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2020-069 Bond Credit RatingsDate: July 31, 2020 Report No. 2020-069       INFORMAL STAFF REPORT TO MAYOR AND CITY COUNCIL SUBJECT: Bond credit ratings for the upcoming General Obligation (GO) and Certificates of Obligation (CO) bond sales. BACKGROUND: The purpose of this report is to provide the City Council notice of recent bond credit ratings from Fitch Ratings (Fitch) and Standard & Poor’s (S&P) for the upcoming GO and CO bond sales. The City Council is scheduled to consider adoption of bond ordinances to authorize the bond sales on August 4, 2020. DISCUSSION: On June 16, 2020 the City Council adopted Ordinance No. 20-916 and 20-917 directing the publication of a Notice of Intention to issue COs. The City Council is scheduled to consider adoption of bond ordinances to authorize the bond sales on August 4, 2020. On July 8th, staff and the City’s financial advisor, Hilltop Securities Inc., participated in conference calls with analysts from Fitch and S&P to discuss the City’s financials and upcoming GO and CO bond sales. As a result of these conference calls, and a review of financial information, both S&P and Fitch assigned a rating of ‘AA+’ to the City’s upcoming bond sales. This is the second highest rating offered by either rating agency. There is no change to either rating from the prior year and both indicated a stable rating outlook for the City. For your review, staff has attached the rating reports and a ratings chart for both rating agencies Please do not hesitate to contact me if you have any questions. ATTACHMENTS: Fitch and S&P Credit Rating Reports Ratings Chart STAFF CONTACT: David Gaines, Assistant City Manager/CFO (940)-349-8260 David.Gaines@cityofdenton.com Summary: Denton, Texas; General Obligation Primary Credit Analyst: Jim Tchou, New York (1) 212-438-3821; jim.tchou@spglobal.com Secondary Contact: Kate Boatright, Farmers Branch (1) 214-871-1420; kate.boatright@spglobal.com Table Of Contents Rating Action Stable Outlook Credit Opinion Related Research WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 1 Summary: Denton, Texas; General Obligation Credit Profile US$62.42 mil GO rfdg & imp bnds ser 2020 dtd 08/01/2020 due 02/15/2040 Long Term Rating AA+/Stable New US$58.49 mil certs of oblig ser 2020 dtd 08/01/2020 due 02/15/2050 Long Term Rating AA+/Stable New Rating Action S&P Global Ratings assigned its 'AA+' rating to Denton, Texas' approximately $62.42 million series 2020 general obligation (GO) refunding and improvement bonds and approximately $58.49 million series 2020 certificates of obligation, and affirmed its 'AA+' rating on the city's existing GO debt and certificates of obligation. The outlook is stable. The bonds are payable from a direct and continuing ad valorem tax levied, within the limits prescribed by law, on all taxable property within the city. The certificates are payable from revenue from a direct and continuing ad valorem tax levied, within the limits prescribed by law, on all taxable property within the city and a limited surplus net revenue pledge of its utility system, not to exceed $1,000. However, we rate the certificates based on the city's ad valorem pledge. State statutes limit the maximum ad valorem tax rate for home-rule cities to $2.50 per $100 of taxable assessed valuation (AV) for all city purposes. Administratively, Texas' attorney general will permit the allocation of $1.50 of the $2.50 maximum tax rate for all GO debt, as calculated at the time of issuance and based on 90% tax collections. In fiscal 2020, the city is levying 59.045 cents: 20.509 cents for debt service and the remaining 38.536 cents for operations. Based on the application of our criteria, titled "Issue Credit Ratings Linked To U.S. Public Finance Obligors' Creditworthiness" (published Nov. 20, 2019, on RatingsDirect), we do not differentiate between Denton's limited-tax GO debt and general creditworthiness. We think that the city's ability to meet debt service and continue to operate successfully has a strong link to its creditworthiness, and that there are no significant resource fungibility limitations. We understand officials intend to use series 2020 bond proceeds to finance various improvements, including street, park system, and public safety facilities for the police department, and to refinance portions of the series 2010 certificates of obligation and series 2010 and 2010A GO bonds for debt service savings. Series 2020 certificate proceeds will be used to finance vehicles and equipment, fire station improvements, municipal government building renovations, park renovations, wastewater system improvements, and electric light and power system improvements, among others. