Why No Pension Bonds?

How Build America Bonds have crowded out 'Benefits Bonds.'
July 16, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  columnist
Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

Six months ago, I wrote a column explaining the economics of issuing taxable municipal bonds to pay off some of the unfunded liabilities of public pension funds and retiree medical (OPEB) trusts. I dubbed them "Benefits Bonds." Back then, I had expected that by mid-year, the municipal bond market would thaw enough to enable states and municipalities to re-finance their retirement plans with more affordable bond issues.

Guess what? It didn't happen. Even though the stock market now sits below where we started the year, and thus remains "discounted" by recent historical standards, the interest rates on taxable municipal bonds have actually climbed higher in many states.

The culprit? It's the Obama administration's Build America Bonds (BABs) that have waltzed into the taxable municipal market space and crowded out "benefits bonds." So far, BABs have been wildly popular in many states, because the issuer's net cost of financing is lower than conventional tax-exempt muni bond interest -- given the 35 percent federal interest subsidy that BABs receive. So a 7 percent BAB actually costs a state bond issuer only 4.55 percent.

BABs are popular with pension funds and foreign investors, which actually expands the market for state and local debt. That's a good thing. And certainly we would all agree that we'd rather see public agencies sell taxable bonds to fund their infrastructure under BAB rules to stimulate the economy than simply re-finance their pension funds with Pension Obligation Bonds (POBs). So as a matter of public-policy priorities, the market is working properly.

Sadly, however, the window for taxable benefits bonds (POBs and OPEB-OBs) might not open until such time as the stock market recovers so much that the returns on pension and OPEB trust funds will not outperform the borrowing costs of a bond issue. That remains to be seen.

This could change. If taxable municipal bonds become eligible for federal guarantees as they would under Representative Gerald Connolly's credit enhancement bill (HR 1669), there could be an open season on benefits bonds. That would actually be great for the stock market, incidentally, as there could be as much as a trillion dollars invested in equities if the benefits bonds window actually opens up through a federal credit backstop on taxable bond issues. More importantly, we could restore many public pension funds and retiree medical plans to proper funding levels despite the recent market malaise.

I'm not holding my breath, however. Public sentiment toward federal credit guarantees of municipal obligations seems rather tepid right now. Admittedly, with California teetering on the brink of fiscal meltdown, that could change rapidly if the political theatre turns into Armageddon. President Obama may feel compelled to launch Stimulus II on Labor Day if unemployment exceeds 10 percent as most expect, and there's a long shot that the package could include Connolly's muni bond provision. (See my companion column.) However, the mood among Congressional Republicans is anything but friendly toward bailouts for state governments right now. My previous column discussed the conditions and strings that would probably need to be attached to clear Congress.

From a financial markets investment perspective, there appears to be plenty of time to issue pension obligation and OPEB obligation bonds in this business and market cycle. As you can see from the chart below, the economy is not getting better yet: it's getting less worse, which means we haven't yet reached the trough of this recession.

Graphic: PFM Group

Another tidal wave of residential mortgage foreclosures is coming, and commercial real estate looks even worse. That means the housing industry will suffer for many months to come. Until the economy is actually growing and enters its recovery stage, there should be ample time to invest for the long term using taxable bond proceeds -- as long as they carry interest rates well below today's 7 percent handles. Most issuers would be more comfortable with a borrowing cost at or below 6 percent, to reinvest in stocks that historically earn 10 percent. (As I've explained before, it makes no sense to sell taxable bonds to buy bonds in a pension portfolio; a smarter strategy is to sell only enough to purchase the equity share of the portfolio.)

Stay tuned for a future update in the event taxable market conditions turn favorable for this strategy. Those who are interested in issuing benefits bonds should start doing some groundwork soon, however, as the window won't last forever if a sustainable recovery gets underway in 2010. Historically, the interest-rate trough only lasts six months after the recession bottoms -- and stocks historically have rallied 40 percent from their bear-market bottom in the next 12 months. After that, the risks of losing money in the next recession begin to mount.