OREANDA-NEWS. Fitch Ratings has assigned a 'AAA' rating to the following Los Angeles Unified School District (the district) general obligation (GO) bonds:

--$455 million 2016 GO refunding bonds, series B (dedicated unlimited ad valorem property tax bonds).

In addition, Fitch has affirmed the following district ratings:

--$650 million GO bonds, election of 2008, series A (2016) (dedicated unlimited ad valorem property tax bonds) at 'AAA';

--$575 million 2016 GO refunding bonds, series A (dedicated unlimited ad valorem property tax bonds) at 'AAA';

--Issuer Default Rating (IDR) at 'A+'.

The Rating Outlook is Stable.

The 2016 GO refunding bonds, series B are expected to sell competitively on Aug. 18, 2016. Bond proceeds will refund for interest savings certain outstanding GO bond maturities totalling $563 million.

SECURITY

The bonds are secured by unlimited ad valorem property taxes levied on all taxable property in the district.

KEY RATING DRIVERS

SPECIAL REVENUE ANALYSIS: The 'AAA' rating on the series 2016 GO refunding bonds, series B is based on a dedicated tax analysis without regard to the district's financial operations. Fitch has been provided with legal opinions by the district's bond counsel that provide a reasonable basis for concluding that the tax revenues levied to repay the bonds would be considered 'pledged special revenues' in the event of a district bankruptcy.

GROWING TAX BASE; MODERATE DEBT: The economic resource base supporting the GO bonds is strong, diverse, and growing. The unlimited nature of the tax offsets any concern about tax base volatility. The district's debt burden is moderate relative to the tax base.

RATING SENSITIVITIES

Tax Base Drives GO Rating: The 'AAA' GO bond rating is sensitive to a significant and long-lasting decline in the district's tax base and economy, which Fitch considers unlikely.

CREDIT PROFILE

The district is the nation's second largest public school district. As with most California school districts, the bulk of Los Angeles Unified School District's operational revenues are derived from a state-determined per pupil funding formula, although capital funding is largely locally funded. The district's tax base growth has been strong and steady. The unemployment rate has improved significantly in recent years. Income metrics are somewhat below-average, reflective of a large urban region.

Tax Revenue to Repay Bonds Viewed as Pledged Special Revenues

Fitch believes that taxes levied for bond repayment would be considered pledged special revenues under the U. S. bankruptcy code, and therefore the lien on pledged revenues would survive and would not be subject to the automatic stay (i. e. payment interruption) in the event the district were to file for bankruptcy. Fitch has reviewed and analyzed legal opinions provided by the district's bond counsel and believes they provide a reasonable basis to conclude that these revenues would be treated as pledged special revenues due to certain provisions of the state constitution (primarily Proposition 13), which limit and direct the use of pledged property tax revenues for bond repayment.

As a result, Fitch analyzes these bonds as dedicated tax bonds. This analysis focuses on the district's economy, tax base, and debt burden without regard to financial operations, because Fitch believes that bondholders are insulated from any operating risk of the district. Fitch typically calculates the ratio of available revenues to debt service for dedicated tax bonds, but the unlimited nature of the tax rate pledge on the district's bonds eliminates the need for such calculations.

The tax base provides extremely strong fundamental support for the bonds. Concentration is very low with the top 10 taxpayers (a mixture of commercial properties) accounting for less than 2% of AV. This tax base experienced just one year of AV decline during the recession (a 2% drop in fiscal 2011). Subsequently, AV has grown 31% to the current all-time high of $606 billion in fiscal 2017.

In terms of future AV growth, there is considerable potential for both new construction and redevelopment of existing properties. This is particularly evident in downtown Los Angeles. The approximately $300,000 median AV for single family residences suggests that there is considerable stored value under Proposition 13 that will be released as properties change ownership and taxable AV catches up to market values.

IDR Expands Analysis to Include Operating Performance and Framework

The 'A+' IDR considers the district's adequate gap-closing capacity and reserves, as well as its future fiscal challenges. The district is currently benefitting from improved state education funding, particularly given its high population of targeted students. However, sustained declining student enrollment contributes to fiscal challenges as enrollment drives a large portion of revenues. The IDR also incorporates the district's moderate long-term liability burden, rising fixed costs (including retiree costs), and demonstrated ability to contain spending as needed.

Economic Resource Base

In 2017, the district expects to operate 1,074 schools and educational centers including a projected 54 affiliated charter schools. A further 228 fiscally independent charter schools are expected to operate within district boundaries, up from 179 in 2012. The district covers approximately 710 square miles, including almost all of the city of Los Angeles and all or part of 25 other cities, as well as providing services to several unincorporated areas of Los Angeles County. The district serves a population of 4.7 million.

