Fitch Rates Delaware's $119MM GO Bonds 'AAA'; Outlook Stable

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has assigned an 'AAA' rating to the state of Delaware general obligation (GO) refunding bonds, series 2016D in the approximate amount of $119 million. The par amount is subject to change based on market conditions. The bonds are scheduled to be sold via negotiation on or about June 22, 2016.

In addition, Fitch has affirmed Delaware's 'AAA' Issuer Default Rating (IDR) as well as the 'AAA' rating on the state's outstanding GO bonds.

The Rating Outlook is Stable.

SECURITY

General obligation, full faith and credit of the state of Delaware.

KEY RATING DRIVERS

Delaware's 'AAA' IDR is derived from its considerable economic resources, which have grown through deliberate policies to maintain a climate attractive to banking and financial institutions, and strong financial operations that are supported by proactive management and institutionalized protections designed to ensure surplus operations. Above-average debt levels incorporate state issuance for purposes that are addressed at the local government level in other states while pensions are well funded.

Economic Resource Base

Delaware's economy is largely based on service-providing enterprises, including financial activities, professional and business services, and education and health organizations. Economic growth has been brisk over the past several years following slower growth emerging from the recession, and unemployment rates are well below the U.S. average. Continued growth in the financial services industry is expected to offset reductions related to an ongoing Dow Chemical and DuPont merger that will reduce employment in the state by a modest 1,700 jobs.

Revenue Framework: 'aa' factor assessment

Financial operations are supported by a diverse array of revenue sources with the personal income tax (PIT) accounting for the largest share at over 30%. Much of the balance of revenue sources reflect Delaware's leverage of its status as the legal home to over half of all publicly traded corporations in the U.S. and include taxes on limited partnerships, franchises, and other business entities. This structure results in a revenue framework that is highly influenced by national economic trends.

Expenditure Framework: 'aaa' factor assessment

While carrying costs are above the U.S. state average, Delaware has demonstrated ample expenditure flexibility and the broad expense-cutting ability common to most U.S. states. Moreover, the state is statutorily restricted to budgeting 98% of expected revenue, providing a cushion for revenue variability. Education is a key cost driver as the state is highly involved with funding local education, including funding an equal share of employer pension contributions for school district employees.

Long-Term Liability Burden: 'aaa' factor assessment

Debt levels are above average for a U.S. state incorporating state issuance for projects usually funded at the local level, but are only a moderate burden on resources. On a combined basis, the burden of the state's net tax-supported debt and unfunded pension obligations exceeds the median for U.S. states but has declined in recent years through limited borrowing. Pensions are well-funded although other post-employment benefit (OPEB) obligations are sizable.

Operating Performance: 'aaa' factor assessment

The state has exceptional financial resilience and institutionalized protections are designed to ensure surplus operations. Strong management of its financial operations results in the maintenance of ample financial cushion even through economic downturns. The ongoing monitoring of revenues and operating expenditures offsets volatility in its revenue sources and provides for rapid gap closing.

RATING SENSITIVITIES

The rating is sensitive to shifts in the state's fundamental credit characteristics including continuation of the state's conservative budgeting practices and strong economic foundation.

CREDIT PROFILE

Revenue Framework

General Fund (GF) revenues are derived from an array of sources, with a considerable concentration in those related to business endeavors and financial institutions. Various fees and taxes as well as abandoned property receipts are all linked to companies being legally domiciled in the state. Abandoned property, which includes accounts and securities and typically accounts for over 10% of GF revenues, is subject to significant volatility, making the six-times per year forecasts by the independent Delaware Economic and Financial Advisory Council (DEFAC) challenging. DEFAC is an important contributor to the state's maintenance of fiscal balance through its provision of objective assessments of the state's economy, revenues, and expenditures.

The state's revenue mix includes the PIT, which accounts for the largest share of GF revenues at 32%. The top PIT rate of 6.75% was slated to roll back to 5.95% in fiscal 2014; however, the state approved almost a full maintenance of the higher rate in the 2013 legislative session to sustain revenue collections. The PIT has continued to record moderate growth since 2013, offsetting more negative results in corporate-based taxes such as the corporate income tax (CIT) and bank franchise taxes. Lottery revenues, which include gaming and account for over 5% of revenues, have also been pressured, reflecting competitive growth in nearby gaming venues. Similar to the PIT approach, higher gross receipts tax rates were scheduled to be reduced beginning on Jan. 1, 2014; the state chose to maintain almost the full amount of the higher rates but provided for additional carve-outs and exemptions.

Frequent forecast updates have allowed the state to quickly respond to changing economic conditions; an important attribute as most of the state's revenues are subject to economic variability with some baseline sluggishness that has required tax policy changes to fund increasing expenditures. Delaware's revenue growth absent tax policy changes has been comparatively slow; PIT and business tax trends are expected to remain stable over the next two to three years absent a significant pull-back in the economy, based on recent results and current forecasts for economic growth. Fitch expects these revenues to remain highly correlated with national economic trends with growth approximate to inflation, absent tax policy changes.

While lottery revenues, which includes revenues from video gaming and casino tables, have stabilized after consecutive years of declines, competitive pressures are expected to tamp down collections, as additional, competing venues are scheduled to come on line. The potential softening is expected to be less severe than in recent years, as the mid-Atlantic gaming market is reaching market saturation and the state believes that new facilities will draw from customers that reside within those states rather than within Delaware, unlike in recent years.

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.

