Fitch Rates Medellin At bbb+ But Capped By Colombia Sovereign BBB- Rating

Fitch Ratings has affirmed the Colombian City of Medellin’s Standalone Credit Profile (SCP) at ‘bbb+’. Medellin’s IDR is capped by Colombia’s sovereign rating of ‘BBB-‘/Outlook Negative, reflecting Fitch’s view that a subnational in Colombia cannot be rated above the sovereign.

The affirmation reflects Fitch’s expectations that Medellin will maintain an adequate operating performance and manageable debt levels in spite of the economic impact of the coronavirus pandemic. The payback ratio (net adjusted debt/operating balance) is expected to be around 9x over a five-year rating horizon. Secondary metrics are actual debt service coverage ratio (ADSCR) and the fiscal debt burden, which are expected to be below 1x and close to 90% in 2024, respectively. Medellin’s ratings reflect the combination of a ‘Midrange’ risk profile and a debt sustainability score of ‘a’ under Fitch’s rating case.

• Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘BBB-‘; Outlook Negative;
• Long-Term Local-Currency IDR at ‘BBB-‘; Outlook Negative;
• National Long-Term Rating (NLTR) at ‘AAA(col)’; Outlook Stable;
• NLTR of the senior unsecured notes for COP248,560 million issued in 2014 at ‘AAA(col)’.
• National Short-Term (NSTR) Rating at ‘F1+(col)’.

While Medellin’s most recently available data may not have indicated performance impairment, material changes in the central government’s debt, revenue and costs are occurring across the sector and likely to worsen in the coming weeks and months as economic activity suffers and government restrictions are maintained or broadened. Fitch’s ratings are forward-looking in nature, and the ratings firm indicates that it will monitor developments in the sector for their severity and duration and incorporate revised base- and rating-case qualitative and quantitative inputs based on performance expectations and assessment of key risks.

Risk Profile: ‘Midrange’

Fitch has assessed Medellin’s risk profile at ‘Midrange’, reflecting that all six key risk factors are assessed as midrange: revenue robustness and adjustability, expenditure sustainability and adjustability, liabilities and liquidity robustness and flexibility. In other words, Medellin’s risk profile is assessed as ‘Midrange’ because the municipality has presented a solid operating performance, a moderate level of indebtedness and high levels of capex, mainly financed with tax revenues, a significant amount of resources stemmed from Empresas Públicas de Medellín E.S.P. (EPM) and long-term debt. Furthermore, this risk profile is in line with that of the Colombian territorial entities rated highest by Fitch.

Revenue Robustness: ‘Midrange’

Medellin’s operating revenue is mostly made up of predictable and growing tax items (notably property tax and tax on industry and commerce) and stable transfers from the Colombian state (BBB-/Negative). Tax revenue rose at a nominal CAGR of 6.2% in the period 2015-2019, similar to the nominal GDP growth of 6.8% in the same period. Medellin’s tax revenues accounted for 45.9% of operating revenue on average in the last five years (2015-2019). According to their contribution to tax revenue, the most important taxes are property tax (IPU, its Spanish acronym) and tax on industry and commerce (ICA, its Spanish acronym), which accounted for 41.1% and 35.8%, respectively, in 2019. Fitch foresees a slower growth pace in Medellin’s operating revenues in 2020 and 2021, due to the effect of the coronavirus, but also considers recovery prospects afterwards due to the municipality’s economic strength. As of September 2020, the tax revenue of the municipality has fallen close to 10% year over year (yoy), in accordance with Fitch’s expectations for the sector. ICA has been the most affected tax revenue, decreasing by nearly 17% as this tax is closely linked to the economic cycle.

On the other hand, national transfers come from a sovereign counterparty rated at ‘BBB-‘/Outlook Negative. Fitch considers that the transfers framework and its evolution are stable and predictable. However, the fiscal pressures national government faces may lead to stagnation or even a reduction of transfers and could worsen in the current scenario of economic downturn caused by the coronavirus lockdown. Nonetheless, the city’s operating revenue structure presents a low dependence on transfers, so the exposure to this risk is lower for Medellin than for municipalities with lower fiscal autonomy.

