Ratings Slump No Obstacle to Alaska Pension Bond Sale

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LOS ANGELES — Alaska's coming $2.3 billion pension obligation bond deal will drive the Frontier State to another downgrade, but neither the state's advisors nor a buyside expert sees any obstacle to the state's desired pricing.

S&P Global Ratings placed Alaska on CreditWatch Negative Oct. 7 saying it anticipates lowering the state's various credit ratings one notch after the POB deal closes, which would bring its GO bonds to AA, appropriation-backed bonds to AA-minus, and moral obligation debt to A.

"I don't think the POBs and downgrades will impact pricing to any great degree," said Tom Schuette, partner and co-head of investment research and strategy for Gurtin Municipal Bond Management. "Nothing here is much of a surprise to the market. Alaska stopped trading like a triple-A a long time ago."

Alaska plans to sell the taxable bonds to both institutional and retail buyers Oct. 26, state officials said.

Investors were already penalizing the state for its budget problems, pension concerns and dependence on a slumping oil industry, Schuette said.

The deal has been well received internationally in marketing efforts that include Asia and Europe as well as the U.S., said the financial advisor on the deal, Steven Kantor, a Hilltop Securities managing director.

Alaska, through its Alaska Pension Obligation Bond Corporation, had originally planned to price between $2.35 billion and $3.33 billion in taxable POBS.

The state decided to set the deal at $2.3 billion, because "we thought it would be easier to price up, then down," Kantor said. "We don't have an amount we need to borrow. We have a rate that is a trigger point for us."

Fitch Ratings and Moody's assigned the pension bonds AA and Aa3 ratings, respectively. Both continue to assign a negative outlook to Alaska.

Citi is billing and delivery agent and co-senior manager with Bank of America Merrill Lynch and Goldman Sachs. Jefferies, JPMorgan, Key Capital, RBD Capital and Wells Fargo are co-managers. Orrick, Herrington & Sutcliffe is bond counsel. K&L Gates is underwriters counsel.

The fixed-rate bonds will be sold in four tranches: $464.8 million in serial bonds with maturities from 2018 to 2024; $250 million in term bonds due 2026 with a preliminary weighted average maturity of 8.6 years; a $535.5 million term bond due 2031 with a preliminary weighted average maturity of 12.6 years; and a $1.1 billion term bond due 2039 with a preliminary weighted average maturity of 19.2 years

S&P said its anticipated downgrade comes because the large size of the issue relative to Alaska's population and economic base will balloon its debt ratios while absorbing much of the state's potential bonding capacity. Only 736,000 people live in Alaska.

The bonds are being issued to reduce a substantial portion of the unfunded accrued actuarial liability of to the state's two largest pension systems: the State Teachers' Retirement System and Public Employees' Retirement System. The proceeds will be applied to make deposits to PERS and TRS, to pay a portion of the interest on the 2016 bonds and to pay issuance costs.

PERS was funded at 78% in fiscal 2015, with total assets of $16.2 billion and total liability of $20.6 billion, according to an investor presentation posted on munios.com. TRS was funded at 83% in fiscal 2015 with total assets of $8.1 billion and total liability of $9.7 billion.

After the issuance of the bonds, the aggregate funded ratio is estimated to be 81.5% for PERS and 90% for TRS, said Deven Mitchell, Alaska's debt manager.

The state hopes to achieve 4% interest rates on the POBs, Mitchell said.

Historically, the state has been able to achieve 8% returns on its pension fund, Mitchell said, and its 20-year rolling average today is just under 7%.

If the state issued $3.3 billion in POBs, the state would realize present value savings of $1.76 billion through 2039 if the pension fund achieves 8% earnings, but that drops to $1.08 billion if the pension fund earns 7%, according to S&P.

Even at the lowered amount, the savings is still highly beneficial to the state, Mitchell said.

The state's previous GO sales have priced in the 3% range and Mitchell said the state's targeted rates are achievable.

"Even with the state's rating adjustments, we have seen compression, because absolute rates are so low," he said.

