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Rating Update:

MOODY'S REVISES KANSAS DEPARTMENT OF TRANSPORTATION'S HIGHWAY REVENUE BONDS' OUTLOOK TO NEGATIVE FROM STABLE; RATING AFFIRMED AT Aa1

01 Jun 2011

NEGATIVE OUTLOOK APPLIES TO APPROXIMATELY $1.8 BILLION OF OUTSTANDING DEBT

Kansas Department of Transportation
State
KS

Opinion

NEW YORK, Jun 1, 2011 -- Moody's Investors Service has revised the outlook for the Kansas Department of Transportation's (KDOT) approximately $1.8 billion of outstanding highway revenue bonds to negative from stable, while affirming the rating assigned to the securities at Aa1.

RATING RATIONALE

The Aa1 rating reflects the strong debt service coverage by the pledged revenues, which include motor fuels tax collections, license and permit fees, a portion of state sales and use tax and federal reimbursements. The negative outlook reflects the fact that the state (with an issuer rating of Aa1, negative outlook) repeatedly has relied on State Highway Fund (SHF) resources in recent years to manage its general fund operating deficits. Withdrawals planned for fiscal 2012 indicate that SHF revenues are insufficiently insulated from general state needs for KDOT's bonds to achieve a rating higher than the state's. Such draws will exacerbate declines in the SHF's assets, limiting KDOT's flexibility and adding to potential pressure from sources such as increasing leverage, revenue shortfalls or liquidity needs related to variable-rate debt.

Strengths:

-- Additional bonds test requiring three times coverage of debt service by pledged state-source revenues

-- Rate covenant requiring funding of debt-service reserve if coverage falls below three times

-- Constitutional dedication of primary SHF revenue sources

-- Department's ability to limit capital expenditures in response to weakening revenues

Challenges:

-- State legislative history of allocating SHF monies to general state operating needs

-- Weakening of motor fuel tax revenues

-- Statutory basis of pledged revenues

-- Easing of additional bonds test requirements expected in coming years

DETAILED CREDIT DISCUSSION

HIGHWAY FUND HAS HISTORY OF USE FOR GENERAL FUND PURPOSES

State general fund pressures have affected the SHF repeatedly in recent years. The state's governor on May 28 signed budget legislation authorizing quarterly draws totaling $205 million from the SHF to support the state general fund in fiscal 2012. This authorization extends the state's practice of using the SHF as a general operating reserve. In 2002, Kansas approved a $94.6 million loan from the highway fund to the general fund and, in the next session, the legislature moved not only to defer repayment, but to borrow $30.6 million more from the SHF for highway patrol costs. Both loans were to be repaid in four equal parts. The first two repayments were made, in June 2007 and June 2008, respectively. No payment was made in 2009. The state general fund also received SHF transfers in 2010 and 2011 of, respectively, $143 million and $149 million. The SHF transfers are in amounts consistent with the SHF resources not dedicated by the state constitution to roads and bridges.

NEW CAPITAL PROGRAM WAS AUTHORIZED IN 2010

The Kansas State Legislature in 2010 enacted a $6.4 billion, 10-year program to improve its transportation system, primarily by maintaining current roads, bridges and other elements. Debt financing for the program was originally expected to consist of least $1.7 billion of highway revenue bonds, including the $325 million of taxable Build America Bonds KDOT sold last summer. KDOT had $291 million of unspent bond proceeds as of April 30 from that offering, which is expected to cover construction through the program's first two years. Significant annual new debt issuance is also anticipated in fiscal years 2013 through 2019.

PLEDGED REVENUES PROVIDED 4.2 TIMES COVERAGE OF 2010 DEBT SERVICE

Security for KDOT's highway bonds is a first lien on SHF revenues, which include motor-fuel taxes and vehicle-registration fees constitutionally dedicated to road and highway projects. The rating is supported by strong coverage from these sources, as well as the department's control over expenditures, which can be reduced in response to declining SHF revenue. Pledged fiscal 2010 receipts of $729 million (excluding governmental transfers) were 4.2 times the year's debt service of $174.4 million. Fiscal 2010 revenues cover current expected maximum annual debt service (MADS) by 3.8 times.