Moreover, the total ownership of EPM has been a key factor in the municipality’s financial performance and an outstanding source of resources, as the significant amount of common and special financial surpluses transferred to the entity have increased its flexibility to finance capex and social investment (around 55% of EPM’s net income). This gives the city an incomparable position with respect to other Colombian entities during the pandemic. Financial surpluses transferred from EPM to Medellin in 2019 totaled COP1.3 trillion. For 2020, Medellin will receive COP1.5 trillion. If EPM’s financial transfers decrease, Medellin might eventually delay its capex plan or decrease social transfers. It is worth mentioning that EPM’s transfers are not used to pay debt service and liabilities with financial institutions.

Revenue Adjustability: ‘Midrange’

Given the relatively high proportion of local collection of total revenues, Medellin’s ability to cover a reasonably expected revenue decline is estimated to be above 50%. Medellin can set the rates for most of its taxes within the limits established by National Law. Besides, it has property tax rates that are far below the legal limit and its taxpayers can relatively easily afford potential rate hikes.

During the last five years, Medellin’s tax collection has shown a positive trend. This is because of good management of the fiscal model, the payment culture of taxpayers and the region’s economic performance. The economic base and activity are diverse, limiting risks of concentration in taxpayers. The municipality has implemented important fiscal strategies in order to continue its strong revenue collection using technology, in addition to new payment methods and regulatory and monitoring actions. In 2020 the municipality implemented specific fiscal stimuli or tax benefits to ease the impact of the coronavirus pandemic on taxpayers such as deferral of tax payments, discounts on taxes and reductions in interest and charges (Decree 678 of 2020).

Expenditure Sustainability: ‘Midrange’

Medellin’s main responsibilities are the provision of basic services such as education (payroll of both teachers and administrative personnel), healthcare (insurance and subsidies to low-income people), water supply, sanitation and transportation, among others; all of which are mainly addressed with transfers. In 2015-2019, even though operating expenditure growth has been superior to that of operating revenue in real terms (3.3% vis a vis 1.8%), Medellin’s operating margin, as per Fitch calculations, has been adequate and averaged 16.7% in the reference period. Fitch believes these responsibilities are moderately countercyclical and expects stable growth in the mid-term.

Despite extraordinary expenses related to health, Fitch expects that operating expenses will remain under control for the rest of the current administration. To tackle health contingencies, Medellín has allocated resources of COP236.5 billion (equivalent to 4.2% of total revenue in 2019). As of September 2020, total expenditure has decreased by 4.2% yoy despite a 37.5% yoy rise in health expenditure due to the pandemic.

Expenditure (Adjustability): ‘Midrange’

Medellin’s expenditure structure is relatively flexible despite the limited ability to cut some transfers earmarked for health and education as policies are decided at the national level. Medellin has moderate expenditure adjustability, given that operating expenditure for the central administration as well as for investment sectors was slightly above 58.3% of total expenditure from 2015 to 2019; while capex accounted for 40.1% of total expenditure in the same period. The observed expenditure composition includes adequate capex, financed with operating balances and EPM’s resources, which in Fitch’s view denotes a moderate margin to cut expenditure.

Medellin is about to sign a co-financing agreement with the national government in order to finance an important transport infrastructure project, Metro de la Via 80. Medellin has assumed Future Budget Allocations (FBA, authorizations against tax revenues in future budgets for paying certain expenses) for up to COP1.3 trillion for this project between 2020 and 2034, which adds some inflexibility to the expenditure structure. The current administration is planning to increase capex, as a countercyclical measure to boost the local economy amid the coronavirus pandemic.