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 2 Credit overview We expect ongoing economic development in Denton will likely continue to support future property and sales tax growth, the city's two leading revenue sources. We believe the city will continue to benefit from its access to the broad and diverse metropolitan statistical area (MSA), which we view as a positive credit factor. In our opinion, Denton's very strong management, which has resulted in consistently strong budgetary performance, further supports the city's credit quality. We think very strong management will likely be key to Denton successfully navigating the financial challenges presented by COVID-19. We imagine challenges associated with COVID-19 and the related recession could pressure the city's budgets, as it will most local governments, during the next one to two years. In line with our view of the ongoing economic contraction, we expect sales taxes could lag historical performance. (For further information, please see "The U.S. Faces A Longer and Slower Climb From The Bottom," published June 25, 2020.) We, however, do not expect it to have an effect on Denton's ability to maintain very strong reserves during the next few fiscal years because of the city's formal minimum-fund balance policy. Management will continue to monitor budget-to-actual performance closely and make adjustments as necessary. We expect budgetary performance will likely remain relatively stable in fiscal 2021 as a result of management's conservative budgeting approach and identified areas for cost-control. We also think the city's participation in the broad and diverse Dallas-Fort Worth-Arlington, TX MSA will likely contribute to overall rating stability. Therefore, we do not expect to change our rating during the next few years. Although our outlook is generally for two years, we recognize the potential for downside risk because of COVID-19 and the related recession during the next six to 12 months. The rating also reflects our opinion of the city's: • Very strong economy, with access to a broad and diverse MSA and a local stabilizing institutional influence; • Very strong management, with strong financial policies and practices under our Financial Management Assessment (FMA) methodology; • Adequate budgetary performance, with balanced operating results in the general fund and a slight operating surplus at the total governmental fund level in fiscal 2019; • Very strong budgetary flexibility, with an available fund balance in fiscal 2019 of 27% of operating expenditures; • Very strong liquidity, with total government available cash at 144.3% of total governmental fund expenditures and 11.0x governmental debt service, and access to external liquidity we consider strong; • Weak debt and contingent liability profile, with debt service carrying charges at 13.1% of expenditures and net direct debt that is 129.1% of total governmental fund revenue; and • Strong institutional framework score. Environmental, social, and governance (ESG) factors We have analyzed the city's environmental factors, including health and safety risks posed by COVID-19, coupled with social and governance risks relative to the economy, as well as the city's financial management, budgetary performance, budgetary flexibility, and liability profile, and determined all are in line with our view of the sector WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 3 Summary: Denton, Texas; General Obligation standard. Tornadoes and flooding pose the greatest environmental threats to the city. Officials would rely on cash-based reserves to minimize one-time service disruptions, if necessary, until receiving federal funds for eligible damages. Stable Outlook Downside scenario We could lower the rating in the unlikely event that growth-related or fixed-cost pressure were to weaken budgetary performance, leading to sustained and significant reserve drawdowns. Upside scenario We could raise the rating if continued economic expansion were to result in improvement of wealth and income to levels we consider comparable with those of higher-rated peers, coupled with reduced debt, while management maintains strong finances. Credit Opinion Very strong economy We consider Denton's economy very strong. The city, with an estimated population of 135,989, is located in Denton County in the Dallas-Fort Worth-Arlington, TX MSA, which we consider to be broad and diverse. The city also benefits, in our view, from a stabilizing institutional influence. The city has a projected per capita effective buying income of 88.5% of the national level and per capita market value of $92,806. Overall, the city's market value grew by 11.5% over the past year, to $12.6 billion in 2020. The county unemployment rate was 3.0% in 2019. The local economy, largely based in retail, manufacturing, distribution, education, and health care, has recently grown in tandem with robust geographic and economic expansion in the Dallas-Fort Worth Metroplex. As home to both the University of North Texas and Texas Woman's University, the city also benefits from a stabilizing institutional presence, in our view. Primary leading city employers include: • University of North Texas (4,626 employees), • Denton Independent School District (4,417), • Peterbilt Motors -- Headquarters & Plant (3,075), • Texas Woman's University (1,875), and • Denton State Supported Living Center (1,700). The local property tax base is very diverse, with the 10 leading taxpayers accounting for just 7% of taxable AV in fiscal 2020. Taxable AV has demonstrated steady year-over-year growth