Though a spike in interest rates is largely responsible for the decline in pension obligation bond issuance in California, the Howard Jarvis Taxpayers Association may have played a role.
In 2021, the anti-tax organization began challenging lawsuits that local governments had filed seeking expedited judgment to validate proposed pension obligation bond issuance.
Most cities abandoned the validation lawsuits when the taxpayer's association filed challenges, but San Jose and Escondido responded and won in lower court and appeals court.
While the market still prevents POB sales, the parties could be taking the fight to the state Supreme Court, if the high court grants a review.
"These got really popular when interest rates were low," said Laura Dougherty, staff attorney for the taxpayer's association. "They thought money could be saved, if they borrowed low and invested the money to reap a higher return."
Pension obligation bonds are taxable bonds issued by a state or local government to pay down obligations to the public agency's retirement system.
The bonds are fundamentally a calculation that the issuer can borrow at a lower interest rate than that money would earn in the pension fund through investment returns. Higher bond interest rates up front make that harder to achieve.
"Pension obligation bonds are risky; and this is a huge debt instrument that clearly to us — invokes the constitutional debt limit provision," Dougherty said.
California was the biggest source of POB issuance when sales of the taxable debt instrument
At its height in 2021, California issuers sold more than $6 billion in pension-related debt, some as lease-revenue bonds and not the more traditional pension obligation bond structure, according to data provided to The Bond Buyer by the California Debt and Investment Advisory Commission.
But the party petered out when the Federal Open Market Committee began raising rates after holding them near zero as recently as first quarter 2022. In March 2022 the hiking cycle began, and after 11 hikes, culminated in a rate between 5.25% and 5.50% in July 2023. Although rate cuts have been expected,
In 2022, the volume of pension bonds fell to $1.07 billion.
Dougherty filed challenges to 12 pension obligation bond validation lawsuits, resulting in 11 cities and Riverside County deciding to back away from efforts to issue the debt.
The cities are Alameda, Cathedral City, Chico, Fullerton, Indio, Lomita, Sebastapol, Simi Valley, Susanville, Vernon and West Covina.
"Most of the time I have been practicing law, if Howard Jarvis or a gadfly responded to a validation, the city would stop, because they don't want a contested validation," said Cyrus Torabi, a partner at Kutak Rock, who said his remarks are his own, he's not speaking on behalf of the firm.
San Jose decided to respond to the taxpayer association's challenge of its validation suit and prevailed in Superior Court, and on April 29, the California Sixth Circuit Court of Appeal affirmed the lower court's decision. Escondido in San Diego County also decided to respond to the challenge to its validation lawsuit, and also prevailed in Superior Court and then had the decision affirmed by the California Fourth Circuit Court of Appeal.
"At this moment, we don't plan on moving forward or doing anything with pension obligation bonds, because it wouldn't quite pencil out," said Rick Bruneau, San Jose's director of finance. "Where rates are today, we aren't in a position that we would recommend issuing pension obligation bonds."
The city had asked the court to validate a $3.5 billion POB. As of June 2023, the city's total unfunded liability was $3.25 billion, Bruneau said, adding he thinks the higher amount was the amount of the city's unfunded liability in 2021, when it first broached issuing a POB and filed the validation lawsuit.
If the city did issue the debt, he added, it would be in tranches topping out at $1 billion and the market conditions would have to be right. Pension reforms implemented by the city in 2011, like creating a lower tier of benefits for new employees, also put the city on track to have its unfunded liability paid down by 2040, so the bond maturities would have matched that reality, Bruneau said.
San Jose officials are waiting to hear whether the state Supreme Court will uphold the decision to validate issuance of the bonds, Bruneau said.
The taxpayer's association on June 10 filed a request for review with the state Supreme Court in the San Jose case and is still waiting to hear whether the high court will grant review.
Though market conditions don't favor issuing this type of debt now, Bruneau said, it's another tool in the toolbox.
"It's not something we would eagerly move into without a lot of caution about what the potential implications would be," he said.
Dougherty challenged both cities' validation cases on constitutional grounds, arguing debt issuance that exceeds the city's debt ceiling has to be approved by voters.
"It's been part of the constitution since 1879, and that is what we are standing up for. It is a matter of informed consent," she said.
In the Escondido ruling handed down June 24, the appeals court agreed with the city's ruling that the issuance of pension obligation bonds does not create a new indebtedness or liability for purposes of the California constitutional debt limit, Torabi wrote in a client brief. The finding was the same one it had handed down in the San Jose case in April, he said.
The appeals court held that POBs merely "change the form of an existing indebtedness (pension obligations) from an obligation payable to the California Public Employee Retirement System to one payable to bondholders," he wrote.
In her brief to the state Supreme Court, Dougherty said she "highlighted that the court of appeal did something radical by saying the constitutional provision doesn't apply."
One issue is that unfunded liability is always a fluctuating number, it's an estimate, so you don't always know what it is, while issuing pension bonds would set an amount, Dougherty said. So it's not really exchanging like for like, she said.
The other issue she raises is the courts ruled in a 2011 Orange County case that unfunded liability is not existing debt, so you can't vote on it. But, when bonds are issued it becomes debt, she said.
In the Orange County case, officials filed a lawsuit seeking validation to go to voters to reduce lofty pension benefits granted during better times. The court ruled in that case that unfunded liabilities and enhanced benefits are just estimates, so it's not existing debt.
Dougherty contends that contradicts what the appeals courts have said in the recent POB validation cases.
Though S&P wrote in a January report that POB issuance had halted in 2023 primarily due to high interest rates, Todd Kanaster, a director at S&P Global Ratings, said the debt instrument could come back into favor in a few years.
"Since the consumer price index has gone down to 3%, our economists say it could drop to 2% within the next couple of years," Kanaster said. "That means, rates could be coming back down. If that happens, it's logical to expect POB issuance to come up again."
Given the time it takes to structure a bond deal, there would be a lag between the drop in interest rates and a pickup in issuance, he said.
If San Jose receives its validation, Bruneau said the city plans to establish a POB policy to be approved by the City Council, because the vote to seek a validation judgment received a 9-2 vote and the finance staff would prefer unanimity before making such a move, he said.
"If all the sudden tomorrow rates dropped to zero and the courts had cleared it, we could fast track establishment of a POB policy, or bring it concurrently with the work toward a bond sale," Bruneau said. But he would only consider that if "conditions were so prime we wouldn't want to miss the window."
He said, however, he thinks the country will be in an elevated interest rate environment for some time.
