Fitch Rates Knoxville, TN's Series 2014 GO Bonds 'AAA'; Outlook Stable

Fitch Ratings has assigned an 'AAA' rating to the following general obligation (GO) bonds of the city of Knoxville, Tennessee (the city):

--$32,000,000 GO bonds, series 2014.

The bonds are scheduled to sell competitively during the week of Sept. 1. Proceeds will be used for various public improvements.

Additionally, Fitch affirms its 'AAA' ratings on the following outstanding city bonds:

--$7.6 million GO refunding bonds series 2005A;

--$72.6 million GO refunding bonds series 2012.

The Rating Outlook is Stable.

SECURITY

The bonds are general obligations of the city backed by its full faith and credit and unlimited taxing authority.

KEY RATING DRIVERS

STRONG FINANCIAL MANAGEMENT: Knoxville's sound operating results and solid reserve levels are the result of its strong financial management, prudent fiscal policies and history of conservative budgeting practices.

HIGH LEVEL OF LIQUIDITY: Consistent high levels of reserves and cash balances bolster the city's financial flexibility. The city is not constrained by legal tax limits and moderate current tax levels provide flexibility.

SOUND AND ESTABLISHED ECONOMIC UNDERPINNINGS: Government, health care, and a burgeoning energy sector are major components of the city's broad economy and supplement the historical anchors of retail and manufacturing. Employment indicators are favorable, but wealth levels are below average.

AFFORDABLE DEBT BURDEN: Debt levels are moderate and not expected to change as future borrowing needs are limited. Pension funding costs are projected to increase but overall funded levels are adequate. Total carrying costs for debt and future retirement costs are low and the city can absorb the expected increase in these costs over time.

VARIABLE RATE DEBT EXPOSURE: The city's variable rate exposure as a percent of total debt is well above average, although overall debt service is moderate as a percentage of spending and the city's budgetary flexibility mitigates its vulnerability to interest rate fluctuations.

RATING SENSITIVITIES

CONTINUED STRONG FINANCIAL MANAGEMENT: The rating is sensitive to shifts in fundamental credit characteristics including the city's strong financial management practices. The 'AAA' rating and Stable Outlook reflect Fitch's expectation that such shifts are highly unlikely.

CREDIT PROFILE

BROAD AND STABLE EMPLOYMENT BASE

The city and the surrounding area serve as the economic anchor of northeastern Tennessee. The diverse and relatively resilient economy has gained long-term stability from the presence of the government, education and health services sectors.

The University of Tennessee (27,000 students on the Knoxville campus) and its medical center are two of the city's major employers at 6,550 and 4,061 employees, respectively. Covenant Health (revenue bonds rated 'A' Stable by Fitch) is the city's largest employer (9,122 employees). The headquarters of the Tennessee Valley Authority is also in Knoxville along with Oak Ridge National Laboratories and other large governmental installations in the area, all of which anchor the economy.

The city's 2013 population of 183,270 is up 5.4% since 2000. Overall population growth in the state was 14.2% for the same period. Income levels are well below state and national averages but the cost of living is below average and the high student population may skew the income data. The poverty level is a high 23.3% compared to 14.9% nationally. The city experienced recent growth in both employment and labor force, contributing to a decline in unemployment rates to 7.4% for June 2014 (down from 8.6% a year ago and equal to the state rate).

The city's large tax base totals $14 billion and experienced 4% growth as a result of the 2013 revaluation. The top 10 taxpayers represent a high 17% of assessed value (AV) but are not concentrated. The largest taxpayer, Fort Sanders Regional Medical Center, represents a modest 2.6% of the 2013 AV.

STRONG FINANCIAL MANAGEMENT

Ample reserves and conservative budgeting are the hallmarks of the city's favorable financial profile. Reserve levels consistently exceed the city's formal policy of maintaining a general fund balance equal to 20% of budgeted operating expenses and an informal policy of 25%. The city has augmented the general fund balance in nine of the last 10 fiscal years.

Fiscal 2013 concluded with a $10.4 million addition to fund balance as revenues were $12.2 million greater than budget. The favorable revenue growth was driven by strong property tax and business tax collections, as well as an extraordinary one-time gain in proceeds from the state's Hall income tax (up 214% or $8.6 million from fiscal 2012). The budget included an appropriation of $4.4 million in fund balance but the positive results negated the drawdown. The city's unrestricted general fund balance at year-end was strong at nearly $70 million, or 39.2% of spending.

