Governments increased their use of pension obligation bonds in 2021

A new report from S&P Global Ratings highlights an increase in debt issuances from pension obligation bonds (POB) rated by S&P in 2021. As of mid-Sept. 2021, the number of pension obligation bonds rated by S&P has already more than doubled the previous annual total. In dollar terms, the report says that with 3.5 months remaining in the calendar year, the pension obligation bonds issued this year had totaled $6.3 billion compared to $3 billion in pension obligation bonds issued in all of 2020.

A pension obligation bond (POB) is a taxable bond usually issued by state or municipal governments to cover normal annual contributions or unfunded accrued actuarial liabilities (UAAL). While there are multiple reasons governments issue POBs, interest rate savings or arbitrage are central to the logic behind issuance. It is expected that the rate on the bond issued is lower than the expected rate of return on pension assets.

The S&P report authors contend “low interest rates and accelerating pension costs will continue to spur [issuance].” The GMS Group recently quoted a 20-plus year AA municipal bond yield of 2.93 percent—several percentage points lower than the assumed rate of return of state and municipal pension plans.  Data from the California Debt and Investment Advisory Commission shows that several California local governments issued POBs at a true interest cost of less than 2.8% in 2021 (true interest cost is the annual percentage rate a bond issuer pays on the overall series of bonds including origination fees and expenses). These include Santa Cruz County, the city of Manhattan Beach, and Orange Unified School District.

However, as the S&P report also notes, “an increased spread does not mean free money; it indicates increased exposure to market volatility risk when proceeds are deposited in the pension trust.”

This “spread” is classified by Roger Davis at Orrick as risk arbitrage: “…borrowing against the credit of the state or local government and participating through the pension fund in a portfolio of investments that is designed to produce a higher yield and manage the higher risk through diversification.”

As Davis also notes, there is no guarantee this arbitrage opportunity is profitable.

S&P outlines that the projected savings are frequently offset with poor investment performance or other changes that are not seen at the time of issuance. The Government Finance Officers Association (GFOA) considers POBs “very speculative” and “involve considerable investment risk.”

Still, S&P Global Ratings maintains pension obligation bonds can reduce the variability of contributions and may make sense within a larger funding reform solution. On a cautionary note, the report does identify areas of risk.

Most notable is market timing risk—analogous to the market timing retail investors face. Putting a large sum of money in at one time subjects that sum to short-term volatility. It is generally considered less risky to “dollar-cost average” by making incremental purchases over a longer interval of time. The S&P report tracked similar approaches, “establishing a set-aside reserve fund, often an IRC Section 115 trust dedicated to pension.”

However, depending on the time interval, such a strategy may not pay off in the current financial market. The S&P 500’s price-to-earnings ratio is reaching highs only surpassed during the tech bubble. Outlined by Reason Foundation colleague Marc Joffe in late 2018: “The worst time to issue a POB is near a market top, but, of course, it is impossible to know ahead of time that the market is peaking.”

Only time will tell whether the current rise in pension obligation bonds was well-timed or not but policymakers and public pension stakeholders should closely monitor whether these bonds and the assumptions driving them actually provide the long-term cost savings hoped for.