Pension funding bonds, also known as pension obligation bonds, rarely improve the credit quality of the state or the local government that issues them, says Moody's Investors Service in a report.

Whether the bonds will have either a neutral or negative impact on the government's credit quality at the time of issuance depends on factors that include the use of the proceeds, the relative size of the bond issue, and the level of future budget savings that government managers assume from the issuance.

Moody's explores the credit implications of pension funding bonds in the report, "State and Local Governments Face Risks with Pension Funding Bonds."

"If bond proceeds substitute for annual contributions to pension plans or are used to pay pensioners, we consider it a deficit borrowing and would view the financing as credit negative, particularly if it is large relative to the budget (e.g. over 5%), is part of a continuous pattern of reliance on one-time resources, or is used in the absence of a plan to restore budget stability over the medium term," said Marcia Van Wagner, Moody's vice president -- senior analyst who wrote the report. "In general, we consider it to be positive for credit when management strategies are directed toward sustained improvement in net funded status of the pension plan, but negative for credit when management strategies primarily seek near-term budget savings without improvement in pension funded status."

If pension bonds merely shifted an issuer's long term obligations from one similar form to another, in this case from an unfunded pension liability to bonded debt, they would tend to have a neutral credit impact, says Moody's. Their risks, however, may include budget risks stemming from the government's anticipated high returns on bond proceeds as well as the possibility of a market downturn that could wipe out a portion of the proceeds.

Moody's rates pension bonds based on the pledged security, which may be a general obligation of the issuing government, an appropriation obligation, or debt backed by a special revenue stream such as the sales tax. Regardless of the specific security pledge and rating, the debt always becomes part of Moody's assessment of the issuing government's general credit profile and general obligation rating. It is therefore possible that a strong security on the bonds themselves could warrant a high rating but that the issuance of the bonds is sufficiently credit negative to put downward pressure on the issuer's rating.

"Governments contemplating pension bonds must sift through a number of factors influencing their decisions, including the specifics of their pension plans and the structure of the bonds," says Van Wagner. "However, pension bonds are often a red flag associated with greater rigidity of long term obligations, failure to find sustainable solutions to pension funding and a pattern of pushing costs off into the future. For this reason, most pension bonds have, at best, a neutral impact on our overall assessment of an issuer's credit quality."

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.