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A Glass-Half-Empty Strategy for Public Pensions

If stocks keep declining, the outlook for pension obligation bonds improves. State and local financial teams should prepare now for a cyclical opportunity.

Glass half full/empty
At the risk of sounding like the broken clock that is accurate twice a day, I’d like to revisit the case for authorizing pension obligation bonds that could be sold if the stock market falls materially lower in 2022. With the Federal Reserve tightening interest rates, some market analysts now put the chances of a recession at about 50 percent, so this is becoming a plausible scenario with ramifications for public employers and their pension funds.

Those familiar with my previous writings on the POB window will recall that it’s been my view for 15 years that stock market cycles are what should drive the decision to borrow money in the muni bond market to shore up an underfunded pension plan — and not just because interest rates are low.

For those unfamiliar with the concept of POBs, the basic idea is that a public employer can borrow money in the municipal bond market at relatively low taxable interest rates and use the proceeds to reduce the unfunded liabilities of the pension fund, which in turn would invest in securities or other products with a higher long-term rate of return.

Skeptics would say that it’s like borrowing on a home equity loan to fund your IRA, and some professional associations have issued red-flag warnings about the strategy. Add to that the political challenge of convincing a group of elected officials that it’s a good idea to borrow money when their own 401(k) and IRA balances are shrinking every month. So this is definitely a contrarian concept.

Nonetheless, last year POB issuance ran higher than the previous five years, because financial advisers and underwriters naively pitched the idea when borrowing rates were low and stocks were at historical highs. Their clients are now suffering huge losses on the investment side of those transactions, which proves the folly of their one-dimensional thinking.

There is a smarter way, but it requires patience and skill: The best time to make lemonade from lemons is when stock markets are depressed — when the glass looks half empty, not half full. The history of modern capitalism is that stock market selloffs are eventually followed by growth periods that handsomely reward the investors who were greedy when others were fearful. Therein lies the thesis of the POB window: When stock indexes are down by more than 30 percent, the historical record is quite clear that investments in an equity portfolio at that point have reliably produced a materially higher rate of return than the lifetime interest costs of a taxable pension obligation bond. It’s not an everlasting opportunity, so we call it a “window” because it typically closes quickly once the economy starts to stabilize and stock prices start to recover.

I won’t revisit all the pros and cons of this idea in this column. That ground has been covered time and again. The last time I addressed the cyclical opportunity was in March 2020, in the early stages of the COVID-19 pandemic when stocks had plunged in value. The POB window that time was too short for most issuers to exploit, because stocks quickly rebounded as Congress, the White House and the pharmaceutical industry worked swiftly to take unprecedented measures to shore up the economy and fight the virus.

Anticipating Hairpin Curves

We’ve entered a different kind of bear market now, as rampant inflation and the consequent monetary tightening by the Fed have spooked investors, who fear a recession lies ahead. This time, it seems less likely that a magic pill will quickly rescue the stock market, and the Ukrainian conflict obviously is a troubling known unknown. Interest rates are still escalating and stock valuations are not really cheap by historical standards, so it’s hardly a free lunch at this point. But there are still good reasons to anticipate that stocks might fall further. As of last week, the S&P 500 index was down about 20 percent from its previous peak, after falling about 23 percent in mid-June and then recovering a bit.

The chart below shows how much stock indexes fell in previous recessions, which tells us that in mid-June we were just approaching the median level of cyclical price losses, but worse could come if a full-blown recession eventually follows this period of Fed tightening.
S&P 500 chart
Source: Wall Street Journal; data: Deutsche Bank
The setup today requires strategic thinking. It’s similar to buying a bargain-priced stock option for almost nothing beyond the cost of writing up documents and enduring skeptics in a public meeting. Success requires planning ahead, anticipating possible hairpin curves in the road, and executing through them in broad daylight with detractors second-guessing every move. Leading such an initiative requires homework, investment knowledge, self-confidence, credibility and stamina.

