As interest rates continue to rise, the draw of pension obligation bonds appears to be falling fast.
A financial instrument that has appealed to many municipalities to remedy underfunded pension plans is once again looking like a losing borrow and bet scheme.
“Typically, the biggest risk with POBs is market timing risk,” said Todd Kanaster, Director at S&P Global Ratings. “If the market takes a downturn within the first few years following issuance, it may be hard to overcome.”
POBs are taxable bonds issued by state and local governments to pump revenue into underfunded pension plans. The premise is based on a gamble that the bond proceeds will be invested, usually in the stock market, which will provide enough return to cover the debt service while bolstering the pensions.
But many muni thought leaders have been and remain skeptical about the basic arithmetic.
“When you take out a pension bond, you’re really moving a liability from your your left front pocket to your right front pocket,” said Bill Glasgall, Senior Director, Public Finance, Volcker Alliance.
During times of low interest rates and a soaring stock market the promise of free money can be hard to resist by an issuer eyeing a struggling pension fund.
“Pension funding bonds should not be viewed as a short-term budgetary gimmick or as a silver bullet for unsound contribution practices,” said Omar Daghestani, Managing Director, Public Finance, Stifel. “It is important to view pension funding bonds in the context of a broader, long-term strategy that addresses prior structural imbalances and maintains flexibility to deal with future changes in plan assumptions, longevity, investment returns, and other factors.”
S&P recently released a report predicting a continuing move away from POBs. Per the report, “POB and OPEB obligation bond issuance has been accelerating in the U.S. while interest rates have been low, but that shifted when interest rates spiked in 2022. A higher interest rate environment will likely lead to fewer opportunistic POB issuances, although we expect issued POBs will continue to be used as a budget stabilizer for volatile or rapidly increasing amortizations.”
Municipalities who invest in POBs are not naturally more vulnerable to credit rating scrutiny.
“I have worked on over 42 issues totaling $2.5 billion of pension funding bonds over the past three years. All those issues have achieved a neutral or positive rating impact.” said Daghestani
The high-risk transactions still fall under sound financial planning, if executed correctly “Typically, POB issuance is in line with current credit views and so doesn’t have a major impact on the rating,” said Kanaster. “POB issuance is only part of the overall credit picture and generally reflects broader considerations. An issuer with well-regarded management policies may be more likely to have well-regarded procedures in place for POB issuance.”
Even though many large municipalities embraced POB’s during the good times, the Government Finance Officers Association remains opposed to the instruments, as stated on its website, “POBs are complex instruments that carry considerable risk.” For municipalities who blow through the warning signs the organization has discussed banging out a list of POB best practice bullet points but so far it is sticking with its disapproval.
The fund managers have their own check-list. “Best practice is specific to each issuer, relative to the fund provisions, state statues and other considerations,” said Daghestani. ”Pension funding bonds benefit from spreading expected savings over the term of the structure, not extending the amortization and use of a contingency reserve fund. Fixed rate debt and use of a 10-year par call are also good policy.”
Data from an earlier report released by S&P Global in October of last year projected a 60% drop of POB issuances The states heavily relying on POBs are Michigan, Illinois, Arizona, and California. California used to be the largest source of POBs but reduced its issuance in 2022 while Illinois boosted theirs.
The Arizona State Retirement System developed an innovative public finance program designed to reduce the impact of slumping POB proceeds by way of a contribution prepayment plan. Coconino County, kicked in a $50.8 million debt-financed payment while Pinal County added close to $110 million.
The numbers attached to the problem can be overwhelming. Stifel estimates that aggregate unfunded pension liability for the 44,000 U.S. municipalities range from $1 trillion to $4 trillion, the upper end of that range being the size of all outstanding municipal debt combined.
Solutions to the problem may extend beyond economics.
“Substantive reforms are helpful and are an important element of any financing, but the cashflow benefits are usually limited initially and require significant legislative work,” said Daghestani.
Other creative financing alternatives to POBs are also generating some looks. Contemplating the sale of public assets is another possibility but privatization comes with its own set of risks.
“Numerous state, state and local governments have lots of lots of assets that are not managed particularly well. This could be air rights, land, buildings, solar, solar panel rights, and broadband,” said Glasgall.
Assuming the Federal Reserve’s tightening fiscal policy eventually yields results in the form of lower interest rates and a boost to the market, POBs could make a triumphant return.
“We have seen, over the past five years, increasing POB issuance as rates were low, dropping precipitously last year as rates increased,” said Kanaster. “If inflation does come back down, it would stand to reason that issuance and interest may pick up accordingly.