Thursday, December 13, 2012

Pension Bonds Increase Default Risk?

Brian Chappatta of Bloomberg reports, Muni Pension-Bond Sales May Increase Default Risk, Moody’s Says:
State and local governments issuing bonds to bolster their pension funds may increase the chance of defaulting on their debt while probably failing to improve their credit quality, Moody’s Investors Service said.

The securities will have either a neutral or negative effect on a government’s creditworthiness, depending on the size of the sale and the use of proceeds, Moody’s said in a report today. Turning unfunded pension promises into bonds keeps liabilities unchanged, though it raises the risk of a default as the amount of debt increases.

“Pension bonds are often a red flag associated with greater rigidity of long-term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future.” Moody’s analysts Marcia Van Wagner and Timothy Blake wrote in the report. In some cases, “the issuance of the bonds is sufficiently credit negative to put downward pressure on the issuer’s rating.”

Illinois has borrowed $17.2 billion since 2003 for pension benefits, according to Moody’s. The state’s worst-funded retirement system has only 43.4 percent of assets needed to cover its obligations, according to data compiled by Bloomberg. Moody’s downgraded Illinois in January, citing its “severe pension under-funding.”

Illinois Governor Pat Quinn said yesterday that the battle to control employee pension costs “is our fiscal cliff and we need to deal with it” or ratings companies would lower the state’s grade again.

Municipal defaults this year are still at the lowest since at least 2009, with 80 issuers failing to pay this year, according to data from Concord, Massachusetts-based Municipal Market Advisors.
Reuters also reports, Pension bonds risky for state and local governments-Moody's:
Municipal bonds that states and local governments use to pay for some of their public pension obligations rarely improve the issuer's credit quality, Moody's Investors Service said on Tuesday.

"If bond proceeds substitute for annual contributions to pension plans or are used to pay pensioners, we consider it a deficit borrowing and would view the financing as credit negative," Marcia Van Wagner, the senior Moody's analyst who wrote the report, said in a statement.

Cities and counties in the United States seem to have gotten this message, even though many face big unfunded pension liabilities. Despite some large state pension obligation bond deals in 2012, issuance has declined from 2011.

In the first seven months of 2012, there were just 14 such deals worth $604 million, compared to $4 billion issued in 2011, according to Thomson Reuters data.

The negative credit implications hold especially true if the borrowing is large relative to the issuer's budget, for example over 5 percent. The bonds are also viewed negatively if they are part of a pattern of one-time fixes or don't come alongside a plan to restore budget stability, Moody's said.

"Pension bonds are often a red flag associated with greater rigidity of long term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future," said Van Wagner.
Pension bonds are indeed a red flag because it's just another "extend and pretend" gimmick that doesn't tackle the root problem. It also adds debt to already overextended municipalities, some of which have gone bankrupt and stopped paying their pension payments.

I've already covered whether municipal woes will unleash a debt crisis. More recent events in California have not rocked municipal bonds and appetite for munis remains strong even though it's leveling off.

According to Reuters, the US municipal bond markets shrank in the third quarter:
The U.S. municipal bond market shrank in the third quarter of 2012, to $3.719 trillion from $3.732 trillion in the second quarter, the Federal Reserve said on Thursday.

That was still larger than the level of outstanding debt the year before, when the market was $3.708 trillion in the third quarter of 2011, according to the Fed's quarterly report on fund flows.

Households' appetite for the bonds sold by states, local governments and other authorities continued to drop off. They shed $245.5 billion bonds in the third quarter and $3.5 billion in the second. Households have cut their holdings in muni debt for six quarters in a row.
That seems to be changing. Concerns over fiscal cliff and higher taxes are boosting  demand for munis. Also, many municipal bond investors feel that state and local governments are implementing the right reforms to tackle their mounting pension woes.

The article above mentions the grave situation in Illinois but as aiCIO recently reported, Kentucky now has the honor of being the worst funded public pension in the United States:
America’s public pensions have hit a new low.

At a board meeting today, the Kentucky Retirement Systems (KRS) announced that its funded ratio is now 24.5%, according to former KRS trustee Christopher Tobe, beating out Illinois’ as the lowest in nation.

From 2007 to the fiscal year-end of 2011 (the latest date for which data is available), KRS’ total assets dropped by more than a third, from $6.44 billion to $3.97 billion. In KRS’ 2011 annual report, Chief Operations Officer William Thielen acknowledged the dwindling funding ratio, and attributed it to a variety of causes.
Funding ratios have fallen both steadily and significantly over the last decade as a result of unfavorable market conditions, higher than anticipated retirement rates, employer underfunding…and increased expenses or annual cost of living adjustments that are not pre-funded by the employers,” Thielen wrote.

