California POB issuance falls off a cliff as interest rates rise

Issuers in California have been the largest source of pension obligation bonds in recent years, but the Fed has brought that to an end, at least for now.

The Federal Open Market Committee Wednesday said it was increasing its federal funds rate by 0.5%, to a range of 4.25% to 4.50%, after announcing four 0.75% hikes this year. More increases are expected.

Pension bonds are fundamentally a calculation that the issuer can borrow at a lower interest rate than that money earns in the pension fund through investment returns. Higher bond interest rates up front make that harder to achieve.

At its height in 2021, California issuers sold more than $6 billion in pension-related debt, some as lease-revenue bonds and not the more traditional pension obligation bond structure, according to data provided by the California Debt and Investment Advisory Commission. In 2022 through the first week of December, that volume fell to $1.07 billion.

“POB issuance in first quarter 2022 was much lower than in first quarter 2021, likely due in part to inflationary pressures and expected increases in interest rates,” according to the June issue of Debt Line, CDIAC’s monthly newsletter.

The first quarter of 2022 saw $719 million in POB issuance in the state, a 62% decrease from first quarter 2021, according to the Debt Line article.

As rising interest rates take pension obligation bonds off the table as a solution for cities grappling with unfunded pension liabilities, city finance managers are looking to other methods of dealing with looming pension overhangs.

“Due to rising interest rates and market volatility, POBs are no longer compelling,” said Julio Morales, a senior managing director with Kosmont Financial Services, a California firm that works with public agencies and private entities that require public finance expertise, including real estate and economic development programs.

Morales worked with Upland, a San Bernardino County city of about 80,000 to create an alternative to reduce unfunded pension liabilities. The system was given the acronym BLAST, standing for bonds, lease investment, additional discretionary payment, savings and transfer.

The city privately placed with JPMorgan $15.75 million in 20-year tax-exempt water bonds at 1.92% in March to finance pay-go capital projects, and then transferred money from the city water department’s enterprise fund to the general fund to pay a portion of the city’s $127 million unfunded accrued liability, or UAL. The loan, which took the form of an investment, matched the terms of the water bonds, $15.75 million for 20 years at 1.92% interest.

The city also moved $5 million from the sewer fund’s available reserves to the general fund. The city then made an additional discretionary payment from monies held in the 115 Trust, established in 2016 to help cover pensions, to pre-pay $10 million of its UAL, saving $19.6 million in total UAL payments. The City Council also adopted a formal pension funding policy, which requires that 50% of the savings realized from the BLAST strategy should be deposited into the 115 Trust, which will help address future changes in the unfunded liability. The last step was to transfer $15.3 million from the reserves in the water, sewer and solid waste fund to pay off those employees’ 12.9% share of the UAL.

The BLAST strategy, of which implementation commenced in December 2021 and was completed by spring 2022, is projected to save the city $66.8 million in UAL payments over the next 22 years, lowering its UAL payment by $3 million or $4 million annually, without the use of taxable pension obligation bonds, according to a two-page explainer produced by Upland assistant city manager Stephen Parker and Morales.

Morales came aboard in January 2021 to help the city deal the unfunded pension liability. At the time, the annual fixed dollar amounts the city was required to make to the California Public Employees’ Retirement System to pay down its UAL, based on CalPERS’ discount rate of 7%, were expected to total $228 million over a 22-year period, Morales said.

“I was honest about the risks involved in issuing POBs. I told them it is not a panacea,” Morales said.

Other municipal financial advisors had been telling the city that issuing POBs was a simple refinancing, he said.

“I was a city councilmember at one point, and I know if you lie to them, you don’t have a future working with them,” said Morales, now an FA, but a former city finance manager and banker as well.

The city nevertheless explored issuing POBs, seeking the required court validation to issue the taxable debt, but backed off when the Howard Jarvis Taxpayers Association filed a response challenging the POB validations, Morales said.

Even when interest rates were low and the arbitrage worked, Morales said he presented municipal clients with an array of solutions, and always makes sure his clients understand the risks involved.

The Government Finance Officers Association’s advice is unambiguous: “State and local governments should not issue POBs.”

The GFOA isn’t alone in being wary.

“I think it’s important to pause before you start to issue these bonds, before you even think about investing in them,” Richard Ciccarone, president and chief executive officer of Merritt Research Services, told The Bond Buyer in 2020. “We found the security seemed to be an inferior security [during the municipal bankruptcies of 2012-15.] They did not put you in a strong position in bankruptcy.”

The GFOA offers five reasons behind its anti-POB guidance.

Among these are that POB proceeds might fail to earn more than the interest owed over the term of the bonds, leading to increased overall liabilities for the government, and that they are complex instruments that carry considerable risk.

The guidance was issued in 2015, but Emily Brock, director of GFOA’s Federal Liaison Center, said GFOA does periodic reviews of its best practices recommendations.

“We officially stand by it,” Brock said. “Each time we review our best practices, we have people come and speak, and will review them to make sure they are relevant and current. But, I don’t have any indication that anything is going to change right now.”

Morales doesn’t think that pension bonds are the evil empire they have been deemed by some in muniland, and says the GFOA’s position on POBs released in 2015 needs to be updated.

He says most issuances of POBs over the past several years are less risky. For instance, the GFOA warns the bonds often lacked call features and incorporated the use of derivatives, which he said haven’t been common features of POBs over the past several years.

With that said, Morales said his approach has always been an education process.

“A lot of people will walk city leaders through pension obligation bonds – and some people say “this is the only thing that solves the problem. It is the only thing that gives a quick fix, but that doesn’t mean it’s the right answer.”

And given the current interest rates, it isn’t a fix at all.

Upland had faced financial struggles for at least a decade, resulting in city leaders and residents approaching presentations from outside financial advisors with a jaundiced eye.

BLAST worked so well for Upland that 60 miles south in Temecula, Ward Komers, the assistant finance director, is crafting a similar solution. Komers worked with Upland as an outside financial advisor when the city was crafting BLAST.

Temecula’s UAL is $46 million, not the $127 million that Upland was facing, Komers said.

“It’s a pretty significant difference, and Upland has a tighter annual budget than Temecula,” he said.

Temecula, a Riverside County city with about 110,000 residents, also benefits from a sales tax that contributes $20 million a year in revenue, which gives it extra breathing room that Upland didn’t have.

If that’s the case, why replicate Upland’s solution in Temecula?

Komers said that, though Temecula’s UAL is 75% funded, city leaders would like for it to be 100% funded.

“Another city might be happy with 30% or 40% funded, but because they are fiscally conservative here, they would like it be 100% funded,” he said. “Any time we can reduce debt we want to.”

They will take an existing fund balance or reserves, and use a portion to pay down the loans on the city’s civic center, which will generate $3 million a year in budgetary savings, and that savings will be applied to the pension debt.

“It’s the main principal of what they did in Upland,” Komers said. “It’s about how you leverage cash to accelerate savings and pay down debt.”

Temecula also has a Section 115 pension trust, and will use $5 million of that to make a payment toward the pension liability.

“That will generate some savings that will be applied in the future,” he said.

Those methods will generate $30 million in pension debt savings, enabling the city to pay its UAL off in seven years, he said.

“You get a beneficial cycle, rather than a vicious cycle, that really starts compounding,” he said.