Revenue Framework: 'bbb' factor assessment

Despite student enrollment declines, general fund revenues have rebounded in recent years due to state economic improvement and a high unduplicated count of targeted students. However, the district's independent legal ability to raise revenues is constrained by Proposition 13, which requires voter approval for tax increases.

Expenditure Framework: 'aa' factor assessment

The district has a moderate fixed cost burden and solid flexibility to adjust spending. However, it faces considerable expenditure pressures to be competitive with local charter schools and meet partially funded federal and state special education mandates. Based on a recent California Department of Education (CDE) decision, the district must also determine in the near term how best to comply with LCFF requirements for unduplicated count students.

Long-Term Liability Burden: 'aa' factor assessment

The long-term liability burden is moderate relative to the district's huge economic resource base. The district participates in two adequately funded state-run pension plans and is beginning to address its significant unfunded accrued other post-employment benefit (OPEB) liability by funding a trust.

Operating Performance: 'a' factor assessment

The district maintains midrange general fund reserves, providing some financial cushion. Fitch assesses the district's gap closing capacity as adequate relative to the expected revenue loss (4%) during a 1% GDP decline scenario.

Revenue Framework

State aid and local property taxes provide the majority of district operating revenues. State aid has been expanding due to improvements in the state's economy and a new funding formula (LCFF) which provides additional funds for targeted students. In its fiscal 2017 budget, the district estimates that it will have a high 84% unduplicated count of students who are English language learners, eligible for free or subsidized lunches, or in foster care. Actual revenues grew by 13% during fiscal years 2013-2015, notwithstanding student enrollment declines. There is no parcel tax to provide additional local revenues.

Prospects for future revenue growth will be largely driven by the degree to which state revenue growth offsets projected student enrollment declines. During fiscal years 2003-2019, the district projects it will lose one-third of its students during which time approximately 113,000 students will enroll in an ever growing number of fiscally independent charter schools within the district.

The district has the largest fiscally independent charter school program in the country, with charter school enrollment projected to grow 1,243% between fiscal years 2003-2019. By contrast, district enrollment is projected to continue declining due to lower county birth rates, student out-migration, and a high student dropout rate (17% versus the statewide average of 11%). To partially offset the related revenue declines, the district has focused on improving student attendance. The district estimates that a 1% attendance improvement generates approximately $40 million in additional revenues per year.

State law requires voter approval of tax increases, limiting the district's ability to control revenues. However, Fitch expects that the district will continue to manage its revenue pressures satisfactorily.

Expenditure Framework

The district has considerable expenditure flexibility given its ability to raise class sizes, modify program offerings, and defer non-essential expenditures. In addition, the district's labor environment is moderately flexible and a high rate of employee attrition through retirements is expected over the next few years.

The fiscal 2017 budget assumes that 80% of general fund expenditures will go on personnel costs, which are rising. Fiscal 2017 is the first full year in which the district will fund the 10% employee remuneration increase implemented incrementally during the prior two years, along with increasing its contributions to employee retirement systems.

Fitch expects expenditure growth to be moderately above expected revenue growth in order to compete with the growing charter school sector, meet LCFF requirements for a large unduplicated count pupil population, and comply with special education mandates which are only partially funded by the federal and state governments. Future labor negotiations will likely focus on the balance between remuneration increases and staffing numbers, taking into account declining student enrollment, charter school competition, and voter reaction to the proposed extension of a temporary income tax increase.

The district's mandate to provide educational services places some limitations on its ability to make expenditure reductions in the event of a revenue decline. Further, many of the district's expenditure reduction options would be subject to collective bargaining, legislative changes, or external approvals. The district's options will also be constrained by continuing student enrollment declines.

Long-Term Liability Burden

In fiscal 2016, the district's long-term liability burden (overall debt plus unfunded pension liabilities) is moderate relative to its resource base at about 19% of personal income. The bulk of the district's direct debt is funded from an unlimited property tax levy restricted to this purpose. Direct debt amortization is moderate at approximately 46% in 10 years. The district does not plan to issue new money debt in the next 12 months. Five bond measures since 1997 have received between 63% and 71% voter approval indicating historically good taxpayer support.

The district participates in two state-funded pension systems, both of which are mandating increasing employer contributions over the next few years to improve their funded ratios. At June 30, 2015, the district's proportionate share of CalSTRS' and CalPERS' net pension liabilities was $4.5 billion (assuming 7.6% and 7.5% discount rates, respectively). Using Fitch's more conservative 7% discount rate, the district's proportionate share increases to $5.8 billion or a low 1% of the district's fiscal 2016 AV.

