[September 04, 2014]

Fitch Affirms Texas PSF Rating at 'AAA'; Outlook Stable

Fitch Ratings affirms its 'AAA' rating on the Texas Permanent School Fund's (PSF) bond guarantee program (BGP).

The Rating Outlook is Stable.

SECURITY:

Local school district bonds approved under the program are guaranteed by the corpus and income of the PSF. By law, a school district must notify the Commissioner of Education at least five days before a maturity date if it will be unable to pay debt service. Funds would then be transferred from the appropriate PSF account of the state treasury to the paying agent in an amount sufficient to pay debt service.

KEY RATING DRIVERS

RELATIVELY LOW-RISK BOND PORTFOLIO: The credit quality of the participants in the guaranteed bond portfolio remains strong. Nearly all of the bonds are backed by the districts' unlimited ad valorem tax pledge. However, the PSF has marginally increased some risk to the program by providing guarantees for certain charter school districts.

DISCOUNTED ASSETS PROVIDE STRONG COVERAGE: Under Fitch's stress scenarios, the discounted asset portfolio is sufficient to cover potential bond defaults for several years at a level that Fitch would expect from a 'AAA' guaranteed portfolio.

SOLID STATUTORY AND OPERATING PROVISIONS: Leverage limitations set by the state and federal governments enhance the program's guarantee.

STRINGENT PROGRAM OVERSIGHT: The state's oversight of Texas school districts provides added protection to bondholders against program bond defaults.

RATING SENSITIVITIES

DECLINE IN QUALITY OF GUARANTEED BOND PORTFOLIO: A material deterioration in the aggregate quality of the guaranteed bond portfolio could result in negative rating action.

DETERIORATION IN FUND ASSET QUALITY: Significant declines in asset quality due to market losses or changes in asset allocations toward securities to which Fitch gives little to no credit (e.g. land, alternative investments) could cause negative rating pressure.

INCREASE IN LEVERAGE: A material increase in the amount of guaranteed obligations relative to PSF assets as discounted by Fitch could cause negative pressure on the rating. However, Fitch believes that the program's current leverage limitations make this unlikely.

CREDIT PROFILE

The PSF is a perpetual endowment that was established in 1854 to support Texas public schools. As of July 31, 2014, the fund had a market value of $37.4 billion and a book value of $27.3 billion. Funds are invested in a diversified mix of equities; fixed income; land, minerals and real assets; and alternative investments, with a small allocation to cash. The PSF makes limited distributions to school districts to support their operations. Over the past several years, these distributions have accounted for only approximately 3% to 4% of the total fund and are capped at 6%.

On Nov. 8, 1983, Texas voters approved a constitutional amendment providing for the guarantee of school district debt by the PSF. The commissioner of education, an appointee of the governor, typically grants guaranties for voter-approved school district debt. Under law, a school district must notify the commissioner no later than five days before a maturity date if it will be unable to pay principal and/or interest due to bondholders. The law charges the commissioner to immediately instruct the comptroller of public accounts (the comptroller) to transfer funds from the appropriate PSF account of the state treasury to the paying agent for the bonds in an amount sufficient to pay principal and interest that otherwise would default.

RATING FACTORS CONSIDERED IN PSF ANALYSIS

Fitch's evaluation of the Texas PSF BGP considers three quantitative areas: the guaranteed portfolio's expected default risk, available PSF assets after discounting/liquidation stress, and the trend of leverage capacity. Fitch reviews the ability of the PSF to pay school district debt under stress scenarios consistent with an 'AAA' rating that would affect both the PSF's guaranteed debt and its asset portfolio. Fitch's review also considers three qualitative areas: guaranteed bond portfolio underwriting and monitoring, PSF investment policy, and fund distributions to schools.

GUARANTEED PORTFOLIO CREDIT RISK

As of July 31, 2014, the PSF's BGP had guarantees outstanding totaling $58.4 billion, up from $55.2 billion at fiscal year-end 2013. This total represented roughly 2x leveraging of the book value of the fund's assets as of that date. The current portfolio of 810 school districts is moderately diverse with the top 10 districts accounting for approximately 25% of total outstanding guaranteed bonds. The districts' credit quality is generally strong. Fitch estimates that over 50% of the outstanding guaranteed bond principal is in the 'A' and 'AA' categories. No Texas school district has defaulted on its debt since the Great Depression.

Beginning in May 2014, the PSF began issuing guarantees for bonds offered on behalf of a charter district by non-profit corporations. The guarantee capacity under the program is based on a ratio of charter students to public school students (currently 3.95%), as annually determined by the Commissioner of Education. Ths percentage is applied against the available capacity of the bond guarantee program. Currently, there are nine charter school districts with an aggregate principal amount of $273.3 million that are guaranteed under the PSF (0.49% of the guaranteed portfolio).

Fitch does not expect a significant concentration of charter school district bonds guaranteed under the program due to current capacity limits and stringent application requirements. However, the inclusion of charter school district debt, which is not supported by ad-valorem taxes like that of public school districts, marginally increases the risk of the BGP.

