Fitch Rates Tucson, AZ GOs, COPs; Outlook Revised to Stable

Fitch Ratings has assigned the following ratings to the obligations of Tucson, Arizona listed below:

--$20 million general obligation (GO) bonds, series 2012-D (2016) 'AA-';

--$24.2 million GO refunding bonds, series 2016 'AA-;

--$36.8 million certificates of participation (COPs), refunding series 2016 'A+'.

The bonds and certificates are scheduled for a negotiated sale the week of June 6, 2016. Series 2012-D (2016) proceeds will finance street and roadway improvements, series 2016 bond proceeds will refund a portion of the city's outstanding tax-supported debt for interest savings, and the series 2016 certificates will refund a portion of the city's outstanding COPs for interest savings.

In addition, Fitch has affirmed the following ratings:

--$213.5 million GO bonds outstanding at 'AA-';

--$242.4 million COPs outstanding at 'A+';

--$83 million senior lien street and highway user revenue bonds outstanding at 'AA'; and

--The city's Issuer Default Rating (IDR) at 'AA-'.

Fitch has also upgraded the rating on $10.2 million Rio Nuevo Multipurpose Facilities District (MFD) COPs (City of Tucson Convention Center Expansion Project), series 2009, which are paid from city appropriations, to 'A+' from 'A'. The upgrade reflects application of Fitch's revised criteria for U.S., state, and local government credits, which was released on April 18, 2016. The revised criteria include more focused consideration of project factors in ratings for appropriation-backed debt; the COPs do not carry any of the additional risk features that Fitch identifies for rating more than one notch below the IDR under the revised criteria.

The Rating Outlook is Stable for the street and highway user revenue bonds and revised to Stable from Negative for the IDR, GO bonds, COPs and Rio Nuevo MFD COPs.

SECURITY

The GO bonds are payable from an unlimited ad valorem tax levied against all taxable property in the city. The COPs are payable from lease payments by the city, subject to annual appropriation. These securities are rated one notch below the city's IDR, reflecting the slightly higher degree of optionality associated with payment of appropriation debt. The senior lien highway user revenue bonds are payable from a priority lien on highway user taxes and other taxes, fees and charges collected by the state and returned to the city for street and highway purposes.

KEY RATING DRIVERS

The pace of Tucson's economic recovery since the last recession has been moderate at best. Recent and proposed developments and infrastructure improvements suggest the pace of growth may accelerate, but the city still is constrained by limitations on revenue raising ability, and large and increasing public safety pension outlays will continue to pressure operations. However, the 'AA-' IDR is supported by the city's solid control over spending and moderate liability burden. A new management team has proposed a balanced fiscal 2017 operating budget, addressing a chronic credit concern. Improvement on this concern, as well as the steady albeit somewhat modest economic improvement, is the primary driver behind the Outlook revision to Stable from Negative. Operating reserves provide a limited cushion in the event of another downturn.

Economic Resource Base

Tucson is located in southern Arizona and is the state's second largest city with an estimated population of about 532,000. Services, military, higher education (University of Arizona), and government are the area's prominent employment sectors.

Revenue Framework: 'a' factor assessment

Growth prospects for revenues are positive and are likely to generally track U.S. GDP gains. Increases to both property tax and local sales tax rates are limited, either by statute and city charter (property tax) or voter approval (sales tax).

Expenditure Framework: 'aa' factor assessment

The pace of spending growth is expected to generally track revenue gains as population-driven service demands increase. Annual carrying costs--for debt service and retiree benefits--are moderately high, reflecting very large and increasing public safety pension contributions.

Long-Term Liability Burden: 'aa' factor assessment

Debt levels are moderate and the pace of amortization is very rapid. The combined debt and pension liability is also a moderate burden on resources.

Operating Performance: 'a' factor assessment

Limited revenue raising flexibility weakens Tucson's gap-closing ability, although management has demonstrated sufficient spending flexibility to maintain reserves through the recent severe economic downturn. The city's reliance on economically sensitive revenues for operations increases its vulnerability to recessionary periods.