The bond sale is not a deficit financing, said Mitchell, adding that the state has already fully funded its fiscal 2017 payment to both PERS and TERS.

Mitchell said the Government Finance Officers Association's many concerns about issuing POBs don't apply to the way Alaska is issuing its bonds. The state isn't taking a pension holiday or using variable-rate debt, which has created problems for other POB issuers, Mitchell said.

Alaska is "making a long-term play, rather than avoiding costs in the short term," Mitchell said.

"We already have the debt on the balance sheet, it is actuarially assumed," Mitchell said. "If we fail to make the ARC payments, it is structured similarly to failing to make debt payments."

The way the debt is structured pushes the savings into the future and if the savings do not materialize, it doesn't create a worse scenario for the state, he said.

The bonds will result in level debt service after fiscal year 2018 and fully amortized debt at 23 years, Mitchell said.

The rating agencies' analysis is a little inconsistent, Mitchell said.

All of the rating agencies have begun to view unfunded pension liability more like an actual liability and with the implementation of GASB 68, pension liability is included on the state's balance sheet, Mitchell said.

"When we say we are going to exchange cash flows, which are actuarially assumed cash flows with debt service payments structured in a way that responds to their concerns, because we are not taking a payment holiday, they say because you are issuing the debt, it automatically results in a rating reduction," Mitchell said.

Unlike many other states, Alaska's other post-employment benefits liability for TRS is fully funded and it is in the high 90 percentage for PERS, Mitchell said.

Alaska also has a Permanent Fund that was constitutionally created in 1977 to stash up to half the revenue it receives from oil corporation taxes. The fund's current principal balance is $44.2 billion plus an $8.6 billion earnings reserve, Mitchell said.

The state has paid "dividends" to the state's residents from interest earned off the fund each year that average around $1,000 annually. Alaska's 780,000 residents each received a $1,022 dividend check this month.

That could change under Alaska Gov. Bill Walker's proposal for a structural overhaul of the state government that would fund the general fund budget primarily from Permanent Fund investment earnings.

Walker's plan would transfer $3.3 billion of permanent fund investment earnings, targeting a 6% annual return assumption annually to the general fund, and fund the citizen's dividends with oil-related revenues, according to Moody's. The plan would "effectively shift the oil price volatility risk from the general fund to citizens," Moody's analysts wrote.

The plan has the potential to represent a more sustainable level of funding for the state's budget.

Walker's plan did not make it through the legislature and the state ended up passing another imbalanced budget for 2017 with about $1.2 billion of projected revenue against $4.4 billion of authorized spending.

"That raises the prospect of another $3 billion deficit and another year of uncertainty about how the state will fund itself in the future," Moody's said.

The state has been funding its repeated budget shortfalls by tapping a budget reserve that is on pace for exhaustion within a year or two.

The state's debt burden prior to the POB sale at $1 billion of GOs is moderate, according to Moody's, which ranks the state 30th-highest against other states calculating debt burden versus gross domestic project. But Moody's said adding $3.3 billion in debt would catapult the state to fourth-highest.

"Our baseline assumption remains that the state will come to a political compromise and reach a sustainable solution to its imbalance before coming close to depleting its reserves," Moody's analysts said.

The size of the deal and extremely low interest rates globally make the Alaska municipal bonds attractive for international investors, Kantor said.

"It is a large transaction and international investors want size, because it will enable the bonds to be part of an index fund, which is important to international investors," Kantor said. "Alaska is a well-known commodity, particularly in Asia. The governor has been active in marketing the state."

Schuette said he thinks the state will find a receptive market for the bonds.

It will pay a penalty relative to high-quality states because of its fiscal issues, but market conditions favor the state and many investors still view the state's credit quality as solid, he said.

Gurtin does not plan to participate in the sale, however.

"While we still believe Alaska maintains an adequate credit cushion and has time to make needed budget adjustments, we also do not like the moral obligation pledge that secures the POBs and are avoiding adding it for our strategies," Schuette said.

 

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