since fiscal 2014, and management expects another 7% increase for fiscal 2021. Recent economic developments include: • United States Cold Storage completing its six million cubic-foot facility in 2019, which was a $28 million capital WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 4 Summary: Denton, Texas; General Obligation investment on a 40-acre site that created 100 jobs; • Eleven new commercial development permits, which, with a combined total value of more than $140 million, is the largest investment, with two industrial shell buildings totaling more than 600,000 square feet; and • The recent approval of the Cole and Hunter Ranch developments, which include a combined 6,400 acres for development. The master planned communities will include 12,900 single-family units, 6,450 multi-family units, 485 acres for commercial development, and 256 acres for industrial development. With a planned 40-year build-out, these developments will be the largest and most significant developments in Denton. Very strong management We view the city's management as very strong, with strong financial policies and practices under our FMA methodology, indicating financial practices are strong, well-embedded, and likely sustainable. Key policies and practices include management's: • Conservative revenue and expenditure assumptions when compiling the annual budget, which typically allows for favorable budget variance by fiscal year-end; • Budget amendments that, if needed, the city council can make--management informs the council quarterly on how the budget is developing through budget-to-actual reports; • Formal debt and investment management policies, reviewed annually, with quarterly investment reports to the council; • Annually updated, long-range capital improvement plan and multiyear financial forecast; and • Formal policy of maintaining a minimum unassigned general fund balance at 20% of budgeted expenditures and an additional 5% resiliency reserve, for 25% combined, to safeguard against unusual financial circumstances or economic downturns. Adequate budgetary performance Denton's budgetary performance is adequate, in our opinion. The city had balanced operating results in the general fund of 0.4% of expenditures, and slight surplus results across all governmental funds of 1.0% in fiscal 2019. We have adjusted our ratios for what we view as recurring expenditures out of the general fund and capital outlay across all governmental funds financed with debt. Our forward-looking opinion of adequate budgetary performance reflects uncertainty concerning the effect and duration of COVID-19 and the related recession on the city. Management attributes fiscal 2018 performance largely to actual expenditures coming in under budget by $2.7 million, supported by reduced costs in personnel services, materials and supplies, maintenance and repairs, and service operations. These expenditure savings offset revenues missing the city's budgeted target by $800,000. In fiscal 2019, property taxes generated 47% of total governmental activities, followed by sales taxes at 25% and franchise fees at 17%. For fiscal 2020, management is projecting near break-even operations after implementing several cost-control initiatives in response to anticipated revenue losses as a result of COVID-19, whereby officials froze merit increases, initiated a hiring freeze, delayed some capital projects, and implemented a voluntary separation program, which was WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 5 Summary: Denton, Texas; General Obligation offered to all employees. For fiscal 2021, the preliminary budget is balanced. Supporting both fiscal 2020 and fiscal 2021 budgets is approximately $7.6 million the city received from the county in Coronavirus Aid, Relief, and Economic Security (CARES) Act funding to use toward COVID-19-related expenses. Very strong budgetary flexibility Denton's budgetary flexibility is very strong, in our view, with an available fund balance in fiscal 2019 of 27% of operating expenditures, or $30.7 million. The city has historically maintained very strong reserves, consistently exceeding its formal policy of maintaining 20% of budgeted expenditures. With fiscal year-end 2020 expectations of near break-even operations, coupled with an expected balanced budget for fiscal 2021, we expect budgetary flexibility will likely remain very strong during the next few fiscal years. Very strong liquidity In our opinion, Denton's liquidity is very strong, with total government available cash at 144.3% of total governmental fund expenditures and 11.0x governmental debt service in 2019. In our view, the city has strong access to external liquidity, if necessary. Denton's access to the market during the past two decades, including numerous GO and revenue-backed bond issuances, demonstrates its strong access to external liquidity. It has historically maintained what we consider very strong cash, and we do not believe cash will likely materially weaken during the next few fiscal years. All city investments comply with Texas statutes and its own formal policy. Investments were in treasuries, agencies, certificates of