LEVERAGE CONSTRAINT WILL BE EASED BY 1999 RESOLUTION AMENDMENT

The 3.8 times coverage of projected MADS meets a test imposed by the resolution that, in 1992, established KDOT's highway revenue bond program. The 1992 resolution states that additional parity debt may only be issued if actual SHF state-source revenue covers resulting MADS by three times. The test is based on actual state-source receipts in any consecutive 12-month period in the 18 months prior to issuance. A 1999 amendment to the resolution allows federal aid revenues to be included in the calculation, once bonds sold before 1999 are no longer outstanding. Bonds issued prior to 1999 consist of Series 1998, which are scheduled to mature on September 1, 2013. Upon maturity of the 1998 bonds, KDOT will be able to increase its borrowing, diluting coverage from state-source revenues. KDOT has no plan to defease the 1998 bonds prior to maturity, but debt-issuance plans for coming years depend in part on the ability to increase leverage of state-source revenues. Legislation authorizing KDOT's current capital program caps debt service at 18% of projected SHF receipts and imposes a maturity limit of 20 years, with a special 25-year provision for the 2010 BABs issue.

INCREASED STATE SALES TAX REVENUES WILL SUPPORT FUTURE BORROWINGS

Increased sales and use tax revenue allocations will support KDOT's future borrowings. The state last year raised its sales and use tax rate to 6.3% from 5.3%. Based on statutorily determined allocations of this revenue, SHF sales tax receipts were expected to be bolstered modestly, by about $21 million, in each of the three years through June 30, 2013. In fiscal 2014, the statute reduces the rate by 0.6 percentage point, but raises the SHF allocation, to 18.42% from 11.23%, generating recurring, additional revenue of $175 million. The increased state sales tax allocation will help lift total state-source SHF revenues to a projected $1.02 billion in fiscal 2015. Sales and use tax revenues are expected to account for a growing share of total SHF receipts. This continues a trend that began in 2004, when Kansas lawmakers passed legislation boosting the sales tax revenues deposited directly into the SHF. At the same time, provisions for sales tax transfers from the general fund to the highway fund were eliminated. The practice of making such transfers already had been suspended for fiscal 2003 and 2004 to provide fiscal relief to the state. Sales and use tax revenues directly deposited to the highway fund are more insulated from negotiations over the state's general fund budget. However, as was the case in the current budget session, the state has the ability to appropriate such resources for other uses once they have flowed into the SHF, because they are not constitutionally protected.

INCREASED SALES TAX REVENUE WILL HELP OFFSET MOTOR FUEL TAX REVENUE WEAKNESS

Growing sales tax allocations will help reduce KDOT's dependence on motor fuel taxes. These revenues (taxes on gasoline and diesel fuel) account for about 38% of state-source highway fund revenues now, and their share is projected to fall to 29% in fiscal 2015. Based on consumption trends, we expect fuel tax collections to be flat or declining in coming years, unless the state increases its tax rates (currently 24 cents per gallon for gasoline and 26 cents per gallon for diesel). Kansas in recent years has imposed modest increases in its motor fuels tax levies, but competition from neighboring states with low gasoline tax rates may deter further increases.

RESERVE ACCOUNT FUNDING PROVISIONS MITIGATE RISK OF REVENUE DETERIORATION

The 1992 bond resolution requires the state to provide the highway fund with revenues at least three times the principal and interest due in each fiscal year, excluding federal and local funds. Federal funds will be included in the calculation once the 1999 amendment becomes effective. KDOT must start funding a reserve account for each outstanding series, on a monthly basis over four years, if it fails to meet the coverage requirement. The reserves are to be funded at the lesser of MADS, 125% of average annual debt service or 10% of total issue proceeds. Once three times coverage of debt service by pledged revenues has been maintained over the course of two successive years, the debt service reserve requirement expires. These provisions establish a strong incentive for the state to maintain the statutorily based flow of revenues to the SHF and also provide a safeguard against revenue deterioration caused by economic factors.

KDOT HAS LARGE, BUT DIMINISHED, VARIABLE-RATE DEBT COMPONENT

KDOT has greatly lowered variable-rate debt exposure in the past two years, raising the fixed-rate portion to 64% of outstanding obligations, from 38%. The department eliminated its exposure to auction-rate securities, refunding Series 2003C in May of 2008 with variable-rate demand obligations (VRDOs) and converting Series 2004B to a fixed-rate mode in September of 2008. Five standby bond purchase agreements (SBPAs) provide liquidity for purchase of the VRDOs in the event of remarketing failures. We believe KDOT will continue to carefully monitor use of these agreements, which include two expiring in the next 12 months.