It gets worse: “While improved market conditions and the increased funding in…FY 2011 have slowed the growth of the unfunded liabilities of the various systems, KRS uses a five-year smoothing method and the full effects of the market losses in 2008 and 2009 will not be realized for another three years.”

Tobe attributes KRS’ sorry state to other factors.

“This 24% is unique,” he wrote in an email. “Unlike Illinois, most Kentucky officials were not aware of the extent of this underfunding. This is primarily due to complete lack of transparency. KRS held back disclosing this level for nearly a month from their normal November meeting.” 

KRS officials were subpoenaed by the US Securities Exchange Commission in 2011 as part of an investigation into the role of middlemen in public pensions.
Wow, talk about Kentucky fried pensions! All the pension bonds in the world won't help Kentucky get out of its pension hellhole.

Earlier this week, I covered Virginia's bonus bonanza and mentioned the Virginia Retirement System (VRS) was 70% funded in 2011 but that dropped to 65% this year. In New Hampshire, a watchdog group notes the pension funding ratio dropped to 56%:
According to the Comprehensive Annual Financial Report (CAFR) of the New Hampshire Retirement System, the funding ration for the state pension system fell by 1.3 percentage points to 56.1%.

Plan liabilities grew by approximately $363 million while plan assets declined by roughly $116 million, leading to a decrease in the funding ratio. As a result, the unfunded liability grew to $4.5 billion.

Pension payouts to retired employees also rose by $28 million to just shy of $550 million.

On the asset side, total contributions by employees and employers grew by $28 million. Most employee groups saw an increase in total contributions as a result of the pension reforms passed in 2011, with the exception of Employees due to layoffs. State, Local and County Governments contributed roughly $255 million while employees contributed $200 million.

Investments gave the NHRS a 0.9% return, yielding an additional $32 million. Though returns were below the assumed rate of return of 7.75%, the NHRS’s investment experience for FY12 was in the same range as similar public sector pension systems.

Turning to demographics, due to layoffs, active membership in the NHRS fell by roughly 1,100 to 48,625. Conversely, the number of retirees grew by 1324 to 28,454.
I don't want to alarm or depress anyone but it's best to expose the magnitude of the catastrophe rather than bury our heads in the sand hoping it will magically go away.

And while Canada has its share of pension problems, they're nothing compared to what is going on in the United States. The Canadian press makes a big stink about Ontario Teachers' pension deficit but the Oracle of Ontario is still 94% funded and uses the lowest discount rate in the industry (5.3%).

Ontario Teachers' just announced an agreement to sell its one-third interest in Express Pipeline System (Express System) to Spectra Energy Corp (Spectra Energy) for approximately $430 million.

Teachers' partners in Express System, Borealis Infrastructure (OMERS Borealis) and Kinder Morgan Energy Partners, L.P. (Kinder Morgan), are also selling their interests to Spectra Energy. It is anticipated this transaction will close in the first half of 2013 after regulatory approvals have been obtained:
Teachers' acquired its interest in 2003 through its Infrastructure Group.
"The Express Pipeline System was one of Teachers' earliest infrastructure investments and has been a good investment for the Fund," said Stephen Dowd, Teachers' Senior Vice-President, Infrastructure and Timberland. "We have had a positive relationship with our partners, Borealis and Kinder Morgan, and we will continue to look at future opportunities in the pipeline sector."

Teachers' Infrastructure Group currently manages an international portfolio of approximately $11 billion, including water and wastewater, electricity distribution, gas distribution, airports, power generation, high-speed rail, port facilities and timberland. 
And North America's best pension plan, the Healthcare of Ontario Pension Plan (HOOPP) keeps leading its peers and is in the enviable position of being overfunded. HOOPP just released its Pensions in Perspective newsletter, which I highly recommend you all read.

I doubt Ontario will ever need to sell pension bonds to cover its pension obligations. US public pension funds can learn a lot from their Canadian counterparts. In the private sector, instead of offloading pension risk to insurers, they should follow Bell Canada and make voluntary pension contributions to top up their plans (FYI: Goldman's unit just insured GM's UK pension fund).

Below, Nuveen Asset Management CIO and Global Fixed Income Head John Miller discusses municipal bonds and his investment strategy. He speaks on Bloomberg Television's "Market Makers."