Illinois municipalities eyeing pension obligation bonds to deal with the strain of public safety contributions received a shot across the ratings bow this week as Moody’s Investors Service cut East Moline’s rating by two notches as it preps a POB.
Moody’s dropped the city to Baa2 with a stable outlook from A3 with a negative outlook.
The city’s views its plan to sell $41 million of taxable general obligation bonds to pay off its public safety net pension liabilities as a prudent step that will save tax dollars in the long run — if the arbitrage play on interest rates pays off.
Moody's raised concerns over the risky strategy but said the borrowing itself didn’t drive the downgrade.
Moody’s attributed its action to the sum of the city’s bonded, pension, and other post-employment benefits burdens.
“The downgrade was really driven the high leverage,” Ryan Patton, Moody’s lead analyst on East Moline, said in an interview along with Tom Aaron, a public pension specialist.
In reviewing the credit profile ahead of the deal, analysts found the city had one of the highest leverage ratios compared to operating revenues among all municipalities it rates nationally. “The fixed cost is an issue we’ve been watching for some time,” Patton said. The city's total leverage from debt, pensions and OPEB is 8.2 times operating revenue.
East Moline is a non-home rule city of 21,000 in western Illinois along the Mississippi River.
The use of POBs may not have been the driver but as a strategy for managing liabilities it does pose “additional credit risk” and that’s “certainly a credit negative,” Patton said. The rating agency last reviewed the credit two years ago.
The downgrade underscores the complicated picture and stigma attached to POBs. Backers promote them as a good option when used under the right economic circumstances but the Government Finance Officers Association recommends against due to the arbitrage risk that the investments purchased with the bonds could return less than the interest the issuer pays out on the POBs.
“Our general view on pension is credit neutral at best and usually negative,” Aaron said. The current low interest rates might lure government borrowers “but those same low interest rates work against” the government and pension fund as investor.
“Ultimately, not all POBs are the same” and that matters in the credit review, Aaron said. Strictly paying down liabilities is best but others resemble deficit financing with capitalized interest or proceeds going to cover near-term contributions or back-loaded amortization schedules.
“Not every pension bond is the same and not every pension bond will have the same credit impact,” Aaron said.
East Moline’s pension bonds solely pay down the liabilities for the police and fire pension funds and have level debt service of approximately $2.8 million annually through 2040 and there’s no capitalized interest, Patton said.
East Moline officials expressed disappointment in the downgrade as they believe Moody’s overlooks the positive impact of using the proceeds to fully cover the city’s unfunded liabilities.
“They based their downgrade on pension burdens and high OPEB costs. The Pension Obligation Bonds we are getting prepared to issue is an effort to stabilize the growing pension burden through level debt service to address these concerns,” East Moline Finance Director Annaka Whiting said in an email.
Baird is underwriter and Speer Financial is advising the city. The City Council approved the borrowing Monday. The borrowing will bring the city’s GO debt level to $66 million.
“We have also received cooperation from our police and fire unions on limiting retiree health insurance benefits for future employees which will help reduce our OPEB liability,” Whiting said. “We are confident we are heading in the right direction regardless of Moody’s rating decision.”
The city’s police fund was 51% funded and its firefighters fund 61% at the close of 2020, according to the city’s financial results. The city reported unfunded pension liabilities of $67.1 million, $37 million for police and $30 million for fire. The city participates in the statewide Illinois Municipal Retirement Fund for its general employees and that is well-funded.
The city began exploring POBs as a means to reduce the accelerated rate in which the cost of the pensions would increase in the next 10 years. “The debt service would level off those payments, reducing the burden on both the city and residents,” Whiting said.
In addition to a GO pledge, the bonds are secured by tax receipts levied for police and fire pensions and corporate purposes, distributions of personal property replacement taxes and sales taxes collections distributed by the state.
Local governments outside Chicago are required under a state mandate for public safety funds to reach a 90% funded ratio by 2040. If local governments don’t make an ARC payment, pension funds for the last several years have enjoyed the ability to file claims to intercept various tax or grant revenues that flow through the state.
Whiting said the city has never been under threat of a state intercept. The Illinois Municipal League is pressing for legislation that would extend the date 2050.
Moody’s said growing OPEB and pension costs have contributed to operating deficits for East Moline but overall cash levels remain sound and the city’s management reduced expenses to stabilize operations in 2020 and maintains adequate reserves. Financial operations are stabilizing and the city enjoys ample liquidity across governmental funds and enterprises.
The city is receiving $2.8 million, half of which is being received this month and the other half next year, under the non-entitlement unit of government American Rescue Plan Act allocation for coronavirus relief. Whiting said the city is still weighing how best to use the funds as part of its budget process.
Pension-related borrowing is on the uptick this year compared to recent memory, said Lisa Washburn, chief credit officer at Municipal Market Analytics. At least $10 billion has been sold to date although the Bloomberg data includes a broader range of pension financings, such as Illinois’ $850 million issue which earmarked just a portion for a pension buyout program, Washburn said.
“Timing is critical,” Washburn said. “Those that issue POBs at the wrong time may end up having to pay both the debt service costs and cover added contributions related to investment underperformance. I don’t think municipal governments should be able to gamble with taxpayer money.”
Several other Illinois municipalities around the Quad Cities region that includes East Moline are considering POBs also, according to local published reports.
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