INTEREST RATE SWAP EXPOSURE IS ALSO RELATIVELY HIGH

KDOT is a party to seven interest-rate swap agreements intended to hedge against increases in variable-rate obligations. The swaps correspond to bonds with a principal amount of $717 million, including a swap linked to the 2004 auction-rate securities that are now in fixed-rate mode. Total swap exposure is relatively high, at more than a third of outstanding debt. The most recent mark-to-market valuation of the swaps was negative $48 million, compared with $60 million at the time of our last review, in July of 2010. KDOT has posted $19 million of collateral under these agreements in connection with swaps entered into with Goldman Sachs Bank USA (Aa3, negative outlook). This exposure is manageable, given KDOT's monitoring practices and the potential availability of the state's liquid resources (more than $2 billion) in an emergency.

Outlook

The outlook for Kansas Department of Transportation highway revenue bonds is negative, based on the fiscal pressures of the state, which has frequently relied on KDOT resources to help close budget deficits.

What could move the rating -- UP:

- Increase in coverage required by additional bonds test

- Closure of lien to parity debt issuance

- Track record of protecting state highway fund from use for general state purposes

What could move the rating -- DOWN:

- Downgrade of the state; further use of SHF by state for general operating purposes

- Increased leverage based on 1999 resolution provisions incorporating federal resources into additional bonds test amount

- Declines in motor-fuel tax collections leading to lower-than-projected debt-service coverage

- Economic weakness eroding flow of sales tax revenues to state highway fund

- Liquidity stress related to swap and variable-rate debt exposure

The rating on the current issue was assigned by evaluating factors we believe are relevant to the credit profile of the issuer, such as i) the business risk and competitive position of the issuer versus others within its industry or sector, ii) the capital structure and financial risk of the issuer, iii) the projected performance of the issuer over the near to intermediate term, iv) the issuer's history of achieving consistent operating performance and meeting budget or financial plan goals, v) the nature of the dedicated revenue stream pledged to the bonds, vi) the debt service coverage provided by such revenue stream, vii) the legal structure that documents the revenue stream and the source of payment, and viii) and the issuer's management and governance structure related to payment. These attributes were compared against other issuers both within and outside of the Kansas Department of Transportation's core peer group. The Kansas Department of Transportation's highway revenue bond ratings are believed to be comparable to ratings assigned to other issuers of similar credit risk.

REGULATORY DISCLOSURES

Information sources used to prepare the credit rating are the following: parties involved in the ratings, public information, and confidential and proprietary Moody's Investors Service information.

Moody's Investors Service considers the quality of information available on the issuer or obligation satisfactory for the purposes of maintaining a credit rating.

Moody's adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources Moody's considers to be reliable including, when appropriate, independent third-party sources. However, Moody's is not an auditor and cannot in every instance independently verify or validate information received in the rating process.

Please see ratings tab on the issuer/entity page on Moodys.com for the last rating action and the rating history.

The date on which some Credit Ratings were first released goes back to a time before Moody's Investors Service's Credit Ratings were fully digitized and accurate data may not be available. Consequently, Moody's Investors Service provides a date that it believes is the most reliable and accurate based on the information that is available to it. Please see the ratings disclosure page on our website www.moodys.com for further information.

Please see the Credit Policy page on Moodys.com for the methodologies used in determining ratings, further information on the meaning of each rating category and the definition of default and recovery.

Analysts

Edward Hampton
Analyst
Public Finance Group
Moody's Investors Service

Kimberly Lyons
Backup Analyst
Public Finance Group
Moody's Investors Service

Contacts

Journalists: (212) 553-0376
Research Clients: (212) 553-1653


Moody's Investors Service
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New York, NY 10007
USA

MOODY'S REVISES KANSAS DEPARTMENT OF TRANSPORTATION'S HIGHWAY REVENUE BONDS' OUTLOOK TO NEGATIVE FROM STABLE; RATING AFFIRMED AT Aa1
No Related Data.
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