In analyzing the credit risk of the guaranteed portfolio, Fitch uses its Portfolio Stress Calculator (PSC). The PSC derives program rating default stresses based on overall pool credit quality as measured by the rating of issuers, size, bond term, and concentration. For the PSF, Fitch's 'AAA' liability rating stress hurdle is 51.9% This means that based on the credit quality of the portfolio, Fitch would expect program enhancement to be greater than 51.9% to attain an 'AAA' rating. In its stress analysis, Fitch also assumes a standard recovery rate of 90%, which would result in the portfolio's total loss of 5.19% for four years, or 1.3% annually.

AVAILABLE PSF ASSETS AFTER DISCOUNTING/LIQUIDATION STRESS:

In analyzing the sufficiency of asset coverage of PSF's investment portfolio relative to guaranteed bond obligations, Fitch relies on its market value methodology ('Rating Closed-End Fund Debt and Preferred Stock Criteria' published Sept. 4, 2014.) The calculation standardizes asset coverage by discounting portfolio holdings based on riskiness and diversification of the assets and measuring their ability to cover liabilities at the stress level that corresponds to the assigned rating (in this case, 'AAA').

As a baseline, Fitch used published asset discount factors based on the 45-60 business day liquidation window in an 'AAA' scenario. Under such stress, the invested asset portfolio, which had a market value of $20.1 billion on August 31, 2013, was risk-adjusted to $8.7 billion. In a further stress, Fitch calculated asset coverage using peak-to-trough discount factors, risk-adjusting the assets to $5.9 billion. Both cases afforded no credit to less liquid holdings such as land and alternative investments, which as of July 31, 2014 comprised 41% of the portfolio.

ANALYZING THE STRESS RESULTS

Fitch applied the guaranteed bond portfolio's stressed yearly loss of 1.3% and discounted portfolio values ($8.7 billion for a 45-60-day stress and $5.9 billion for a peak-to-trough stress) to assess the ability of the assets to pay school district debt. The results indicate that the fund provides sufficient capacity to cover losses from hypothetical defaulted school districts for several years under Fitch's stress scenarios.

PROGRAM LEVERAGE CAPACITY:

The BGP's leverage capacity is restricted by both state statute and IRS rules. While both allow leverage up to 5x the PSF's book value (which includes alternative investments to which Fitch gives no weight), the State Board of Education (SBOE) annually reviews the state capacity limit, which is currently 3x book value. SBOE must annually analyze its legal authority to increase the limit, insuring it does not violate federal law or jeopardize the bonds' 'AAA' ratings. As of July 31, 2014, the PSF's book value totaled $27.2 billion, and the state capacity limit was $81.75 billion. The BGP's leverage of $58.4 billion (including charter school district guarantees) was 2x the book value, well below the current state capacity limit and the static IRS limit of $117.3 billion.

The BGP's future capacity will be dependent upon the fund's investment performance, school district bond issuance and the state and federal limits. Fitch views positively the requirement that SBOE annually adjust the limit if the credit quality of the program is threatened.

DISTRIBUTIONS TO SCHOOLS:

In accordance with a constitutional amendment, the PSF makes annual distributions to school districts to support their operations based on a percentage approved by SBOE. The distribution comprises all dividend and interest income earned by the PSF, including unrealized gains/losses. Between 2006 and 2013, distributions averaged approximately 3% of the fund's market value annually. Fitch believes that the risk that distributions will hinder the PSF's ability to guarantee program debt is small because Available School Fund distributions account for only a small portion of the fund and annual distributions are limited each year.

GUARANTEE PORTFOLIO UNDERWRITING AND MONITORING:

BGP approval by the Commissioner of Education (Commissioner) is restricted to bonds that are voter-approved and backed by a property tax levy from an accredited school district, with the exception of certain charter districts. Approval is granted to districts issuing new money bonds for capital facilities; districts issuing refunding bonds which produce debt service savings; and districts with less than $1,982 annual debt service per student in average daily attendance at the time of the application for the guarantee. Fitch believes school district oversight in Texas remains strong. The Texas Education Agency (TEA), which is headed by the Commissioner, also provides control on school district credit quality by reviewing performance and financials annually. Charter school district bond guarantees require approval by the Attorney General, an unenhanced investment grade rating from a nationally recognized investment rating firm, and completion of a limited investigation conducted by the TEA.

PSF INVESTMENTS:

The PSF's financial assets, with a fair market value of $30.2 billion (excluding land assets) at July 31, 2014 are managed under the direction of the SBOE, with management duties delegated to the PSF's investment office, a division of the TEA. The investment objective is to grow the fund's market value to meet the required school district distribution rate while sustaining the market value for the purpose of the guarantee program.

Given that one of the SBOE's objectives is to grow the balance of the fund, approximately 40% is allocated to a mix of domestic and international equities, with another 41% allocated to alternative investments and the remainder to fixed income securities (mostly U.S. treasuries, government agency, and high-grade corporate obligations). Land, real assets and minerals, which had a fair value of $7.2 billion at July 31, 2014, are under the management of the School Land Board.

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

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria' (June 16, 2014)

--'State Revolving Fund and Municipal Loan Pool Rating Guidelines' (April 28, 2014)

--'Rating Closed-End Fund Debt and Preferred Stock' (Sept. 4, 2014)

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

Rating Closed-End Fund Debt and Preferred Stock

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=765528

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=865454

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