DALLAS — The Kansas Development Finance Authority is ready to go to market with $1 billion of pension obligation bonds that drew heated debate in the longest legislative session in the state's history.
The taxable bonds are expected to price Aug. 12 with closing Aug. 20, said Jim MacMurray, senior vice president for finance at KDFA.
"This will be the largest deal KDFA has ever done," MacMurray said.
Co-book runners on the negotiated sale are Bank of America Merrill Lynch, led by director Eric Cowan, and Wells Fargo Securities, led by vice president John Moore. Co-managers are Piper Jaffray, Citi, Stifel Nicolaus, and Hutchinson, Shockey, Erley & Co.
Kelsi Spurgeon, principal at Columbia Capital, and Lisa Daniel, managing director at Public Financial Management Inc. are co-financial advisors on the deal.
The finance team will hold road shows in Chicago, Boston and New York in preparation for the sale, Spurgeon said.
"This is a strong state credit," Spurgeon said, "a state with a moderate debt burden that doesn't bring deals of this size and structure to market very often. I expect a strong response from the market."
Despite recent troubles in the state's finances, the bonds earned ratings of Aa3 from Moody's Investors Service, with a stable outlook, and AA-minus from Standard & Poor's with a negative outlook.
The pension bond rating is one notch lower than the state's Aa2 issuer rating to reflect appropriation risk, analysts said. The 2015H bonds are secured by payments from the Kansas Legislature, which must be approved annually.
Moody's analysts led by Dan Seymour credit the state with moderate debt levels, a history of strong governance, and a diverse, though slowly growing, economy, underpinned by the aerospace industry and low unemployment.
"The below-average rating also recognizes the structural imbalance in the state's budget and reliance on interfund borrowing, as well as an underfunded pension plan to which the state is not making actuarially determined contributions," Seymour said.
The state's financial operations continue to struggle in the aftermath of significant income tax cuts enacted in 2012 and 2013, which have depressed revenues, analysts noted.
"The income tax cuts were not accompanied by corresponding spending cuts or expected economic growth and subsequently depleted the state's financial reserves," Seymour wrote. "Resulting revenues significantly below estimates are now also causing budgetary stress."
On July 30, Kansas budget director Shawn Sullivan closed a $62 million deficit through $24 million in cash transfers and $38 million in spending cuts.
Brownback's funding shift was part of the Legislature's plan to cover a $400 million shortfall in the current fiscal year. Most of the shortfall was covered by increases in sales and tobacco taxes that represented the largest tax hike in the state's history. To offset the cuts in income taxes, lawmakers raised the state's sales and tobacco taxes, easing the burden on high-income groups.
House Bill 2135, authorized Sullivan to lapse appropriations or transfer funding from special revenue funds to the State General Fund, up to a total of $100 million, at any time during fiscal year 2016.
Among the cuts was an $8 million reduction to the Kansas Department of Transportation that state officials said would not reduce highway construction.
"These cost savings are in line with the governor's priority to protect core state services including K-12 education and public safety," Sullivan said.
Pension obligation bonds would represent more than a third of net tax supported debt after this issue, and general fund debt service would increase to more than 3% of revenues, analysts said.
"This wouldn't represent an increase in liabilities," Seymour said. "A net pension liability would simply be converted into a debt liability. However, we do note a number of risks presented by POBs, including the risk that market returns will be less than the interest cost on the bonds, and the exchange of a 'soft' liability (pension) for a 'hard' liability (debt). Also, the state has reduced pension contributions the next few years, indicating that these bonds are being used to some extent as budgetary relief."
In a record-breaking 113-day session that ended June 12, Kansas Legislators approved the pension bonds in the process of closing a $400 million budget deficit for the fiscal year that began July 1. Brownback had originally proposed $1.5 billion of POBs, but Senate Bill 168 trimmed that to the current $1 billion.
With proceeds from the bonds deposited in the Kansas Public Employees Retirement System, the state's funded pension ratio is expected to improve to 66% from the current 60.7%. The unfunded actuarial liability is expected to fall to $6.28 billion from $7.26 billion.
According to an actuarial analysis for the Kansas Public Employees Retirement System, the $1 billion of bonds could produce savings of $1.8 billion from all funding sources.
"Based on budget system expenditure data, the amount of state general fund resources used to finance state and school employer contribution payments is approximately 85%," according to a fiscal note.
"If this percentage is applied to the long-term savings figure, reduced employer contributions totaling $1.5 billion from the State General Fund could be created by the bill," the note said.
The interest rate of the bonds cannot exceed 5%, according to the fiscal note.
The bonds' principal and interest would be an obligation of the KDFA. The Department of Administration and KDFA would be authorized to enter into contracts to implement the payment arrangement after the bonds are issued.
"For FY 2015, it is estimated that savings of $52.1 million from the State General Fund and $58.0 million from all funds would result from the budget plan that reduces the employer contribution rate for the last six months of the fiscal year," Sullivan wrote.
The pension system projects a $9.8 billion shortfall in funding for retirees' benefits through June 2033. Lawmakers have moved in recent years to close the gap, but the bill would give KPERS an infusion of funds quickly.
The legislation anticipates the state taking 10 years longer, until 2043, to close the shortfall while reducing the state's annual costs.
Some lawmakers questioned the wisdom of replacing a liability with a debt, even though the invested proceeds of the bonds could grow at a faster rate than the interest, especially at the historically low rates available in the current bond market.
The hypothetical scenario calls for selling 30-year bonds at a rate below 5% while earning pension-fund returns of 8%, according to state officials.
Since 2012, most public pension bond deals have priced well below 4%, except for some maturities around 2032 that got rates around 5%, according to information supplied to The Bond Buyer by Interactive Data.
In 2003, the Kansas Legislature approved a $500 million bond issuance for KPERS, whose investment returns exceeded interest payments by $174 million, according to state officials.
The Kansas pension bond issue would be one of the largest since Illinois sold $3.7 billion in 2011. Lawmakers in neighboring Kentucky and Colorado shot down much larger pension bond proposals in their 2015 sessions.