SAN FRANCISCO — The recent bankruptcy filings of Stockton and San Bernardino share a common element — both troubled California cities target pension obligation bondholders for sizable haircuts.

Both plan to eliminate general fund payments on their pension obligation bonds as they restructure. Stockton filed for Chapter 9 bankruptcy in June, and San Bernardino filed Wednesday.

Stockton's proposal calls for the city to walk away from $102 million of its $124.3 million of outstanding pension debt. It will only make pension bond payments from enterprise funds that are separate from its general fund. San Bernardino adopted an emergency budget that includes no general fund payments toward its $50 million of pension bonds.

The proposed haircuts by the two cities spotlight both the high level of pension bond issuance in California and the potential weakness of the security when tested by bankruptcy.

However, the risk to the market is hard to pinpoint as investors are searching for every bit of yield and the bonds are structured in various ways by a variety of issuers.

Issuers from California have more distinct pension obligation bond deals than any other state over the last 10 years — 97 issuances at more than $9 billion par from 2002 to 2012, according to Thomson Reuters.

Only Illinois issued a higher amount of pension bond debt, $21 billion, thanks to huge state-level deals.

Because local governments in California need to get voter approval to raise taxes or issue general obligation bonds backed by a tax pledge, issuers have turned to alternative debt structures that don't require voter approval, such as lease-revenue debt and pension obligation bonds.

"I think it is endemic of the higher fiscal stress in California," said Matt Fabian, managing director at Municipal Market Advisors. "Pension obligation bonds are issued primarily to fund budget shortfalls, not to close pension funding gaps."

Fabian said his firm elevates default risk on any issuer that sells pension obligation bonds, but noted that it is hard to specifically target different series of pension bonds because of the variety of structures employed. Typically, the bonds are as secure as a fairly weak lease or guarantee, he said.

Stockton's clear position is that its pension obligation bonds are less secure than other bond obligations.

"This obligation is an unsecured obligation of the city, with no other collateral or pledged revenue stream committed to the payment of debt service," officials wrote in the city's formal restructuring proposal.

Stockton wants the court to allow it to forever walk away from all general fund responsibility for the pension obligation bonds.

Because of the variety of pension obligation bond structures and issuers around California, in addition to high demand for yield amid a record-low interest rate environment, reaction in the market appears tempered, though selling is evident, said Kelly Wine, executive vice president of R-H Investment Corp., a broker-dealer in Los Angeles.

"All these cities that are under pressure right now, you are seeing people that want to get out of these [pension bond] positions whether it is at a loss or not," she said. "I just think there are fewer bidders for them right now since there is some uncertainty of the credit quality."

Wine said Fresno pension obligation bonds are one of the credits she has seen out for bid.

Fresno, with a population of 500,000, has been dogged by economic problems similar to Stockton and San Bernardino's, with high employee costs and weak tax revenues following the recession.

Moody's Investors Service downgraded Fresno last week, affecting $462 million of debt. The agency dropped Fresno's issuer rating to A3 from A2 and its pension obligation bonds to Baa1 from A2. The outlook is negative.

The 2022 maturity of Fresno's 2002 pension bonds had not traded for three and a half years before June 14, according to the Municipal Securities Rulemaking Board's EMMA website. Since then, investors sold in large blocks $10.74 million of the $69 million maturity.

It's not exactly a panic atmosphere. A customer sold $2 million on July 19 at a price of 104.8 to yield 5.812% — at issuance, the debt, taxable like all pension obligation bonds, priced at par to yield 6.46%. The bonds are insured by National Public Finance Guarantee Corp.

Stockton's pension bonds, which are also insured, have only shown a bit of stress amid thin trading. On June 28, a customer sold $100,000 of a 2026 maturity at 86 cents on the dollar and a yield of 7.724% for bonds that priced in 2007 at 5.675%. These bonds are insured by investment-grade Assured Guaranty, which has indicated its intent to fight back against Stockton's effort to use Chapter 9 to walk away from its pension obligation bond obligations.

Fairfield, Calif., another city with serious financial problems, has also seen more frequent trading of its pension obligation bonds but few signs of stress since it declared a fiscal emergency on April 3.

Since April 13, when an inter-dealer trade moved $2.78 million of the $5.5 million 2034 maturity of Fairfield's 2011 pension obligation bonds, there have been more than 100 small block trades of the maturity. The city issued the uninsured bonds, which don't have a debt service reserve fund, to refinance previously issued pension bonds.

The city's fiscal emergency has not stopped the bond price from rising. When the next large trade of $1 million worth of the debt sold in May the price rose to 117.25% and yield of 6% from the April price of 113.65% at a yield of 6.49%; and has since remain in a similar range although the trades have all been small. At issuance the bonds priced at 96.8% of par to yield 8.5%.

Wine said some clients trying to unwind California pension obligation bond positions appeared to be mainly institutions, some from high-yield funds.

San Diego and Sacramento counties have led the state in the amount of pension obligation bond issuance, with just under $3 billion combined. More than 50 municipalities have issued their own pension bonds directly. The total is higher if pension obligation bonds sold through conduit issuers are included.

The high level of pension issuance is a reflection of a poorly functioning system for financing California local government, one expert said.

"The pension obligation bonds are more the symptom rather than the cause," said Richard Ciccarone, a managing director at McDonnell Investment Management.

Ciccarone said Proposition 13 in 1978 limited California municipalities' traditional borrowing authority, and forced them to seek other, less-secure ways to borrow, one of the results being pension obligation bonds.

Oakland set the precedent for pension bonds when it issued them in 1985.

Ciccarone said pension bonds are a result of the high employee costs that cities incurred as compensation rose across the state. Some cities pegged employee salaries to other comparable cities, setting off a cycle of higher costs and thus pension liabilities during the boom years, before their tax bases fell apart as a result of the recession.

In Stockton and San Bernardino in particular, personnel costs represent approximately 90% of the general fund expenditures, according to JPMorgan.

Many municipalities hoped to lower their costs by selling the pension bonds at a lower interest rate than the rate they must pay their pension systems. But due to the recession and the weak economic recovery, those investment returns have faltered, leaving many cities upside down on their gamble.

The California Public Employees' Retirement System — the largest pension system in the country — announced earlier this month that in the year ending in June, it had achieved a return of just 1% compared to its discount rate of 7.5%.

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.