The district provides relatively generous lifetime OPEBs to eligible employees and their spouses. There is a significant unfunded actuarially accrued liability of $13.6 billion (July 2015 valuation). The district currently has $145 million held in a trust fund for future OPEB liabilities and is budgeting a further $68 million contribution in fiscal 2017. It is unclear if the district is prepared to negotiate less generous OPEB eligibility and entitlements in the future. Absent OPEB reform, Fitch views ongoing funding of the trust as an important tool towards addressing this significant long-term liability.

Operating Performance

During the recession, the district demonstrated its ability to make difficult resourcing decisions by instituting layoffs and furloughs, offering early retirement incentives, negotiating bargaining unit concessions (including work process changes), and increasing class sizes. All of these options remain open to the district as it manages its expenditures in a falling student enrollment environment. However, they might prove harder to implement outside of a recession. In terms of managing future personnel expenditures, the district is most likely to rely on attrition and managed hiring in the short to medium term.

The general fund ended fiscal 2015 with a satisfactory unrestricted general fund balance of $673 million or 11% of spending. This represents an improvement from its recent low unrestricted general fund balance of $436 million or 7% of spending in fiscal 2013. Similarly, general fund liquidity was much stronger in fiscal 2015 and the district did not need to issue tax and revenue anticipation notes (TRANs). Previously, general fund liquidity had been much tighter, and the district had issued $1.4 billion in two series of TRANs for the period July 2012 to November 2013. No TRANs have been issued subsequently, and none are planned for fiscal 2017.

The district projects further general fund strengthening at fiscal 2016 year end when the unrestricted general fund balance is expected to increase to a much higher $927 million or 14% of spending, reflecting higher than budgeted revenues and lower than budgeted expenditures. However, this is somewhat artificially high. It incorporates $218 million in one-time monies held in reserve for fiscal 2017 salary and benefit cost increases and $183 million in unassigned/unappropriated monies, both of which are being used to balance the fiscal 2017 budget. Furthermore, the assigned general fund balance includes $453 million of LCFF monies which are primarily devolved to schools and remain unspent while each school determines how best to expend its share. Those monies might be used to help balance the fiscal 2018 and 2019 budgets.

The district's fiscal 2017 general fund budget assumes a $98 million draw down largely because of ongoing labor cost increases. However, the district expects to continue exceeding its 5% minimum reserve threshold and 1% reserve for economic uncertainties. The district's multiyear projections indicate two years of general fund drawdowns in fiscals 2018 and 2019 as costs continue to rise despite further student enrollment declines.

The district is exploring a range of options to close these gaps through expenditure reductions, savings from employee attrition, and use of one-time monies. Voter approval in November 2016 to extend the current Proposition 30 temporary income tax increase for 12 years would provide greater state education funding in the second half of fiscal 2019 than shown in the current multiyear projections. Further, rising health and welfare benefit cost increases will be partially covered by the district's health and welfare reserve (some of the current $311 million balance will be drawn down in fiscal 2017). While current projections indicate that the district would maintain its 5% minimum reserve threshold and 1% reserve for economic uncertainties in fiscal 2018, the district will need to reduce its expenditures and/or obtain additional revenues in fiscal 2019 to maintain its 5% minimum reserve threshold.

Gap Closing Capacity

Fitch assesses the district's gap closing capacity as adequate relative to the expected revenue loss (a moderately high 4%) during a 1% GDP decline scenario. However, future general fund budget balancing has been complicated by a recent CDE decision that $450 million of the district's fiscal 2014 general fund expenditures for special education services to unduplicated count pupils should not have been included in its estimate of LCFF supplemental and concentration funds expended on unduplicated count pupils. The CDE is making a distinction between services provided expressly for unduplicated count pupils and services provided for all pupils.

Although the CDE did not require the district to amend its fiscal 2017 general fund budget, the district has set aside $246 million pending discussions with the CDE and the Los Angeles County Office of Education to finalize the fiscal 2017 budget. During those discussions, the district expects to better justify the nexus between its budget allocation decisions and LCFF goals, look at program redesign, and examine how reallocating resources could best address the CDE's concerns while simultaneously complying with state and federal special education mandates. The district estimates that its large special education population (14% of its students) consume 16% of its unrestricted general fund revenues since federal and state funding covers only a portion of the actual costs. Major revisions to the district's proportionality calculations could significantly impact fiscal 2018 and 2019 resource allocation decisions.

Annually, the district has access to between $750 million and $900 million in internally borrowable funds, most notably from its workers' compensation fund (first choice), facilities and capital funds, and special reserve funds. Borrowings from these funds must be repaid within prescribed time limits.