Largest deal yet brewing for California’s new pension bond boom
Add Huntington Beach to the list of California cities contemplating pension obligation bonds to alleviate pressure from unfunded pension liabilities.
The City Council in November approved a resolution to issue the pension bonds to refinance $436 million in public employee pension debt and is undergoing a 90-day court validation process. If the court validates the debt, the matter would return to the council in March for final approval.
A POB deal for the full amount would be by far the largest issuance of POBs the state has seen in the past five years.
“We have evaluated the risks and benefits associated with pension obligation bonds and the data clearly demonstrates the need to move forward on this opportunity,” said Councilwoman Kim Carr, a Democrat, in an emailed response.
The council for the Orange County city of 200,000 sees issuing the bonds as a way to swap the 7% interest rate the city pays the California Public Employees’ Retirement System with a bond interest rate as low as 3%, Carr said.
A presentation by City Manager Oliver Chi estimated the city could save $8.5 million a year.
“This debt is not going away and we need to be proactive and find ways to reduce our payments. The POB is a creative and smart solution to our current financial situation,” Carr said.
Chi told the City Council it could issue POBs, raise taxes or make steep budget cuts. The annual cost to the city budget from the unfunded liability has risen from $4.58 million in fiscal year 2009 to $24.93 million in 2019. The city’s analysis projects it will double to $46.02 million in 2031.
To cover the increase, the city would need another $21.09 million a year by 2031.
Approved by a 6-1 vote, Huntington Beach’s measure allows staff to proceed with the steps necessary to issue bonds.
The vote included approving Orrick Herrington and Sutcliffe LLP to handle the judicial validation proceedings and as bond and disclosure counsel, KNN Public Finance as municipal advisor and US Bank as trustee. An underwriter wasn’t named.
The city’s finance team filed the paperwork necessary to start the 90-day process of seeking a court validation to issue the bonds the week after the council vote.
The resolution allows for the sale of several bond issues.
Mayor Lyn Semeta supported the move with the caveat that the city could pull out of the process if the market has changed by the time the 90-day court validation process is completed, according to the council’s meeting minutes.
Carmen Vargas, Ramirez & Co. managing director, gave a presentation at The Bond Buyer’s California Public Finance conference in September showing that there was a surge in POB issuance by California cities in 2018.
California cities have issued $2.2 billion in POBs since 2015, according to data from the California Debt and Investment Advisory Commission. There was a surge in issuance in 2018 approaching $700 million, according to data CDIAC provided to The Bond Buyer.
CDIAC has taken the position that issuers should proceed with caution, because POBs are an arbitrage play relative to growth in the pension fund itself, said Robert Berry, CDIAC’s executive director.
“POBs offer issuers an actuarial arbitrage opportunity, which, in theory, can reduce the cost of pension obligation through investment of the bond proceeds in higher risk/higher return assets,” according to a report published in 2014 by the Center for State & Local Government Excellence looking at how POBs fared after the financial crisis. “By commingling POB proceeds with pension assets, the assumption is that bond proceeds will return whatever the pension returns.”
Low interest rates and the push to reduce pension liabilities have driven an increased interest from California cities in issuing POBs.
“They are taxable issues, so just the compression in the taxable market might be causing people to look at it again,” Berry said.
The POB financing vehicle had fallen out of favor after a series of municipal bankruptcies gave poor treatment to holders of pension obligation bonds. In Detroit and in Stockton and San Bernardino, California, in particular, pension obligation bondholders or their insurers suffered significant losses.
The most recent strain of POBs includes shorter maturities in the 15-year to 20-year range, 10-year calls and elimination of the make-whole provisions more common with taxables, according to Vargas’ September presentation.
POBs traditionally have been a solution for cities that tend to be the most vulnerable with little control over timing of the bond sale, Alicia Munnell, director of the Center for Retirement Research at Boston College, and Jean-Pierre Aubry, the center's Associate Director of State and Local Research, said in a joint interview.
They co-authored the Center for State & Local Government Excellence 2014 report on POBs along with researcher Mark Cafarelli. That report found that POBs on average had produced a real internal rate of return of 1.5% in 2014 after five years of recovery. But if assessed in the middle of 2009, right after the market crash, most POBs appeared to be a net drain on government revenues, according to the report.
If POBs were such a great idea then more cities that are not in financial distress would be issuing them, Munnell said.
“The debt is still there whether you issue a bond to pay it off or pay it off directly,” Munnell said.
If you set the arbitrage aside, the only advantage of a POB is being able to choose the timing on paying back the bond payments, as opposed to having CalPERS set the schedule, she said.
“One of our concerns is that cities often set up bond payments for the first five years as interest only — and they are just kicking the can down the road, rather than amortizing the cost in the pension fund,” Aubry said.
The pair were unimpressed by the shorter maturities and call options in the newer POBs.
“They are going after arbitrage,” Aubry said. “If doesn’t work out, they still have to pay CalPERS more money. I think it’s the same old story. The debt is going to need to be paid somehow.”
State Sen. John Moorlach, R-Costa Mesa, whose district includes Huntington Beach, was alarmed enough to both co-write a newspaper op-ed and send a letter to the City Council discouraging them from issuing the bonds.
The only council member to respond was Mike Posey, the lone council member to vote against the resolution, who called to say he agreed with the senator.
Moorlach understands the appeal when someone walks in the door and says they can help save a city money.
“Cities in California are struggling,” Moorlach said. "Cities up and down the state have reduced police and fire by 20% to make pension payments. Huntington Beach has reduced staffing by 18%, but its pension contribution has gone up by 80%.”
He also says trying to time the market can make you either a hero or a goat.
Inserting a large amount of cash into a pension plan at the wrong time would be very expensive, Moorlach said. Inserting a large amount of cash into a pension plan when the Dow Jones Industrial Average is approaching 29,000 is a signal that it's the wrong time, he said.
The drive by CalPERS to meet even the lower 7% assumed annual return, with current low inflation and low fixed income yields, means the pension fund is motivated to invest in riskier securities to offset those lower returns in its overall diversified portfolio, Moorlach wrote in editorial, co-authored with Shari Freidenrich, the Orange County treasurer and tax collector. "With this exposure, if the CalPERS fund were to take a significant market loss, the HB proceeds in the portfolio would suffer the same loss."
Interest payments on the POB debt will not be reduced even if the bond proceeds paid to CalPERS lose value, Moorlach said.
“Trying to assume, the yield curve and equity markets will cooperate is not something I think is advisable,” he said. “You don’t control either of them and that is what Orange County learned 20 years ago” when it landed in bankruptcy court.