A spike in pension obligation bond issuance by state and local governments last year that was spurred by low interest rates, roaring stock markets and other factors is likely to wane.
With the Federal Reserve raising interest rates this year to combat inflation and stocks and other assets tumbling in value, the ability to arbitrage by investing POB proceeds in assets that generate more than the rates on the bonds has greatly diminished.
Although cheaper stocks may be appealing in terms of the expectation of bigger future gains, rising interest rates will stymie new POB issuance, said Todd Tauzer, national public sector retirement practice leader at Segal, an employee benefits and human resources consulting firm.
“Because of that, there’s not going to appear to be much savings at all,” he said. “Since that is probably the best selling point for pension obligation bonds in a more normal environment, I think we will see a reduction in issuance.”
Longview, Texas, plans to issue $45.6 million of POBs in June to aid its underfunded firefighter retirement system after winning voter approval of the debt earlier this month.
“Up until the time we sell the bonds, we’re going to continue to monitor the market,” said Richard Yeakley, a spokesman for the city of 81,600 in eastern Texas. “It’s expected that those rates may only go up more during the course of the year. We’ve been looking at this bond pension issue for some time and we’re ready to move forward and waiting doesn’t seem like it would help the economic realities.”
As for sinking stocks, Yeakley said “it’s better to buy low.”
“In so much as if the market recovers we’ll see a greater return on the investment, certainly that would be good. We don’t have a crystal ball,” he added.
In November, S&P Global Ratings said it could downgrade the city’s AA rating “if the escalating pension liability for the firefighter's pension plan pressures the city's budgetary performance.” Longview’s actuarial consultants warned earlier this year that without changes, the fund is expected to run out of money within the next 20 years.
Between Jan. 1, 2021, through mid-September, S&P rated 64 POB issues totaling nearly $6.3 billion, a 113% increase over the number of issues it rated in all of 2020. The majority of the debt last year was sold by California and Arizona issuers.
In Arizona, POB issuance jumped in the wake of a recent state law permitting fire districts and others to issue POBs for their unfunded pension liabilities with the Arizona Public Safety Personnel Retirement System, according to Steve Murray, a Fitch Ratings analyst.
He said Arizona issuers set up contingency funds as a buffer for weak market performance or changes in assumptions.
“Having those contingencies in place gave us some comfort,” Murray said. “They're not a cure-all of course. The amounts are not huge. To get through an extended period of major decline, those contingencies may or may not be sufficient.”
On average, public pension systems invest about 47% of their assets in public equities, 24% in fixed income, 7.4% in real estate, and 19.4% in alternative investments, such as private equities, hedge funds, and infrastructure, according to the National Association of State Retirement Administrators. Investment earnings on a national basis have accounted for about 63% of all public pension revenue with the rest coming from employer and employee contributions.
Meanwhile, NASRA said the average investment return assumption for public pension funds has slipped below 7%, the lowest level in more than 40 years, as funds
The Fed reported that public pension assets totaled approximately $5.85 trillion at the end of 2021.
Once-in-a-generation investment returns of over 25% in fiscal 2021 lifted the funded ratio for state pension funds above 80% for the first time since 2008, according to The Pew Charitable Trusts, which is expecting returns to decline.
“With stock valuations well above historical averages and the Congressional Budget Office projecting that real gross domestic product growth — a major driver of equity returns — will be lower in coming years than in fiscal 2021, future returns are likely to drop as stock prices adjust,” a May 3
Since 2015, the Government Finance Officers Association has recommended
“Failing to achieve the targeted rate of return burdens the issuer with both the debt service requirements of the taxable bonds and the unfunded pension liabilities that remain unmet because the investment portfolio did not perform as anticipated,” GFOA’s advisory said.
The stock market drop could cause problems for recent POB issuers.
“The market right after issuance is very important in dictating whether the entire concept of the POB was a positive or a negative,” said Todd Kanaster, an S&P analyst. “If they issued right before a poor market, historically, that’s been hard to recover from.”
Through Friday, the
At a January Longview City Council meeting, a consultant from HUB International said that the biggest concerns about issuing POBs "are that we get some serious negative asset returns in the first couple of years. That would have a significant detrimental effect.”
In a recent report, Municipal Market Analytics cited Kansas, which sold $500 million of
MMA said the state assumed it would earn 7.75% from investing the bond proceeds while paying interest on the debt at rates from 0.207% to 2.774% depending on the maturity. Since the August bond sale, the S&P 500 stock index has declined and other asset classes are down as well, raising the prospect of higher pension contributions or the pursuit of more riskier investments, it added.
“The former option is affordable in the short term, as the state budget continues to generate a strong surplus, but the medium term is a different matter and has been made more difficult by the state’s recent passage of tax cuts,” MMA said.
A KPERS spokeswoman did not respond to a request for comment about the report.
With revenue exceeding estimates, Kansas recently passed a plan to phase out its 6.5% tax on groceries by 2025. Governor Laura Kelly also signed a bill last week to transfer more than $1 billion from the state’s general fund to KPERS.
Tauzer said issuers of POBs sold years ago have built up earnings from past asset growth, although they will lose some of that if stocks continue their slide.
“Whereas those that issued, let’s say in the second half of 2021, they don’t have any buffer and they’ve only seen negative investment returns,” he said.
Risky arbitrage is not the driving force for POBs, according to Jean-Pierre Aubry, associate director of state & local research at Boston College’s Center for Retirement Research. He contended they are mainly used to ease cash flow problems and fiscal stress by structuring the bonds to make payments less arduous in the near term.
“POBs can serve as part of a larger package where you are making other adjustments to the funding and the benefits and everything else,” he said.
Douglas Offerman, a Fitch analyst, said the condition of a retirement system and not the POB is the focus and that a rating will reflect if a POB is issued without changes being made to an unsustainable pension plan.
“On the other hand, if you made changes to your pension over time to create a higher likelihood of funding improvement, we would view (a POB) as relatively neutral in that context,” he added.
