POB Issuance Pulls Back Due To High Interest Rates

With recent interest rate increases, debt issuances to address unfunded pension liabilities have decreased dramatically in 2022. From Jan. 1, to Sept. 30, 2022, S&P Global Ratings rated 25 new pension obligation bond (POB) issuances in the U.S. public finance (USPF) sector totaling a little more than $880 million. If issuance continues at the year-to-date pace, we project 33 rated issuances totaling nearly $1.2 billion. This would be a 60% reduction in POB issuances and an 85% par reduction from the 78 POB issuances, totaling $7.5 billion, that we rated in calendar 2021.

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We expect POB issuance will remain suppressed while interest rates are high

We noted in the 2021 POB survey that high issuance could be spurred in part by anticipation of the end of record low rates, indicating issuance might have been abnormally high even given the low rates. If relatively high interest rates are viewed as temporary, we expect POB issuance will remain suppressed. However, if current high rates are generally viewed as a "new normal," we might see a little bounce back in issuance as issuers looking at POBs for reasons other than perceived interest rate savings stop waiting for rates to drop. On the other hand, if interest rates drop back to recent lows, we could see larger pent-up demand for POBs from issuers looking for interest savings.

POB issuance in the past five years is unlikely to have met return expectations

In our view, one of the biggest risks with POBs is market timing risk. The first few years after issuance are critical in determining whether the POB will end in cost savings. In table 1, we estimate the actual return for a USPF POB issued on Sept. 30, of each of the past five years. Also, using the median assumed annual return of 7% for U.S. public pensions, we calculate the expected return for each of the past five years to 2022 to illustrate how the markets have behaved compared with expectation about recent bond issuance.

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The negative 2.5% for 2017 indicates that a bond issued around Sept. 30, 2017 is likely to have earned a little less than the 7.0% annual expectation, compounding to 40.3% over the past five years. However, this does not indicate that the bond didn't result in cost savings because interest rates have been well below 7%, but does indicate that pension costs will be higher than were planned at issuance. Bonds issued in 2021 have a very steep climb to recover from the poor market returns since issuance. Whether or not investment return benchmarks can be realized in the long term, and issuances become profitable, it's important to note that a restructured contribution schedule might still be beneficial to the issuer even if expectations are not fully met.

Points to consider over the next few years

• Pension plans have generally been de-risking over the past 15 years since the Great Recession, to such an extent that associated costs are affordable for the plan sponsor. De-risking has taken multiple forms, including reduced market risk in the asset portfolio. We view the 7% median U.S. public pension discount rate as high, above our 6% guideline, which indicates to us acceptance of market risk that could lead to contribution volatility. Therefore, we expect market de-risking will continue for issuers seeking budgetary stability.
• Retiree medical plans (other postemployment benefits, or OPEBs) have historically been a lower priority than pensions, exacerbated recently as the COVID-19 pandemic and economic turbulence have dominated headlines, but these obligations have not abated. We see an increased focus on retiree medical plan funding, although we noted vastly differing legal and political landscapes across the county in in the past (see, "OPEB Brief: Risks Weigh On Credit Even Where There Is Legal Flexibility," published May 22, 2019, on RatingsDirect).

New Arizona Prefunding Program Could Be A Trend Setter For Cost-Sharing Plans

For cost-sharing, multiple-employer pension plans, pension trust deposits are spread uniformly across all participating employers. For this reason, POBs have historically not been a feasible consideration; however, the Arizona State Retirement System (ASRS) is starting a new program this year that, similar to a POB, allows a participating employer to irrevocably pre-fund future contributions.

In September 2022, Coconino County, Ariz., issued an excise tax-backed $54 million bond, the approximate amount of its share of the unfunded liability, to pre-fund future county contributions to ASRS. This issuance will be added to the commingled pension trust, marginally improving the funded ratio for all participants, so the county will not report a funded ratio improvement commensurate with the deposit, as is typical with a POB. ASRS will use the nonrefundable deposit to provide contribution credits to the county, currently scheduled from 2026 through 2056. Similar to a traditional POB, the county is exchanging fixed debt payments for variable, and possibly volatile, returns that run the risk of negative market movements and increased long-term costs.

Our Views: The Unique Credit Risks Of POBs and OPEB Obligation Bonds

POBs and OPEB obligation bonds (OOBs) are taxable obligations that U.S. states, local governments, and other public entities use to address unfunded pension or retiree medical 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, S&P Global Ratings analysts look at the individual issue at hand with an understanding of why the bond is being issued, and what plans are in place to mitigate the associated risks.

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Related Research

• Pension Obligation Bond Issuances Continue To Increase In 2021, Oct. 14, 2021
• OPEB Brief: Risks Weigh On Credit Even Where There Is Legal Flexibility, May 22, 2019