Fitch Rates Kentucky SPBCs $322MM Project 99 Revenue Bonds AA-

Fitch Ratings assigns an ‘AA-‘ rating to the Kentucky State Property and Buildings Commission (SPBC) revenue bonds, Project 99 as follows:

–$82.69 million series A;

–$10.35 million series B (federally taxable);

–$229.495 million series C (federally taxable – Build America Bonds – direct payment to the commission).

The bonds are expected to be offered through negotiation on or about Oct. 26, 2010.

Fitch has also affirmed the ‘AA-‘ rating on approximately $6.5 billion of appropriation bonds issued by Kentucky agencies.

The Rating Outlook is Stable.

RATING RATIONALE:

–The commonwealth’s debt is primarily in the form of lease rental bonds, requiring appropriation, and appropriations debt is recognized and accepted as commonwealth debt obligations. Kentucky has a well-established mechanism for lease financing, highlighted by automatically renewable leases and covenants to seek appropriation for debt service.

–Operating flexibility has been reduced as is indicated by the depletion of reserves, budget targets that may be difficult to meet particularly as federal fiscal stimulus funds expire, and a continuing reliance on nonrecurring budget items, including debt restructuring and issuance for operating purposes.

–Commonwealth debt levels are at the higher end of the moderate range and are rising due to significant recent debt authorizations and issuance.

–Kentucky’s economy has been gradually expanding and diversifying but remains exposed to an outsized and generally contracting manufacturing presence.

–Funding for the commonwealth’s pension systems is a credit concern, although enacted pension reform should moderate future expense.

KEY RATING DRIVER:

Return to balanced financial operations, including restoration of depleted reserves.

SECURITY:

The Project 99 bonds are special and limited obligations of the SPBC, payable solely from revenues derived under financing/lease agreements between the commission, as lessee, and the commonwealth’s finance and administration cabinet, as lessor.

CREDIT SUMMARY:

The Commonwealth of Kentucky’s (the commonwealth) debt is primarily in the form of lease rental bonds, requiring appropriation. The commonwealth’s ‘AA-‘ lease appropriation rating on most state appropriation bonds recognizes the well-established mechanism for lease financing, highlighted by automatically renewable leases. The rating reflects the state’s reduced financial flexibility as fund balances have been depleted amidst revenue shortfalls associated with the recession. The enacted budget for the current biennium will require continued aggressive cost cutting. Further, Fitch remains concerned about weak pension funding levels, the commonwealth’s rising debt position and use of debt financing for operations.

Kentucky had enjoyed favorable revenue performance generally since the economic downturn earlier in the last decade, bolstering the commonwealth’s general fund and increasing reserves. However, to manage the fiscal effects of earlier tax reform, the fiscal (FY) 2007-2008 biennial budget relied on use of the general fund balance, the undesignated portion of which was substantially reduced by the end of FY 2008. The commonwealth, therefore, entered the 2009-2010 biennium in a weaker financial position. The 2009-2010 biennial budget was initially structured to achieve budgetary balance largely through the depletion of undesignated and budget reserve trust balances. Weaker than expected revenue collections over the course of the biennium made maintaining balance more difficult and required corrective actions. The commonwealth closed a budget gap of $456 million for fiscal 2009 through an increase in tobacco and liquor taxes, spending cuts, and the acceleration of the use of the budget reserve trust fund into FY 2009 from FY 2010. This depletion of reserves limited flexibility going forward, although tobacco and liquor tax increases and budget reductions provided some structural budget relief.

The state faced a significant budget gap in FY 2010 of just over $1 billion, or 12% of revenues, due to declining revenues and some spending and tax adjustments. Solutions enacted by the legislature in June 2009 relied on the receipt of federal stimulus funds ($788 million), as well as $249 million in budget reductions. Revenues continued to decline during the fiscal year, down 2.4% year-over-year with increases in sales and use tax offsetting continued weakness in personal income tax revenues. The state met its revised revenue target for the year.

The FY 2011-2012 biennial budget, passed in special session, appropriates funds for FY 2011 at approximately FY 2010 levels, followed by an 11% increase in FY 2012 as the benefits of the federal fiscal stimulus program roll off. Significant budget reductions will be required to achieve the FY 2011 funding level because the $1 billion reduction in the FY 2010 appropriation, which is carried through to FY 2011, was largely offset by the receipt of federal fiscal stimulus funds. The budget calls for 3.5% and 4.5% budget reductions for FY 2011 and FY 2012 respectively, which is expected to generate $161 million over the biennium, $225.5 million in fund transfers, and $299.9 million in contract and operating efficiencies. In FY 2011 the identified operating efficiencies include $24 million in employee furloughs, $35 million in agency budget reductions, $5 million in asset sales, and $67 million from debt restructuring. The budget included savings from debt restructuring of $203 million over the biennium and two borrowings related to the financing of retiree health benefits. The state is beginning to address a $100 million gap in the budget created when the enhanced federal matching rate on Medicaid was extended but at a lower rate than anticipated.

Kentucky’s economy demonstrated some resilience in 2008 as it continued to grow while the nation as a whole and many of its neighbors entered recession. Coal production benefited from higher energy prices, and goods producing industries benefited from the weak dollar. Year-over-year employment did not start to decline until September 2008 but by the end of that year the economy was in recession and the pace of decline accelerated throughout 2009 and into 2010. Job growth resumed in April 2010; non-farm employment grew modestly through the spring and summer. Kentucky’s unemployment rate remains above the 9.6% U.S. rate at 10% in August. Kentucky’s per capita personal income for more than three decades has approximated 80% of the U.S. average and currently ranks the commonwealth 46th among the states for this measure.

The slowly improving economy is beginning to have a positive effect on state revenues. General Fund revenues through September are 4.4% higher than the first quarter of FY 2009, slightly higher than the 4.2% increase assumed in the budget. Sales tax revenues have increased 3.4% year-over-year and personal income taxes have increased 3.8%. First-quarter road fund revenues are also positive, up 11.9% year-over-year. The budget assumed 4.9% growth.

Total net tax supported debt approximates $8.3 billion, representing an above-average and increasing 6.1% of 2009 personal income. Kentucky has long used special agencies for its financings, which for capital purposes 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 future legislative biennial budget appropriations, the securing financing agreement is automatically renewable. The state’s other long-term liabilities are high with the funding level for the Kentucky Employees Retirement System only 47.1% as of June 30, 2009, continuing its steady decline. Some pension reforms have been enacted requiring more years of service and higher retirement age for certain workers, with the goal of improving the financial position of the state’s pension systems.

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insight.

Applicable Criteria and Related Research:

–‘Tax-Supported Rating Criteria’, dated Aug. 16, 2010.

–‘U.S. State Government Tax-Supported Rating Criteria’, dated Oct. 8, 2010.

Applicable Criteria and Related Research:

U.S. State Government Tax-Supported Rating Criteria

Tax-Supported Rating Criteria