The Federal Reserve’s effort to rein in inflation might be closing the window on state and local governments’ opportunity to reduce pension burdens by issuing pension obligation bonds. These pension obligation bonds are frequently used by public employers with large pension liabilities. But do they benefit the governments that issue them?
If assets acquired with public obligation bond (POB) proceeds yield more than the bonds’ interest and issuance costs, the government will have additional resources to meet its pension obligations over the life of the bond. For POB deals to work out, asset returns must exceed debt servicing costs. While servicing costs are predictable, asset returns vary from year to year. For example, most public pension systems achieved very large positive investment returns in the 2021 fiscal year, but this year most pension systems will post negative investment returns.
Given the unpredictability of investment returns, it is advisable to issue public obligation bonds only when there is a large margin between expected returns and servicing costs to provide a cushion for prediction errors. In late 2021, a big difference between POB interest rates and assumed returns on assets arguably existed for many issuers, offering a healthy margin. Now, however, with borrowing costs rising, this cushion has eroded.
A popular measure of municipal borrowing rates is the Bond Buyer 20 Index. Because this index relates to tax-exempt general obligation bonds with an average rating of AA (just two notches below the highest bond rating) and a maturity of 20 years. It is not necessarily representative of rates paid by issuers of taxable pension obligation bonds with varying ratings and maturities. But movements in the Bond Buyer index should roughly parallel the rates that will be paid on POBs.
The Bond Buyer 20 Index reached its most recent trough of 2.05% last December compared to its post-pandemic low of 2.03% set in August 2020. But in early 2022, the index spiked, reaching 3.57% in mid-June.
A couple of recent pension obligation bond issuances illustrate the trend in POB debt service costs.
Among the most economical pension obligation bonds were those issued by the town of Andover, Massachusetts, in Dec. 2021. The deal includes 15 different maturities with interest rates ranging from 0.649% for one-year bonds to 2.793% for the longest-dated bonds maturing in 2039. When considering both the range of maturities and the costs of issuance (fees paid to underwriters and other service providers), the true interest cost of the bond issue was 2.367%. Andover benefited by issuing at a time of low interest rates and from receiving a top AAA rating for its bonds. AAA-rated pension obligation bonds are relatively rare because most POB issuers have some degree of financial stress.
More typical of what most prospective POB issuers can expect in today’s environment was the recent experience of Barstow, California. In April, the city issued pension obligation bonds rated A+ with interest rates ranging from 3.109% for one-year money to 5.060% for bonds maturing in 2036. The true interest cost of the deal was 4.639%. Although Barstow’s rate was still below the 6.8% assumed rate of return currently used by CalPERS, the difference is relatively small, placing the city at substantial risk if CalPERS underperforms.
Another large pension obligation bond appears to be in the pipeline. Providence, Rhode Island, voters approved up to $515 million of pension bond issuance in an advisory referendum on June 7, 2022. Although the initiative won by a wide margin, turnout was only 4%, according to WJAR TV. Given deteriorating market conditions and the city’s low BBB+ general obligation bond rating, Providence officials should expect borrowing costs significantly higher than those recently encountered by Barstow. It is also worth noting that rating agencies often assign lower ratings to POBs than general obligations.
Average Investment Returns Can Be Misleading
Pension return volatility raises another issue for pension obligation bonds. If POB proceeds are invested into declining financial markets and lose value in the first year, those assets will have to work extra hard to make up the loss to meet long-term return expectations.
Let’s consider an 11-year timeline. If a system invests $1 million of pension obligation bond proceeds at the beginning of this period and then earns a consistent 7% return, the assets will be worth $2,104,852 at the end of year 11. If, however, the pension system loses 20% in the first year (which is 27 percentage points below the assumed rate of return), the system will have to earn an additional 2.7% each year to average a 7% return annually.
But this average of annual returns is misleading because if the pension fund loses 20% in year one and then earns 9.7% for the next 10 years, it would end up with fewer assets than if it had earned a consistent 7% for all 11 years. The value would be $2,019,093, representing a constant annual growth rate of only 6.6%. To fully make up the loss, the pension system would have to earn an additional 46 basis points each year for an annual return of 10.16%.
The more volatile the series of asset returns, the higher the average annual return has to be to achieve a 7% constant annual growth rate (CAGR). For example, if the pension fund sustained 20% losses twice over the 11 years, it would have to return 14.14% in the other nine years to break even. The unintuitive math behind all of this is well explained by Prosperity Thinkers.
It is worth noting that the timing of the investment losses does not matter in this analysis. A 10% loss in year one, offset by 10.16% gains in each of the following years produces the same result as annual 10.16% gains in the first 10 years followed by a 10% loss in year 11.
Higher interest rates and deteriorating equity market conditions should raise concerns in local governments considering pension obligation bond issuance. While pension obligation bonds may no longer make sense for most issuers in the current context, the future may bring new windows of opportunity. Whatever the general economic conditions, governments considering pension obligation bonds should carefully evaluate the costs, risks, and potential rewards before issuing these securities.
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