PROJECTED BREAKEVEN RESULTS FOR FISCAL 2014

The fiscal 2014 budget was up a modest 1.45% compared to fiscal 2013. Budgeted expenses are up primarily due to increased salary, benefit and pension costs across all departments. Management approved an amendment to the budget for an $8 million increase in funding for one-time capital items to further leverage private investment. The amendment was made possible due to the favorable fiscal 2013 results.

Management is projecting breakeven results as Hall income tax revenues exceeded expectations and local option sales tax collections ended slightly higher than budgeted. Expenses remained in line with the original forecast. Total unrestricted fund balance is projected to remain similar to fiscal 2013 levels. Fitch expects the city's practice of conservative revenue and expense estimations to continue, resulting in maintenance of strong reserve levels.

FISCAL 2015 BUDGET INCLUDES TAX RATE INCREASE

The approved fiscal 2015 general fund budget of $200.5 million is up roughly 9% compared to the prior year. The increase reflects an annual increase in pension costs of $7.4 million, and higher salary and health care outlays. To address these rising costs and to fund capital improvements, management approved a $0.34 increase (14.25%) in the property tax rate. The last tax rate increase was made in fiscal 2005. Other revenues such as the local option sales tax have been conservatively budgeted. An appropriation of $2 million of fund balance was made as required pursuant to the city's charter, which requires that a reserve of at least 1% of operating expenses be budgeted.

MODERATE DEBT LEVELS; HIGH VARIABLE RATE DEBT EXPOSURE

The city's overall debt burden is moderately low at 3.2% of market value and $2,442 on a per capita basis. Debt ratios include debt issued on behalf of the convention center, which is not self-supporting on an operational basis. The general fund has historically funded about $1.8 million annually (approximately 1% of general fund spending) towards convention center operations. The city has no additional debt plans at this time.

The city has $79 million in variable rate debt demand bonds (VRDB) outstanding, which is equal to a high 41% of total direct debt after issuance of the series 2014 bonds. This amount exceeds the city's formal 35% cap on outstanding variable rate debt at the time of issuance due to the more rapid retirement of fixed rate debt since the VRDBs were issued. The city's high proportion of variable rate debt creates above-average risk, although this is somewhat mitigated by the moderate overall debt service (including convention center debt) equal to just 6.9% of fiscal 2013 governmental fund expenditures. Convention center debt is further supported by convention center revenues reported separately as an enterprise fund of the city.

The city is not exposed to third party liquidity provider risk as the series VI-L-1 and series A-4-A VRDBs are index-linked direct placements. Interest rate risk is synthetically fixed via a swap contract on a portion of the variable rate debt ($19 million) through June 2020. The mark-to-market swap value was a negative $2 million as of July 31, 2014.

MANAGEABLE LONG-TERM RETIREE COSTS

Pension and other post-employment benefit (OPEB) obligations are well-managed. The city maintains a single-employer defined benefit plan with separate divisions based on each employee's hire date and classification, and has traditionally paid 100% of its annual required contribution (ARC). The city's pension board chose to lower the discount rate from 8% to 7.375% effective fiscal 2014.

The budgeted contribution for fiscal 2014 of $16 million assumed the 8% discount rate. The new ARC using the reduced rate is $22.1 million. Management plans to use a portion of a $10 million one-time supplemental pension contribution to make up the difference between the new ARC and the amount budgeted for the year. The fiscal 2015 budget includes funding for the full ARC of $23.4 million.

The unfunded pension liability was $164 million as of July 1, 2013 or a low 1.2% of market value. The pension plan is satisfactorily funded at an estimated 73% when assuming a more conservative 7% discount rate. Notably, all new employees hired on or after Jan. 1, 2013 are in a new pension system which has an increased retirement age, reduced multipliers and a shared risk profile which should reduce the pension burden over time. The plan change for new hires was approved by referendum in 2012.

OPEB contributions represented a low 0.7% of fiscal 2013 spending and do not pressure the budget. Total carrying costs are manageable, with debt service (including convention center debt), pension and OPEB pay-as-you-go expenses representing 14% of fiscal 2013 total governmental spending.

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

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS Global Insight, and the National Association of Realtors.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (August 2012);

--'U.S. Local Government Tax-Supported Rating Criteria' (August 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685314

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=861274

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.