RATING SENSITIVITIES

Maintenance of satisfactory financial flexibility through a business cycle, through spending adjustments, reserve funding or some combination thereof will be critical to avoiding downward pressure on the current rating.

CREDIT PROFILE

Tucson is the second largest city in Arizona. Growth of the city's residential base has slowed from its peak in 2001, when it recorded 3,800 single-family home permits. Approximately 380 new housing permits are projected for fiscal 2016, but that number is up from a recent low of 240 in fiscal 2011. Home prices also continue to register gains, with the March 2016 median sale price of $190,000 up more than 10% from the prior year and 52% higher than the 2011 low. Public and private investment in downtown Tucson continues, due in part to a street car rail system that extends from downtown to the university campus (operations began in July 2014). Caterpillar recently announced plans to expand its presence in Tucson, bringing roughly 600 new jobs to a site adjacent to downtown over the next five years. The expansion will bring Caterpillar's total employment in southern Arizona to about 1,000.

Revenue Framework

Local sales tax and state shared revenues (income and sales tax) provide the bulk of Tucson's operating revenues, comprising roughly two-thirds of general fund revenues. Property taxes contribute less than 5% of operating revenues. Revenue performance suffered during the last recession, and growth has been only moderate since the recovery began.

Revenue performance over the past 10 years would suggest future revenue growth will at best match inflationary gains. However, the economic downturn of 2007-2008 was particularly severe in Arizona, and the weak revenue performance for Tucson during that period is outside what Fitch would anticipate in a typical down business cycle. Given the city's diverse economic base, favorable climate and proximity to Mexico, the revenue prospects for the city are solid over the near to intermediate term.

Arizona cities can increase the property tax levy for operations by 2% from the prior year, plus new construction. Tucson also operates under a charter provision that caps the total property tax rate to $1.75 per $100 of taxable value. In addition, any increase in the local sales tax rate must be approved by voters. These constraints impose significant restrictions on the city's revenue flexibility.

Expenditure Framework

Tucson provides the typical range of municipal services, with public safety comprising the largest operating expenditure. The city navigated the recent recession despite the revenue constraints mentioned above. The focus during the downturn was on spending reductions, and management employed a variety of measures to trim outlays, including layoffs, salary freezes, benefit reductions and departmental cuts and reorganizations. Given the magnitude of these adjustments, the degree of remaining financial flexibility that the city can exercise in the next down business cycle bears watching.

Fitch's expectation is that business cycle patterns in Tucson will be more moderate going forward than was the case in the Great Recession and that Tucson will not experience the sharp swings in economic activity and revenues that characterized that period. Spending growth should largely track revenue trends over the near term, as anticipated additional growth is expected to generate the revenue necessary to fund expanded service demands.

Tucson has effectively controlled overall spending growth as the city recovered from the last recession, with fiscal 2015 general fund outlays only 1.7% larger than fiscal 2009 expenditures. An ongoing pressure point is the city's large and increasing public safety pension contributions. While the annual pension payment to the two state-run plans will continue to increase and remain a burden, the city enjoys considerable structural flexibility over other personnel matters. Carrying costs for debt service and post-retirement benefits in fiscal 2015 were fairly high but manageable at 21.5% of governmental spending.

Long-Term Liability Burden

Tucson's governmental debt profile is comprised of GO and COP borrowings for basic infrastructure improvements, and the overall burden is moderate. Management reports no near term borrowing plans beyond the fifth and final component of a $100 million 2012 GO authorization for street improvements; this new money offering is the fourth installment of that authorization.

The city contributes to state-sponsored pension programs for uniformed retirees and maintains a single employer plan for non-uniformed retirees. Recent legislative changes to the two public safety plans should address sizable net pension liabilities for both plans over the long term but will provide no near- to intermediate term relief to very high contribution rates. The combined debt and pension liability for Tucson is moderate at 14.5% of personal income.

