Green Municipal Bond Raises Questions About Pension Fund Borrowing

Last month the California State Teachers Retirement System (CalSTRS) floated $273 million of bonds to finance the construction of an extension to its headquarters in West Sacramento.  This innovative financing is notable both for its environmental aspects and its implications for pension finance.

Because the new CalSTRS office facility will be built using sustainable construction practices and will operate in an energy-efficient manner, it received a green bond certification from the Climate Bonds Initiative, an international body that puts its stamp of approval on environmentally-friendly bonds.

Not only will the new building be green, but Bloomberg reports it will also incorporate design features including “‘irresistible stairwells’ to encourage people to take stairs instead of riding an elevator and a cafe offering healthy meals with ingredients from the on-site garden.”

The bonds, which mature between 2023 and 2048, pay 4 percent or 5 percent annual interest. But, because they were sold at a large premium above face value, their initial yields were much lower. The shortest maturity bond yielded 1.02 percent, while the longest dated bond (which accounts for about 30 percent of the entire issue) yielded 2.21 percent.

Unlike pension obligation bonds issued by state and local governments, the CalSTRS bonds are tax-exempt because they are being used to fund infrastructure. The tax exemption on interest results in lower financing costs since investors are willing to take a lower yield to realize tax savings.

On the other hand, the CalSTRS bonds carry relatively low ratings. Moody’s assigned the bonds a rating of A1, two notches below the Aa2 rating the agency gives to the state of California. One of the two hits to this rating stems from Moody’s concerns about the lease revenue bond structure used for the financing (Moody’s assigns higher ratings to bonds backed by the obligor’s full faith and credit).  S&P rates the bonds one notch below the state of California’s bond rating, while Fitch applies the same rating to both the state and these CalSTRS bonds.

Likely as a result of the lower ratings, the CalSTRS bonds have slightly higher yields than California’s general obligation bonds. Recently, California general obligation bonds maturing in 2032 traded at 1.67 percent versus 1.72 percent for CalSTRS bonds maturing the same year. Although the climate bond certification from the Climate Bond Initiative may entice investors interested in environmental, social and governance issues, it is not clear that the certification lowers yields.

And it’s important to note that getting the certification does come with some costs. CalSTRS contracted with Kestrel Verifiers to verify that the bonds meet Climate Bond Initiative criteria, and, like any third-party assessment process, this verification involves out of pocket costs. The Climate Bond Initiative (CBI) also charges 0.001 percent of the bond’s face value for its services. Although CalSTRS must send annual updates to CBI to retain its certification (which will require some personnel time) there are no ongoing fees.

Overall, the costs of issuance for the CalSTRS bond were $2.5 million or 0.92 percent of face value (according to the official statement). While lower than the 1.02 percent average I reported for a large sample of bonds in a 2015 study, it is relatively high for such a large bond issue. Of the $2.5 million in issuance costs about a third went to underwriters, with lawyers, rating agencies and other service providers accounting for the rest.

The best measure of overall financing costs is the all-in true interest cost (TIC), which takes into account offering premium, costs of issuance and periodic interest and principal payments. Based on information in the official statement, I calculated an all-in TIC of 3.23 percent. An official number should appear on the state treasurer’s DebtWatch platform in the near future.

This financing cost compares quite favorably to CalSTRS’ assumed rate of return of 7 percent. Given the large gap between assumed asset returns and borrowing costs, it seems prudent for CalSTRS to borrow the funds on the municipal bond market rather than removing them from the system’s asset pool. Indeed, a CalSTRS internal analysis (see page 3) based on the 7 percent return shows a $55.8 million present value savings from using bond financing.

But the actual savings, if any, will depend on future returns, which are unpredictable. As my Reason colleagues, Leonard Gilroy and Zachary Christensen, have argued recently, we appear to be in a new normal of lower investment returns.  Ultimately though, even a lowering of assumed returns to around 6 percent would still leave the CalSTRS bond transaction in the black.

The CalSTRS bond offering bears enough resemblance to a pension obligation bond to merit skepticism, but the low, tax-exempt yields achieved by CalSTRS are reassuring.

Critics may note that some savings could have been achieved by relying on state financing, which could have been justified given the fact that a large portion of CalSTRS income is contributed by the state. And advocates of fiscal restraint may question the need for a costly new office, especially at a time of increased telecommuting, but that is a separate discussion. Setting aside the debate over the office and whether the new space is needed, in terms of the bond process, the innovative CalSTRS green bond appears to have been a good deal for California taxpayers and retirees.