered through negotiated sale on or about the week of Feb. 29, 2016.

The Rating Outlook is Stable.

SECURITY

The project 112 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 112 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 general obligation (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. Recent budgetary performance reflects improvement as fiscal 2015 ended with a $165.4 million general fund budgetary surplus and current year revenues are 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.

FUNDAMENTAL CREDIT CHARACTERISTICS: The implied GO rating is sensitive to the commonwealth's ability to address budgetary challenges in more sustainable ways and gradually restore fiscal flexibility. The 'AA-' rating incorporates Kentucky's currently narrow fiscal position, although continued reliance on non-recurring measures to maintain balance could trigger negative rating action.

CREDIT PROFILE
Kentucky's 'AA-' implied GO rating reflects the commonwealth's limited budgetary reserves 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

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 personal income tax (PIT) and sales tax revenues exceeding their targets; growth was 1.7% ahead of the official revenue estimate. April collections were particularly strong, exceeding $1 billion for the first time ever, up 23.3% over the prior year.

The revised official revenue forecast for fiscal 2016 revenue growth (adopted in December 2015) is for 3.2% over actual fiscal 2015 collections. The forecast also projects fiscal 2016 annual PIT growth of 4% and 4.7% growth in sales tax revenues from fiscal 2015 results. Positively, through the first seven months of fiscal 2016 (through Jan. 31), Kentucky's general fund collections have increased 4.7% yoy. PIT collections are up 7.2% yoy and sales tax collections are up 5.9%. Fitch believes the strong revenue performance through three-fourths of the biennium offsets some of the structural weakness of the enacted budget.

The current biennial budget also 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 revenue 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.

EXECUTIVE BUDGET PROPOSES STRUCTURAL CHANGES; ENHANCED PENSION FUNDING

Kentucky's new governor recently released an executive budget proposal focused on reducing baseline services spending to free up resources for increased pension funding and replenishment of reserves. The proposal includes $827 million in additional general fund spending in fiscal 2017 and $1 billion in fiscal 2018. Pension funding makes up the most significant share of the increased spending plan, nearly $500 million in each year. Despite these increases, the executive budget also calls for aggressive reductions in the current fiscal year and baseline reductions in the biennium beginning July 1, 2016 totaling $650 million. The reductions for the next biennium are versus previously projected current services spending.

Overall, the governor's budget plan includes significant increases in pension funding, beyond current statutory requirements. For the state employees system (Kentucky Employees Retirement System, KERS) the proposal exceeds the statutory requirement for full actuarially determined employer contributions (ADEC). Conservatively, the budget plan calls for funding based on the lowered investment rate assumption (to 6.75% from 7.5%) adopted by the board overseeing KERS in December - the current ADEC reflects the higher investment rate until the next valuation at the end of the current fiscal year. The governor also proposes $45 million in each year of the biennium in additional funding for the largest component of the KERS system, the non-hazardous employees plan.

The executive budget also recommends significant increases in annual funding for the Kentucky Teachers Retirement System (KTRS), but still short of the ADEC. Approximately $300 million in additional funding beyond the statutory requirement in each year of the biennium will slow, but not halt, the continued weakening of KTRS' funded position. Full funding of the ADEC requires an additional $200 million in each year. The governor did not propose any policy changes for KTRS (or KERS) but instead plans a detailed study of the commonwealth's pension system over the next several months with policy recommendations to follow.

Reserve restoration is another priority in the executive budget, addressing another key credit concern of Fitch. The plan proposes $89 million in direct contributions in each year of the biennium to the Budget Reserve Trust Fund (BRTF). Contingent appropriations (available if revenues reach forecasted levels) could provide an additional $135.7 million. For this budget, the governor recommends budgeting to just under 99% of forecasted revenues and appropriating any revenues above that evenly between the BRTF and pensions (with 50% to KTRS and 50% to KERS). If the commonwealth fully achieves its revenue forecast, the BRTF will reach $523.8 million or 4.8% of forecast general fund revenues, both of which would be record highs.

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 well-ahead of national trends and the number of manufacturing jobs is approaching pre-recession levels. The sector still remains far short of its all-time peak in Kentucky, just before the 2001 recession.

Overall, the commonwealth's quarterly moving average non-farm employment is up 2% yoy as of December 2015, in line with the national rate. Kentucky's December 2015 unemployment rate of 5.3% is down slightly from 5.5% a year earlier, and is now just above the national rate (5.3%). The labor force continues to contract, but the 1.2% yoy decline in December 2015 is less severe than the 2.5% yoy annual decline in 2014.

The labor force weakness, along with the commonwealth's below-average population growth (2% since 2010 versus 4.1% 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, KERS reported an 18.83% ratio of pension assets to liabilities in fiscal 2015 for its much larger non-hazardous plan with a net pension liability of $10 billion borne primarily by the commonwealth. Funded status deteriorated from fiscal 2014 (22.32% ratio of pension assets to liabilities and a net pension liability of $8.9 billion), partially due to a reduction in the investment return assumption to 7.5% from 7.75%. As noted earlier, the fiscal 2016 valuation will reflect a further downward revision to 6.75% and Fitch anticipates another year of weakened funded status.

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, KTRS, was 42.5% in fiscal 2015 with a significant net pension liability of $24.4 billion. Per GASB 67, KTRS reports that under current policy pension system assets will be depleted in plan year 2039 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 ADEC 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. As noted earlier, the executive budget proposal for the upcoming biennium exceeds the statutory requirement, a credit positive. The 2013 reforms did not address KTRS and its significantly larger liability.

The current year's legislative session will focus on the governor's executive budget plan, including the proposal for a significant increase in pension funding. If the governor's proposals (including a detailed study of the pension systems) are accepted by the legislature, additional policy recommendations regarding pensions could be presented to the legislature later this year or early next year. Fitch will monitor any enacted changes with a focus on how they affect the plans' liability position and commonwealth annual funding demands.

Fitch views the KTRS issues as a challenging but not insurmountable problem for the commonwealth. The governor's proposal to increase funding by $300 million annually over the current statutory requirement closes more than half the funding gap with the ADEC, without any revenue increases or changes to the benefit structures. In the context of a stable-to-improving economic and revenue environment, Fitch anticipates the commonwealth could address the remainder of that gap in a sustainable manner as it did several years ago with KERS and the KTRS other post-employment benefit liability.