Expenditure Framework

As in most states, education and health and human services spending are Delaware's largest operating expenses. Education is the larger line item, as the state provides significant funding for local school districts and the public university and college system. The state's extensive education commitment includes an equal share of annual employer pension contributions for local school district employees. Health and human services spending is the second largest area of spending, with Medicaid being the primary driver. The state's constitution limits annual appropriations to 98% of estimated budgetary GF revenue, plus the unencumbered budgetary GF balance from the previous fiscal year. This limitation is an important balancing measure that provides cushion for revenue variability

Fitch expects that spending growth, absent policy actions, will be ahead of natural revenue growth, driven primarily by Medicaid, and require regular budget adjustments to ensure ongoing balance. The fiscal challenge of Medicaid is common to all U.S. states and the nature of the program as well as federal government rules limit the states' options in managing the pace of spending growth. In other major areas of spending such as education, Delaware is able to more easily adjust the trajectory of growth.

Overall, Delaware retains ample ability to adjust expenditures to meet changing fiscal circumstances. While Medicaid remains a notable cost pressure, spending requirements for debt service and pension obligations are manageable and pensions are well-funded. The state's contributions to OPEB, however, exceeded its contributions to the pension system in fiscal 2015, reflecting both a large unfunded OPEB liability as well as a strong pension funded ratio. Based on the state's actual contributions for OPEB, debt service, and pensions, carrying costs accounted for a still manageable 9.2% of expenditures in fiscal 2015. Pension contributions over the past several years have generally approximated the actuarially required contribution (ARC).

Long-Term Liability Burden

As a small state with a minimal number of local governments, Delaware's service functions are highly centralized, leading to an upper-moderate debt burden. Net tax-supported debt as of June 30, 2016 is expected to equal about $2.4 billion, or 5.4% of personal income, with almost one-third of debt issued through the transportation authority. The ratio has slowly declined since 2008, reflecting steps taken by the state to control its bonding for capital as well as the dictates of a statutory three-part test to limit debt issuance. However, the ratio is well above the 2.4% median debt burden for U.S. states.

Per Fitch's October 2015 state pension update report, the state's combined net tax-supported debt and unfunded actuarial accrued liability (UAAL) for pension obligations equaled 10.1% of 2014 personal income, well above the 5.8% median for states. Debt remains a manageable burden on state resources; debt service was approximately 5.8% of revenues in FY 2015 despite a rapid rate of amortization with about 70% of principal retired in 10 years.

The state employees' pension (SEP) system was overfunded until 2009 when investment losses resulted in a small unfunded liability. Pension reforms effective Jan. 1, 2012 aimed to bolster funding ratios through targeted benefit reductions and increased contributions by new employees. Under the new GASB pension standards, SEP reported a 92.7% ratio of pension assets to liabilities in fiscal 2015 with a net pension liability of almost $665.3 million. Fitch views the OPEB liability as a more flexible obligation and one in which the state can make changes to reduce the liability, easing concern over the state's sizable UAAL for OPEB at $6 billion, equal to 13.3% of state personal income; the highest burden among the 50 states.

Operating Performance

Delaware's ability to respond to cyclical downturns rests with its superior budget flexibility. The state's economic performance through the recent recession closely matched the experience of the nation as a whole and was reflected in a sharp revenue decline in fiscal 2009. To achieve budgetary balance, the state applied almost the entirety of its unencumbered cash balance ($180 million) in fiscal 2009 and reduced expenditures by a comparable amount but did not appropriate from its budget reserve account (BRA), which remained fully funded at 5% of GF revenue.

Financial operations are supported by largely conservative fiscal policies, including a provision in the state constitution that limits appropriations to 98% of anticipated revenues in the forthcoming fiscal year, plus the unencumbered budgetary GF balance from the previous fiscal year. The state closely tracks revenue collections and expenditures during the year and forecasts are updated six times each fiscal year through comprehensive reviews by DEFAC. These practices have proven to be critical to sustaining financial balance, as the state's economy and finances respond quickly to national economic trends.

Delaware has continued to demonstrate ample financial flexibility coming out of the recession and conservative budgeting practices are expected to maintain strong balances and financial cushion. The state has maintained the BRA at the 5% target following the recession although unencumbered cash balances have fluctuated due to inconsistency in key revenue sources, such as franchise taxes and abandoned property revenue, which reflected slow growth coming out of the recession. The BRA was over-funded at 5.4% of revenues in fiscal 2015 (5% statutory requirement) and a similar outcome is expected in the fiscal year that ends on June 30, 2016. Additional unencumbered cash balances bolster the state's financial flexibility; $178.6 million is expected to be available on June 30, a portion of which rolls forward into fiscal 2017 to fund expenditures. The additional cash balance is expected to equal 4.5% of GF revenue in fiscal 2016.

Recent Operating Performance

Financial performance consistent with recent years' outcomes is expected in fiscal 2016, although the state expects revenue growth to be fairly marginal at 0.5% from fiscal 2015 with only slightly better results forecast for fiscal 2017 at 1.3% as compared to more robust growth in fiscal 2015. The negligible revenue growth in fiscal 2016 is projected to result in a need to apply a portion of the unencumbered cash balance to fund projected 2.5% growth in expenditures.

At its May 2016 meeting, DEFAC lowered April's revenue forecast for fiscal years 2016 and 2017, leading to $35.3 million to be reduced from allowable appropriations in fiscal 2017 and lowering expected ending GF cash balances in both years. The revised forecast incorporates lower than anticipated April PIT collections, similar to the experience of other states, as well as reduced CIT collections in both fiscal years. The legislature is currently making adjustments to the governor's proposed budget in consideration of the revised forecast and while employee increases of 1.5% have been granted, many of the permitted cost increases are expected to be offset by other expenditure reductions to maintain balance. The BRA is expected to be maintained at the 5% of revenues statutory limit, providing a level of financial cushion.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

Applicable Criteria

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=879478

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Fitch Ratings
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Fitch Ratings, Inc.
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or
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Source: Fitch Ratings

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