deposit, commercial paper, municipal bonds, and local government investment pools at June 1, 2020; we consider none of these aggressive. We have not identified any contingent liabilities that could pose a material liquidity risk. Therefore, we do not expect liquidity will likely deteriorate from its very strong position during the next few fiscal years. Weak debt and contingent liability profile In our view, Denton's debt and contingent liability profile is weak. Total governmental fund debt service is 13.1% of total governmental fund expenditures and net direct debt is 129.1% of total governmental fund revenue. Total direct debt is approximately $974 million, and overall net debt equals 8.3% of market value. We understand Denton expects to issue approximately $69.2 million in tax-supported debt in fiscal 2021 for various citywide improvements, including streets and public safety. While we do not currently view the amount as significant, due to Denton's rapid pace of growth, we expect the city and school districts serving the city will have ongoing growth-related capital needs that could inflate overall net debt-to-market value ratios above 10%, which could weaken our assessment of the debt profile. Pension and other postemployment benefits • We do not view pension and other postemployment benefits (OPEB) liabilities as an immediate credit pressure because we believe required contributions are currently manageable compared with total governmental expenditures. WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 6 Summary: Denton, Texas; General Obligation • If required material contributions were to increase unexpectedly during the next few fiscal years, we think this would not have an effect on fiscal stability because of the sizable reserves officials could use for contingencies, if needed. • Although OPEB liabilities are largely funded on a pay-as-you-go basis, which, given claims volatility as well as medical cost and demographic trends, is likely to lead to escalating costs, contribution requirements may be amended by the city. Denton participates in the following plans as of Dec. 31, 2018, the latest measurement date: • The state-administered Texas Municipal Retirement System (TMRS): 79.8% funded, with a net pension liability equal to $100.4 million. • The Denton Firefighters' Relief & Retirement Fund: 79.3% funded, with a net pension liability equal to $22.6 million. • OPEB: defined-benefit, group-term life insurance through the TMRS-administered supplemental death benefits fund, and retiree health care. Denton's combined required pension and OPEB contributions totaled 10.0% of total governmental fund expenditures in fiscal 2019. Of that amount, only 0.4% represented OPEB payments. Denton's required pension contribution is its actuarially determined contribution, calculated at the state level based on an actuary study, and the city has historically funded annual required costs in full. Actuarial assumptions include a 6.75% discount rate, which we view as somewhat aggressive, representing market risk and resulting in contribution volatility if TMRS fails to meet assumed investment targets. Additionally, contributions are likely to grow as a result of the use of level-payroll funding, rather than level-dollar contributions, which would result in consistent payments. Strong institutional framework The institutional framework score for Texas municipalities is strong. Related Research • S&P Public Finance Local GO Criteria: How We Adjust Data For Analytic Consistency, Sept. 12, 2013 • Criteria Guidance: Assessing U.S. Public Finance Pension And Other Postemployment Obligations For GO Debt, Local Government GO Ratings, And State Ratings, Oct. 7, 2019 • Through The ESG Lens 2.0: A Deeper Dive Into U.S. Public Finance Credit Factors, April 28, 2020 Ratings Detail (As Of July 23, 2020) Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed WWW.STANDARDANDPOORS.COM/RATINGSDIRECT JULY 23, 2020 7 Summary: Denton, Texas; General Obligation Ratings Detail (As Of July 23, 2020) (cont.) Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO Long Term Rating AA+/Stable Affirmed Denton GO (AMBAC) Unenhanced Rating AA+(SPUR)/Stable Affirmed Denton GO (MBIA) (National) Unenhanced Rating AA+(SPUR)/Stable Affirmed Many issues are enhanced by bond insurance. Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. 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Classification Moody's S&P Fitch Meaning Aaa AAA AAA Prime Grade Aa1 AA+AA+ Aa2 AA AA High Grade Aa3 AA-AA- Investment Grade A1 A+A+ A2 A A Upper Medium Grade A3 A-A- Baa1 BBB+BBB+ Baa2 BBB BBB Lower Medium Grade Baa3 BBB-BBB- Ba1 BB+BB+ Ba2 BB BB Non-Investment Grade Speculative Ba3 BB-BB- B1 B+B+ B2 B B Highly Speculative B3 B-B- Junk Caa1 CCC+CCC+Substantial Risks Caa2 CCC CCC Extremely Speculative Caa3 CCC-CCC-In Default with Little Ca CC CC+Prospect of Recovery C CC CC-In Default D D D BOND RATING CHART Note: City's current ratings for all general obligation debt are: AA+ from S&P and Fitch. Moody's has not rated the City's new bonds since 2011 but maintains a surveillance rating of Aa2 for any outstanding general obligation debt (2011 and prior).