Liabilities and Liquidity (Robustness): ‘Midrange’

Although the local framework imposes debt limits, rules and restrictions on some debt instruments, some loopholes exist for treating off-balance-sheet risks, since prudential limits only consider the direct debt of local and regional governments (LRGs). As a response to the coronavirus pandemic, decree No. 678 eased the solvency (interest payment to operating balance) and sustainability (outstanding debt to current revenue) limits during 2020 and 2021. Thus, the municipality will surpass the limit of 80% of the sustainability metric only in 2021 with the aim of reactivating local economy. For 2021, Medellin will take COP344.3 billion.

As of August 2020, Medellin’s outstanding long-term debt balance was COP1.92 trillion. Around 35.9% of Medellin’s long-term debt was denominated in foreign currency (taken with AFD) and close to 73% was tied to a floating interest rate. In addition, the balance of bonds outstanding reached COP248.6 billion, accounting for 13% of total direct debt. The interest rate on the floating rate tranche of Medellin’s external debt (six-month Libor + 1.7%) will be changed to a fixed interest rate, hence, the municipality would save in interest expenditure and eliminate the exposure to interest rate risk. In December 2020 Medellin will take COP120.0 billion of additional debt. Metro de Medellin, project manager, will take on debt due in 2034 in order to finance Metro de la Via 80. This debt will be covered 70% by the national government and 30% by Medellin with FBAs. At this moment, the financing mechanism that will be used and the debt amount are uncertain. Fitch will monitor the final characteristics of the project in order to assess debt sustainability metrics in a timely manner.

Liabilities and Liquidity (Flexibility): ‘Midrange’

Fitch believes Medellin has better liquidity management, as it has both a larger liquidity position and better access to short/long-term loans with local banks whose counterparty is rated in the ‘BBB-‘ category. In addition, in the short term, the city may borrow up to 1/12th of its current revenue and must repay these loans before the end of the fiscal year. Finally, the Colombian government does not provide emergency liquidity support when LRGs are under pressure. At the end of the year, the city has a high proportion of restricted cash, which moderates its liquidity position. This is offset by adequate guidelines in terms of excess liquidity management.

It is worth mentioning that Decree 678 of 2020 allows territorial entities to contract short-term debt in 2020 and 2021 the purpose of which is exclusively to deal with temporary cash shortages in both operating and capital expenses. These loans may not exceed 15% of current revenue and must be repaid before next fiscal year end and will not be included in calculations of legal limits.

Debt Sustainability: ‘a’ Rating Category

Under Fitch´s rating case the debt payback ratio (net adjusted debt/operating balance), the primary metric of debt sustainability for Type B LRGs, is expected to be around 9x over a five-year rating horizon with a score of ‘a’. Secondary metrics are actual debt service coverage ratio (ADSCR) and the fiscal debt burden, which are expected to be below 1x and close to 90% in 2024, respectively. Fitch includes in its analysis Medellin’s recognition of the obligation with the national government for Medellin’s metro infrastructure financing and considers it an intergovernmental obligation. Thus, the enhanced synthetic coverage ratio, which does not include Metro’s financial obligation, is roughly 2x.

Additional Rating Factors: Fitch calculates enhanced debt sustainability metrics that exclude the metro obligation from debt sustainability metrics to assess a subsequent improvement in the SCP. At present, Medellin’s SCP is strong enough to support current ratings, so this improvement is not used. However, if there were a moderate deterioration in the SCP, an uplift could be considered by using the enhanced payback ratio. According to Fitch’s rating case, the enhanced payback ratio would be below 5.0x.

The City of Medellin is considered Colombia’s second-most important city, after Bogota, contributing approximately 7.3% of GDP, according to the National Administrative Department of Statistics (DANE). The local economy is mainly based on services and commerce, although Medellin is a hub for many industries relevant to national and international trade. The city sustains strong socioeconomic indicators with higher coverage of public services, education and health than national standards. Due to inward migration, Fitch has observed the need for infrastructure in various social sectors. Fitch classifies Medellin, as for all Colombian LRGs, as type B as it covers debt service from its cash flow on an annual basis.