The basic strategy that I would suggest for public financiers is to lay the groundwork now for possible sales of POBs in the event stock market prices fall further, making the upside-downside risk-reward ratio even better. Ideally, this would coincide with a recession scenario; the possibility of a period of 1970s-style stagflation only disguises the opportunity.

So financial advisers and CFOs should instead approach their governing bodies with a proposal to authorize issuance of bonds that will be sold later, but only if stock market prices fall yet further — and upon explicit approval by the elected officials or their finance committee if they insist on blessing the timing.

The bonds’ authorization could also require that the borrowing rate cannot exceed a specified level, such as 4 or 4.5 percent, so it’s not a blank check and the probability of positive future net investment earnings is higher. Such a limitation will be out of reach for many issuers today, who would be best advised to wait until the sun, moon and stars align better for them, but getting the authorization approved now would enable those who can to act swiftly if the day comes to pull the trigger on a timely deal.

Such a pinpoint shelf authorization allows the professionals to work with bond counsel and “get ready to get ready.” The employer’s debt team would then be ready to sell bonds when timing is as close to ideal as any human can achieve. This requires the financial advisers and bond attorneys to work now and be paid later, if at all, so they need to put their fees at risk in their clients’ best interests. Staff should also open discussions with pension plan leaders about the investment of POB proceeds, as explained below. This all takes time, and markets can move faster than governing bodies, as we saw in 2020.

Sensible Strategies for POBs

I’ve often said that such deals should be tranched so that several entry points are staggered over time. Maybe 30 to 35 percent of the total authorization could be sold if the S&P 500 index trades below 3,400, and the remainder could later be issued if the S&P falls below 3,000 or even to some lower level. If necessary, a board finance committee’s approval could thereupon be required. Those details should be left to staff to outline in their proposal to the governing body, as there is no magical market or historical algorithm to rely upon. Bond underwriters will always push to sell as much as possible as soon as possible, because that is how they get paid, but a wise financing team will take a measured approach.

Financial advisers who single-mindedly peddle the POB concept when muni bond rates are low won’t like the idea of POB bonds with interest rates over 4 percent, even if the historical long-term return on stocks from depressed levels is typically well above 10 percent. So a 2022 POB issue should be callable — redeemable at the issuer’s discretion — in case taxable POB rates eventually decline, if and when inflation subsides. A small POB call premium, allowing redemption at five or 10 years, would be a meager price to pay. That’s having your cake and eating it too.

And equally important: While sending the POB proceeds to the pension fund is the standard paradigm, that is actually a suboptimal strategy. Why sell taxable muni bonds in order to fund a pension portfolio that invests a big chunk of its capital in other taxable bonds? There is no beneficial interest-rate arbitrage to achieve there, even in today’s market wherein bond prices in pension portfolios have been crushed right along with stocks. It’s a waste of borrowing capacity and advisory fees.

The better strategy, in my model, is to borrow less of the actuarial deficit and set up a POB trust fund, either inside or outside of the pension fund, to invest solely in a stock index fund. The total issue should never exceed half of the pension’s unfunded liabilities at market value so that the borrowed money can’t inadvertently finance future benefits giveaways. This eliminates unproductive investments, reduces the amount of leverage required, minimizes the costs of issuance and investment, and gives employers greater control over the entire funding process. For the pension trustees, it’s still a win-win: Any solution that improves their plan’s funding ratio is better than no solution.

The POB strategy is not for the faint of heart, and obviously it’s not foolproof. With today’s market conditions, it won’t work right now for employers with low-quality credit ratings as a panacea for their massive pension underfunding. But if the stock market and the economy continue to worsen materially, you can be assured that I’ll be back, pounding my drum on this concept. In the meantime, it makes strategic sense to get ready to get ready.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be considered investment advice.
Girard Miller is the finance columnist for Governing. He can be reached at
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