Sovereign Bonds: The tip of an iceberg
Detroit’s bankruptcy grabs the headlines, but Christopher O’Dea draws attention to an even more significant muni bond development: pension-funding bonds issued by high-quality deleveraging municipalities
It should surprise no one that the solution to public pension underfunding – one of America’s most pressing government-finance problems – might turn out to be a new fixed-income security. What would surprise is that the creator of the new bonds isn’t a new cadre of Wall Street securitisation wizards, but a symbol of Middle America itself – the State of Michigan.
Detroit’s Chapter 9 bankruptcy filing has dominated financial headlines from Michigan since July. But even as Detroit headed towards the abyss, the Michigan legislature in late 2012 passed PA 329, a law granting governmental entities that meet certain conditions the power, for the first time, to issue bonds to plug pension funding gaps.
This is the first comprehensive framework seeking to stimulate a credit market approach to resolving pension and healthcare underfunding, marking a genuine sea-change, but early signs are that both issuers and investors like the new structure. If Michigan’s approach catches on, it could prove to be the tip of a very large iceberg: the median funded ratio of state pension plan ticked below 70% in 2011, and the Center for Retirement Research at Boston College says unfunded pension and healthcare liabilities of state and local government entities in the US top $2.7trn, but most municipalities are potential pension bond issuers – Moody’s rates only 34 of 7,500 local governments below investment grade, with Detroit being one of those.
New financial reporting rules for US municipalities that spotlight pension underfunding also encourage consideration of bonds to reduce pension exposure – Governmental Accounting Standards Board (GASB) Statements 67 and 68 will require local governments to show unfunded pension liability as debt on their financial statements. To potential issuers, Moody’s notes that the impact of pension bonds can range from credit-negative (if bond proceeds replace annual contributions) to credit-positive (if bonds enable structural reform of a plan’s liabilities or ensure its funded status).
Michigan’s law requires municipalities to commit to serious reform. Issuers are required to produce and publish comprehensive financial plans demonstrating that the bond issuance and other financial resources will be sufficient to eliminate the underfunding, give public notice of the intent to issue the bonds, and agree the bond issuance will not exceed the municipality’s taxation limits, and the State Treasurer must approve each deal. Issuers must also de-lever – DB plans must be shuttered, and new employees moved to DC schemes.
Perhaps most important, Moody’s senior credit analyst Hetty Chang notes that PA 329 requires that pension-bond issuers have a rating of AA or higher from at least one national rating agency. “It’s the first time we’ve seen a rating threshold,” she says.
Michigan’s rating threshold recognises that, while there will still be problem cases, bonds can be an effective tool to obtain institutional capital to manage their pension-financing needs. Michigan townships are forging ahead – as IPE went to press, the first four Michigan 329 deals totalling nearly $1bn were pending, all rated AA or higher.
Ironically, the main delay in launching this new market is Detroit’s contention in court that Motown’s general obligation (GO) bonds are unsecured credit, a novel interpretation of the covenant that had previously been the highest security for municipal bonds. The rub is that PA 329 bonds are required to be backed by a ‘limited tax general obligation’ (LGTO) pledge. When Michigan passed the law, a LTGO covenant was the highest security pledge, a promise to repay creditors from all tax revenues available under a municipality’s taxing power. According to John Kamins, a leading municipal finance lawyer at Michigan firm Foster Swift, Detroit’s position that its GO bonds are unsecured rests on the argument that there is no specified revenue source against which bondholders have a statutory lien.
That uncertainty is hampering Detroit’s creditworthy neighbours from quickly tapping the bond markets under the new state law. As the first entity to announce a pension bond, Saginaw County’s underwriting was closely watched. Moody’s rates the bonds Aa3.
Detroit’s bankruptcy filing came just weeks before the Saginaw sale in early August. Lou Orcutt, a banker at Fifth Third Securities, Saginaw’s lead underwriter, said the bulk of the $60.5m issue sold in three, five and 10-year maturities at normal spreads over Treasuries – indicating that investors welcome the new pension-bond structure itself. However, investors looking at the longer-dated tranches sought protection against Detroit’s challenge to GO debt, seeking an additional premium of between 35-50 basis points on maturities from 12 to 20 years. That additional debt service made it uneconomical to complete the sale in August.
The county will try again in the autumn and it’s easy to see why – the proceeds would swing the pension plan from 63% funded to as high as 115%, and stabilise the county budget. Retiring the bonds, with a final maturity of 20 years, would cost between $4.6m and $4.8m per year and leave the pension system fully funded – as required by the new bond law and preferred by Moody’s – while, otherwise, annual pension contributions would rise from $4.5m in 2012 to $11m annually in about the next five years, a hefty sum for a county whose general fund budget is just $44m.
Moody’s notes that there is no free lunch – issuers will remain exposed to additional pension costs if the returns on assets in the bonded plans fall short of projections. But the appeal of the bonding option to issuers and investors is clear: issuers can close their pension gaps; fix annual pension costs; and move to a sustainable plan, while investors receive a high-grade income stream from AA or higher credits.
Washtenaw County is pursuing a plan to sell up to $345m in pension bonds this fall that will save about $110m compared with making ongoing pension payments. The issue of 25-year bonds, which have not been rated yet, assumes a 4% interest rate and a 6.5% return on the invested proceeds, below the actual return history of 6.75% on its pension and retiree health funds, and substantially below the 7.50%-7.75% actuarial assumptions in those plans. The county says it faces personnel and service cuts if the unfunded liability isn’t resolved. As required by PA 329, Washtenaw has closed its DB scheme to new employees as of 31 December, 2013.
Another large 329 deal in process demonstrates the appeal of pension bonds. Oakland County plans to raise as much as $335m to refinance outstanding certificates of participation (COPs) it sold in 2007 to finance retiree healthcare obligations. At the time, the county was not permitted to sell bonds, and the COP structure was the only way to tap institutional investors. S&P rated Oakland County AAA in August – higher than its rating on the US Federal government – so the sale could set a benchmark for subsequent issues. Again, the motivation is strong: Oakland currently pays 6.2% on it 2007 COPs, and expects the rate on the new bonds to be low enough to save $10-15m annually through 2027.
While it may take time to ‘resolve’ Detroit’s bankruptcy – read ‘litigate’, American-style – Michigan has clearly crafted a way forward for municipal governments that want to tap credit markets to eliminate pension underfunding. Peter Hayes, head of the Municipal Market Group at BlackRock, says Detroit’s case warrants attention, given its potential to set precedents concerning the priority of various bond securities. But Detroit’s woes are severe and unique, and BlackRock maintains a positive view for high-grade local general obligation debt. “We do not see Detroit as a domino,” he says.