Will the BOBs Window Reopen?
Several large employers might get a second chance at benefit obligation bonds.
The rage in muni finance this year is BAB: the taxable Build America Bond that qualifies for generous U.S. stimulus subsidies. That helping hand from the feds can make a BAB cheaper to issue than a tax-exempt security. Taxable munis are the new asset class. Over $130 billion is projected to be issued this year, and Congress is now looking at a possible permanent extension.
Meanwhile, what about BOB? BOBs -- or Benefit Obligation Bonds -- are state and local bonds issued in the taxable market to fund retirement systems that are presently underfunded. (In a previous column I dubbed these "benefits bonds" to include pension obligation bonds and OPEB obligation bonds. Now that we have BABs, I'd rather call these BOBs.) The bond proceeds are used to make long-term investments for the pension fund or the OPEB trust. If done properly, the investments will yield higher returns than the borrowing costs, which can reduce outlays in the long run.
In the past year, very few municipal bond issuers sold BOBs, even when stocks were dirt cheap in the financial panic. Milwaukee County successfully sold pension obligation bonds in what appears to have been an opportune phase in this business cycle. Several Midwest school districts sold OPEB bonds at attractive rates in the recession to meet a statutory deadline for favorable taxing authority. Most states and municipalities, however, were too busy dealing with their budget crises. In an historical anomaly, taxable bond yields never followed Treasury bonds down to attractive low levels that would have made the strategy a no-brainer. So most potential BOB issuers stayed on the sidelines. Some now regret their hesitation, after watching the V-shaped stock market recovery from the depths of despair in March 2009.
BOBs will get a lot more attention in 2010-2011 if the Governmental Accounting Standards Board implements its preliminary views that pension funds should discount their unfunded liabilities using a high-grade municipal bond index rather than the investment rate of return. That sets the stage for what I'll call "GASB arbitrage" in the BOBs market -- a concept I will discuss more fully in a future column. In essence, the accounting rules would reinforce the virtuous economics of the BOBs strategy, notwithstanding the market risks.
As my prior research has shown, there is a specific time in the economic cycle when BOBs make financial sense: Interest rates must be low and stock prices must be depressed with a weak economy. Typically, this occurs at the bottom of a recession and during the early stages of economic recovery, as illustrated in the graphic below.
Graphic: PFM Group
My historical research of activity over 14 market cycles in the past 84 years has shown that when stock prices recover from the recessionary trough by more than 58 percent, there are heavy and growing odds that the next recession will bring them back down to that level -- or worse. This makes it increasingly risky for public agencies to issue BOBs when stocks have recovered significantly from the bottom and the economy is growing great guns again. Unfortunately, that is when many pension obligation bonds were sold in prior cycles -- by naïve issuers without the benefit of this research. Just look at the deals sold in 1999 and 2007.
The Great Recession of 2008-2009 brought stock prices tumbling down far more deeply than the average bear market (30 percent down in the past 14 cycles). So there is a case that even with the market's recovery in the last year, there is still plenty of upside room this time around. However, the countering argument is that we have entered a "new normal" and nobody should expect stocks and the economy to recover strongly in the next expansion -- which could well be weaker than normal.
I have been asked by several municipalities if this year's May through June stock market correction was sufficient to make BOBs a viable strategy in this market cycle. The answer is that right now we're right on the cusp. A 58 percent recovery on the S&P 500 sets a technical upper boundary on the pro-forma BOB window of 1068 on that index, and the market lately has flirted around that level, dipping below that mark briefly and then rallying back. For issuers using only that metric, it could still be argued that they are in the range of reasonableness. (There are other measures and metrics that a due diligence process can and should consider, as well as better ways to invest the proceeds besides the traditional pension fund's asset allocation.)
The problem for BOBs issuers at this point in the cycle is that it takes time to get a bond issue off the ground. If the economy resumes a more-normal recovery despite all the angst over Europe, there is a good chance that a POB or OPEB-OB issuer will be too late by the time they get their ducks in a row and sell the bonds, collect the proceeds and invest the money. Thus, the most prudent strategy at this point may be to wait on the sidelines, vet the issue with policymakers and be ready to pounce if the time is right. If the stock market falters in coming months, that would set the stage for an opportunistic entry point. If this sounds a lot like "market timing," it is not. It's more like "value investing" -- looking for the right combination of low borrowing costs (which the legendary Ben Graham would call his "margin of safety") and low stock prices relative to the long-term 30- to 50-year horizon of a retirement plan trust. The patient CFO will wait for the right conditions, and if they don't arise, simply wait for the next recession.
As my mother used to say when a teen-age love interest became enamored with somebody else: "Just wait for the next bus. There will be another bus."
The optimal strategy, in my view, would be to obtain governing body approval to issue BOBs on a standby basis -- with the understanding that the finance committee or elected treasurer approve the actual implementation if proper market conditions arise. My prior column explained the technical features of this strategy.
Nobody needs to rush to market to sell BOBs in this cycle unless today's fears of a double-dip recession or a geopolitical event drive stock prices yet lower. The strong supply of BABs this year has kept taxable muni yields at relatively high levels compared to what we might expect when the federal 35 percent subsidy is gone or replaced by a lower level of 28 percent (as proposed in the federal extension bill). The next recession may not present a blend of raw bond and stock prices that look as cheap as today's, but there will probably be more time to get things organized in the next cycle with less business risk and with less competition from taxable BABs.
In addition to that, we will have greater certainty about the accounting treatment of such transactions and the actuarial implications of the GASB's pension accounting standards for discount rates. That could be a material motivator for this strategy in the next recession -- and in time for the next bus.
Girard Miller's comments are his own and do not necessarily reflect the opinions of any organization with which he is affiliated. His general market observations are intended to encourage balanced deliberations and provide general strategies as part of a thorough due diligence process, and should not be construed as investment advice or a recommendation to sell or purchase specific securities.