Derivation Summary

Medellin’s ‘bbb+’ SCP is derived from a combination of a ‘Midrange’ risk profile and adequate debt metrics, which result in a debt sustainability score of ‘a’ under Fitch’s rating case. The SCP also factors in a comparison of Medellin with peers, particularly with Barranquilla, Colombia whose SCP is ‘bbb’. Medellin’s IDR is not affected by any asymmetric risk or extraordinary support from the Colombian government. Finally, Fitch applied a rating cap on Colombia’s sovereign rating of ‘BBB-‘/Outlook Negative in recognition of a certain degree of interdependence between subnational finances; given the fairly centralized framework. Hence, the municipality’s IDRs are ‘BBB-‘/Outlook Negative. The NLTR of ‘AAA(col)’ was derived from the ‘BBB-‘ IDR, while the NSTR of ‘F1+(col)’ was derived from the NLTR.

Key Assumptions

Fitch’s rating case scenario is a “through-the-cycle” scenario, which incorporates a combination of revenue, cost and financial risk stresses. It is based on the 2015-2019 figures and 2020-2024 projected ratios. The key assumptions for the scenario include:

• Growth in taxes and other operating revenues (fees, fines and others) in real terms is similar to the national GDP in the long term, with a drop in 2020 followed by a full recovery in 2022.
• 6% nominal growth of transfers, according to the national budget. From 2021, growth is a four-year moving average of nominal national GDP growth;
• Real operating expenditure growth of 3% in the long run, with a temporary real growth rate of 6% in 2020.
• Capital revenue will perform as EPM’s financial surpluses do, hence it will be COP1.5 trillion in 2020 and as from 2021 it will increase linked to inflation rate.
• Capex is adjusted according to the decrease in the operating margin, capital revenue and new borrowing with a five-year moving average floor.
• Debt level considers Medellin’s projections.
• Fitch’s adjusted debt includes an estimate of Medellin’s obligations with the national government for the financing of the original infrastructure of the city’s metro system.
• Interest expenditure does not include that related to intergovernmental debt.
• Apparent cost of debt at 9%.
• All cash is considered restricted.

Rating Sensitivities

Factors that could, individually or collectively, lead to positive rating action/upgrade:

• Medellin’s IDR is capped by the sovereign rating. A stabilization of the outlook would be possible only if the sovereign outlook is stabilized.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

• Medellin’s Long-Term IDRs could be downgraded if the sovereign rating is downgraded. If the enhanced payback ratio exceeds 9.0x steadily under Fitch’s rating case coupled with an actual debt service coverage ratio below 1.5x and assuming no changes in the risk profile Fitch could consider a downgrade. This could happen if the entity incurs long-term debt in addition to that considered by Fitch or an important deterioration in the operating balances.
• A prolonged pandemic impact and a much slower economic recovery lasting until 2025 would pressure municipality tax receipts. Should Medellin be unable to proactively reduce expenditure or supplement weaker receipts from increased central government transfers, this may lead to a downgrade.

 Best & Worst Case Rating Scenarios

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579].

Summary of Financial Adjustments

• Net adjusted debt considers other Fitch classified debt.
• Adjusted debt considers the difference between net adjusted debt and unrestricted cash.
• All cash is considered restricted.
• Operating revenues do not include a fiscal surplus from previous years and expenditure does not include fiscal deficits from previous years.
• Fitch does not consider cash proceeds from Fondo Nacional de Pensiones de las Entidades Territoriales (Fonpet) used for pension payments or other expenditure made with these resources.
• Fitch’s adjusted debt includes an estimate of Medellin’s obligation with the national government for the financing of the original infrastructure of the city’s metro system.
• Fitch classifies as capex some operating expenses linked to investment expenditure and financed with EPM’s surpluses.