City streets back new bonds California cities issue to fund pensions
Some California cities have shifted to issuing lease revenue bonds to pay down unfunded pension liabilities instead of using the more familiar pension obligation bond structure.
Two cities in Los Angeles County, West Covina and Torrance, sold or are planning taxable lease revenue bond deals that use their city streets as collateral.
Ultimately, the cities' general funds will pay the debt service.
“Similar to other lease-back deals, the city leases property to the financing authority, the city makes rental payments, and the financing authority makes the bond payments,” said Mike Meyer, a vice president with NHA Advisors, an advisor to the two cities. “It isn’t that common to pledge streets, but several cities have over the years to finance sizeable projects.”
The move prompted city residents to ask if the city defaults on the bonds could bondholders charge tolls on the streets to pay off the bonds.
“In our experience, the structure does not allow for investors to take control of the roads or turn them into toll roads,” Meyer said. “The remedy would be the trustee suing the city for lease payments.”
The West Covina Public Financing Authority priced $205 million in lease revenue bonds July 24 to pay off its nearly $200 million in unfunded accrued California Public Employees' Retirement System liabilities. The bond issue also provides $1 million in working capital that would be paid back in four years.
The bonds, rated A-plus by S&P Global Ratings and carrying a 10-year par call, priced to yield between 1.747% for a 2021 maturity and 3.892% for 2044.
Hilltop Securities was underwriter; Norton Rose Fulbright bond and disclosure counsel; and Wolf & Company and NHA Advisors co-municipal advisors.
The Torrance City Council gave the go-ahead to a similar lease revenue pension deal of up to $350 million on July 28. The Torrance Joint Powers Financing Authority pricing is expected in October.
Morgan Stanley is lead underwriter with BofA Securities and Siebert Williams Shank co-managers; Jones Hall bond and disclosure counsel; and NHA Advisors as municipal advisor.
One hitch that can crop up in the more traditional pension obligation bond structure is that there is more time involved in a validation, said Sara Oberlies Brown, co-head of Stifel California.
“If you can do it as a pension obligation bond, it’s preferable, because you don’t have to commit an asset,” said Brown, whose firm is not involved in the Torrance and West Covina deals. “And, S&P [Global Ratings] rates pension obligation bonds higher than a lease revenue bond.”
If, however, an anti-tax group or taxpayer answers the POB validation, it can cause delays, which can result in additional legal costs for the city, Brown said. If that is the case, it might be faster and more cost effective to do it as a lease revenue bond.
Meyer said lease revenue bonds do give cities “more control of the process and timing, since they aren’t at the mercy of the court's schedule for the validation.”
The validation process typically takes three to four months, but during the pandemic, it is sometimes taking longer, Meyer said.
“Depending on the legal structure, there may be added flexibility for use of proceeds to CalPERS or more strategic timing of investing in the market,” Meyer said. “These things aren’t possible under a traditional POB structure.”
The biggest change Brown said she has seen in bond sales this year over last year has been the increase in pension-related bonds.
The Torrance staff report cited over a dozen governments in Southern California alone that have issued pension bonds since 2018.
“I’m not aware of every entity who has issued UAL restructuring bonds, whether they are lease revenue bonds or pension obligation bonds, but the challenge facing agencies is still the same: How to tackle a CalPERS UAL repayment shape that is rapidly escalating (peaking over the next 10 to 15 years and crowding out other critical priorities) then dropping,” Meyer said. “The ability to re-shape and smooth payments at low interest rates to enhance budget predictability, long-term fiscal stability, and general expected cash flow savings, remains the objective, no matter which structure is utilized.”
CalPERS’ estimates that it is 70.8% funded, which is based on an assumption of future investment earnings averaging 7% a year. In the 2019-20 fiscal year that ended June 30, CalPERS posted a 4.7% return. Over the last 20 years, it has averaged 5.5% by its own calculation.
“What started out as a health crisis turned into an economic crisis and severely affected investors everywhere, including CalPERS,” said Yu (Ben) Meng, CalPERS chief investment officer, said July 15 in a news release announcing its 2019-2020 returns.
“We’ve been doing the hard work of preparing for a downturn for some time,” Meng said. "When it came, we were in a strong position to reduce its impact on our portfolio and take advantage of new opportunities created by the changing economic climate.
“We’ll continue to focus on the long term and execute on our strategy to achieve our 7% targeted return,” said Meng.
Less than three weeks later, Meng abruptly resigned, saying he wanted to focus on his health and his family.
The board held an emergency meeting Monday after Controller Betty Yee wrote a letter to the pension board to discuss whether an investigation should be called after questions were raised about potential conflict of interest in the investments recommended by Meng as CIO.
One element of the increased interest in pension bonds is the decline in revenues cities have experienced amid the pandemic.
But, Brown said, she thinks the taboo that once surrounded POBs has lifted.
“Issuers that would have considered it a couple of years ago, are seeing respected, neighboring communities consider or pursue pension bonds, and that gives them comfort, and cover, as to whether that makes sense for their communities,” Brown said.
Investors also appear to have moved past the beating bondholders took in Stockton, California, and other Chapter 9 cases in which pension recipients were largely unharmed but bondholders took a haircut.
Cities may have more reason to look to pension bonds to ease the pressure of pension liabilities with the decline in revenues resulting from the recession brought on by the cease of business amid the pandemic, but they also may be bracing themselves against the potential for contribution increases from CalPERS.
West Covina’s revenue losses caused by the coronavirus outbreak resulted in City Manager Dave Carmany declaring a fiscal emergency in May. When council members approved the budget in June, they also agreed to keep the budget fluid and tentative, saying the coronavirus has made their financial situation unpredictable.
Both the CalPERS and California State Teachers' Retirement System had a record loss in March, but they were able to turn it around.
“I am happy to report that CalPERS hit 4.7%, which is higher than the benchmark,” California Treasurer Fiona Ma said during a webinar produced by California Debt and Investment Advisory Commission and the California Society of Municipal Finance Officers.
Ma, who is a voting member of both CalPERS and CalSTRS, reminded listeners that the pension funds are long-term investors.
“They are there to make money, so they can pay retirees when the time comes,” Ma said. “I would say to local governments, don’t worry at this moment. Before the pandemic, we were above the 7% number; because of the pandemic, we are below that number, but we are long-term players in CalPERS and CalSTRS.”