Benefits Bonds Revisited
Does it make sense to leverage pension and OPEB funds now?
Two years ago I wrote a column shattering the traditional paradigm of "pension obligation bonds" — the idea that a state or municipality could just borrow its way out of a pension deficit by selling bonds and investing the money in a higher-yielding pension portfolio. Back then we were in the jaws of the Great Recession, and if there ever was a time to issue what I had dubbed "Benefits Bonds" (for both pensions and OPEB retiree medical benefits), that was it. Ironically, that column ran ahead of the March 9, 2009 stock market bottom by 50 days, just enough time to prepare and issue a deal to capture the best conditions in history. Since that time, stocks have appreciated some 80 percent.
Only a few muni bond issuers took advantage of that window, as most were terrified to buy more stocks when it seemed like the world economy was melting down. Few were brave and clever enough to outsmart Mr. Market back then. Finance officers were battening down the hatches in preparation for layoffs.
So now that the market has recovered two-thirds of its Great Recession losses, the question is whether it still makes sense to issue taxable municipal debt to invest in risky securities to fund a pension or retiree medical (OPEB) plan. At this stage in the cycle, is it too late to employ this strategy and still sleep at night?
The right answer, of course, is impossible to know unless you have a magic crystal ball to tell you whether the next recession is months or years away. If we are about to double-dip into a secondary recession similar to the early 1980s or 1937, then the prudent strategy for now is to wait until stocks have declined yet again to bargain-basement levels. Back in October, when the major averages had fallen by 20 percent and news reporters were talking about a "bear market," it looked as if that scenario was about to unfold. The U.S. economic data also had turned punky, and there was serious concern about GDP stalling out. Then, the European community began to step up to what is now a trillion-Euro bailout plan that restored confidence that things over there won't melt down — unless the Greeks refuse to take their medicine. Meanwhile, the stock market has recovered by double digits. So the bargain pricing is gone, at least for now. If Europe unravels any time soon, or the US economy stumbles, it's a good chance that markets could revisit those earlier retracements.
Having researched 85 years of market history,* what I can contribute to the fact set important to municipal bond issuers considering a Benefits Bonds strategy is that since 1926, there have been 14 recessionary market cycles. Historically, the odds of stocks prices declining below one's entry point in the succeeding recession rose above 50-50 once the market rallied by an average of 58 percent from its bottom. In today's market context, that translates to a DJIA level of 10,175 and the S&P at 1052. Those benchmarks should suggest caution to anybody now thinking about issuance of debt to buy securities for the long term, as this cyclical metric for next-recession risk is no longer "cheap" by historical standards.
Of course, there is a theoretical counter-argument that the Great Recession was a six-sigma bear market and the historical averages are deceptive in this case because the market's decline was almost double the previous average. Before 2007, the long-term bear market average downturn was 25 percent, and we plunged 45 percent in the last selloff. So it's reasonable to believe that recovery from that severely depressed panic level can still leave us today with valuations that are reasonable for the long-term institutional investor.
Additional research that I have published in a prior column also shows that purchases of stocks during the Great Depression did in fact produce superior returns over subsequent 10-, 20- and 30-year holding periods, with the exception of investments made immediately prior to the double-dip recession of 1937.
Furthermore, the other side of my historical research shows that in the average market cycle since 1926, the subsequent recession took stock prices back to the same level they had reached in the previous peak. Using that metric and logic, however, one would have to believe that the next cycle will take stocks so high that they can then fall to the DJIA level of 14,000. Nobody in their right mind now forecasts that scenario, as it would imply the Dow rising to a level of 20,000 before the next recession ensues. "If only that were true", most Baby Boomers would tell you, because they would all cash out their 401(k) accounts, buy annuities and move to Fiji or Capri.
So where this leaves us today is that although there is a valid case that "this time it's different" (that the economy and markets have plenty of room on the upside), the risk of a double-dip recession should haunt anybody thinking about the use of leverage to fund a retirement plan mid-cycle in this New Normal economic "recovery period." Think of today's economy as a patient in the recovery room after open-heart surgery, while the Europeans fiddle around with the life-support system. That is perhaps the best way to conceptualize today's general market environment.
On the other hand, another international "scare" in the Eurozone could present a last-chance opportunity to complete a transaction and get proceeds invested before the economy gets out of the recovery room. Nobody can say for sure what the future holds in this regard.
In this context, the best strategy for those considering use of Benefits Bonds may be to discuss these cyclical dynamics with the decision-makers in a long-term strategic planning session, and consider something like one of these two approaches (possibly among others):
- Obtain authorization to issue Benefits Bonds during the next economic recession, in an amount sufficient to fund the plan to the 70 or 75 percent level by investing proceeds entirely in stocks (as explained in my previous column, since there is no point in selling bonds to buy bonds) or sufficient to fund an OPEB plan to the 50 percent level.
- Obtain authorization to issue 30 to 40 percent of that amount now, or upon a market decline of 10 percent, reserving the balance of the borrowing authority until the next declared recession. This approach assures that the employer spreads its market risk over two cycles while gaining some benefit from current valuations if those are deemed sufficiently attractive and prudent.
Both of these strategies require considerable research and "extreme caution" as the Government Finance Officers Association has declared in its advisory statements about the use of pension and OPEB obligation bonds. History has not been kind to most issuers of this kind of debt, because they naively sold at the wrong time in market cycles, so it is essential that you think this through. That said, with interest rates at record lows in the government market, a competent financial professional does need to develop a long-term strategy if the funding ratio of the retirement plan is now still below 80 percent even after the market's recent recovery. Just don't rely exclusively on "Monte Carlo" data provided by thirsty investment bankers who portray this strategy as nearly riskless over 30 years. You need to keep your job through the next recession!
*Note: Additional information on his historical research is available by contacting the author at email@example.com.
Disclaimer: Girard Miller's comments, suggestions and views herein are his own general opinions and do not constitute specific investment or issuance advice nor an offer to buy or sell securities. His independent views do not necessarily reflect those of any organization with which he was or is presently affiliated, including his employer PFM Asset Management LLC.