Operating Performance

While gap-closing capacity is constrained due to revenue raising limitations, the city has demonstrated an ability and willingness to adjust spending levels through a down business cycle. Limited reserves provide a modest cushion, and operations are challenged when economic conditions weaken. However, financial performance would be expected to recover with improving economic activity.

The city effectively managed spending levels during the last downturn, and has continued with restrained spending growth during the subsequent period of economic recovery. Management currently is anticipating a temporary $6 million decline in operating reserves in fiscal 2016 due to a delayed sale of city-owned property. The projected year-end general fund balance of around $59 million is roughly 12% of spending and transfers out. Local sales taxes and state shared revenues are projected to register modest increases over fiscal 2015 totals.

The proposed fiscal 2017 budget is structurally balanced, as management has successfully addressed a chronic imbalance between recurring revenues and expenses. Contributions to both state-run public safety pension plans will increase, with each contribution rate exceeding 65% of total compensation. These funding requirements will be a source of operating pressure until the recently enacted program reforms begin to improve the plans' liability positions. In general, times of economic recovery and expansion will provide Tucson an opportunity to replenish any depleted reserves and bolster its financial position.

Highway User Revenue Bonds

Highway user tax revenues consist of motor vehicle fuel taxes, motor vehicle registration fees, motor vehicle licenses taxes, motor carrier fees, motor vehicle operator's license fees, and other miscellaneous fees and revenues. Highway user tax revenues are collected by the state and deposited into the state highway user fund until distributed.

Arizona cities and towns receive 27.5% of highway user tax distributions. One-half is distributed to cities and towns on the basis of population in proportion to all cities and towns in the state. The remaining one-half is distributed, first, on the basis of county origin of sales of motor vehicle fuels within the state, and second, to cities and counties on the basis of population in proportion to all cities and towns in the county. Arizona cities with populations exceeding 300,000 (including Tucson) also receive a 3% allocation for certain street and highway purposes.

The rating incorporates the possibility of future diversions of highway revenues by the state of Arizona that would reduce distributions to municipalities, although the amount previously diverted was associated with state-wide budget stress during the great recession. Additionally, the state legislature retains the authority to alter the rate of fees that are constitutionally required to be deposited into the state highway user fund, as well as the allocation of such monies between state purposes and the distribution to local governments. However, the Arizona Supreme Court has indicated that these revenues cannot be reduced in a manner which impairs an issuer's ability to meet debt service requirements on the bonds.

Legal provisions provide adequate bondholder protections, including an additional bonds test of 2.0x maximum annual debt service (MADS). Following the required deposits for debt service payments, surplus highway user revenues are used by the city for capital projects and for staffing, maintenance and contractual expenses related to streets and highways.

Fitch views the pledged street and highway revenues as special revenues under section 902(2)(B) of the bankruptcy code, which defines "special excise taxes imposed on particular activities or transactions" as special revenues. Therefore, the rating is not capped by the city's IDR. Fitch believes special revenue status is unaffected by the state's, rather than the city's, responsibility for the levy, collection, and appropriation of the revenues to the city, or the state's discretion as to the distribution of the revenues among local government units.

To evaluate the sensitivity of the dedicated revenue stream to cyclical decline, Fitch considers both revenue sensitivity results (using the same 1% decline in national GDP scenario that supports assessments in the IDR framework) and the largest decline in revenues over the period covered by the revenue sensitivity analysis. Based on the 15-year pledged revenue history, Fitch's analytical sensitivity tool generates a 6% scenario decline in pledged revenues. The largest actual cumulative decline in historical revenues is a steep 26% decline from fiscal 2007-2012.

Assuming issuance up to the 2x ABT, debt service would be covered with a nearly 60% drop in revenues, 8.3x the scenario results and 1.9x the largest actual revenue decline in the review period. Fitch believes that these results are consistent with an 'AA' rating that can withstand a normal economic downturn (noting that the fiscal 2007-2012 performance reflected a more severe economic stress). A return to more severe revenue volatility, while not presently anticipated, could put negative pressure on the rating.

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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