POB Issuance Accelerates

The prevalence of debt issuances to address unfunded pension liabilities continues to increase in the current low-interest-rate environment. From Jan. 1, to Sept. 15, 2021, S&P Global Ratings rated 64 new POB issuances in the USPF sector totaling nearly $6.3 billion; this is a 113% increase in rated POB issuance over the $3.0 billion issued in the entire calendar 2020.

California is still the state that has issued the most POBs, although its share has decreased now that other states have increased their new issuances. We expect continued issuance accelerations as issuers compare peers' seemingly successful transactions with their own large and growing unfunded liabilities, and some issuers might anticipate the end of record low interest rates. The recession and economic disruptions associated with the COVID-19 pandemic serve as reminders of the importance of monitoring volatility in both markets and major revenue streams. Issuers are working to stabilize annual pension and OPEB costs through debt issuance. They are also finding this an opportune time to restructure or revise plan assumptions and contribution methodologies to reduce cost deferrals. While POB issuances appear aimed at fixing annual costs associated with pension plans, only time will tell if plan assumptions, including investment return benchmarks, can be realized and if the issuances themselves will provide long-term cost savings.

The Unique Credit Risks Of POBs And OOBs

POBs and OOBs are taxable obligations that U.S. states, local governments, and other public entities use as a means to address unfunded pension liabilities by issuing debt to fund them and attempting to capture returns between portfolio investments and debt service costs. Rather than oversimplify our credit viewpoint of obligation bonds by expressing a generalized positive or negative view, we look at the individual issue at hand. With an understanding of why the bond is being issued, we analyze the changing credit picture and review management plans to mitigate the associated risks, including changes to plan benefits, contribution methodology, and actuarial assumptions.

POB issuance does not absolve the issuer of pension plan risks. Generally, we believe transactions seeking to refund a pension liability for present-value savings will often not result in savings given the likelihood of poor investment performance, experience, or other changes that could generate new liabilities greater than projected at the time of issuance. In addition, an increased spread does not mean free money; it indicates increased exposure to market volatility risk when proceeds are deposited into the pension trust. Below, we evaluate how an issuer might assess and incorporate the risks associated with market volatility and detail some of the risks involved both with pensions and the debt financing pensions Often, we see some of the expected interest savings from issuance used with the intention of offsetting some of these risks.

Market timing risk

A significant amount of money placed into the market increases exposure to near-term market movement. If markets do not perform to expectations, pension liabilities could grow, potentially defeating the purpose of issuance. Some mitigation techniques we've seen include spreading out the deposit to reduce the likelihood that the deposit is made at a low point in the market and establishing a set-aside reserve fund, often an IRC Section 115 trust dedicated to pensions, to supplement planned contributions and ease the impact on the general fund. The most well-defined set-aside funds tend to have strict definitions of when the balance can be drawn and how funds are invested, and include replenishment clauses as well as dissolution guidelines as the plan approaches full funding.

Cost escalation risk

Pension contributions could escalate over time in the form of either planned amortization payments that increase with expected payroll growth or unplanned increases due to poor experience against risky assumptions. Cost escalation can be a budgetary challenge for issuers to incorporate into their long-term budget planning. With bond issuance, this risk is often mitigated in part by defining the bond repayment schedule to not only be shorter than the pension amortization, but also closer to level dollar. These changes address costs earlier than under the current pension amortization schedule. Long-term cost savings typically stem from either plan changes or the creation of a cheaper new benefit tier for new hires.

Budgetary flexibility risk

Obligation bonds reduce debt capacity as well as create fixed cost burdens that typically have less flexibility than pension and OPEB annual contributions. This could create budgetary constraints and negatively affect an issuer's ability to manage unforeseen near-term liquidity needs.

Political risk

Pension plans that appear to be overfunded, even when calculated using a high discount rate, might result in the issuer facing calls to increase benefits that are perceived to be "affordable" despite risk to the sponsor. Some higher-rated issuers have set the bond issuance to fund to less than 100% while combining de-risking efforts with issuance to reduce the likelihood of appearing overfunded.

We Expect States Will Continue To Issue Obligation Bonds While Interest Rates Are Low

As we review credit concerns for each issuance we see, and its associated risks to the issuer's budget, we anticipate that low interest rates and accelerating pension costs will continue to spur USPF POB and OOB issuance.

Related Research

• Pension Brief: POBs See Increasing Activity In Low-Interest-Rate Environment, Oct. 14, 2020
• OPEB Brief: The Credit Impacts Of OPEB Obligation Bonds, March 11, 2019
• Pension Obligation Bonds' Credit Impact On U.S. State And Local Government Issuers, Dec. 6, 2017