Pension Debt Gains as Yield Converges With New Laws: Muni Credit
Pension bonds are joining the biggest rally in U.S. taxable municipal debt since 2008 as states from Kansas to South Carolina move to curb retirement obligations after four straight years of falling funding ratios.
Kansas plans to tap casino revenue for retirement plans, while Michigan lawmakers debate reducing pensions for new teachers. States and cities are shifting more retirement costs to workers to counter the widest gap between pension liabilities and assets since at least 1994.
Illinois, issuer of the two biggest pension bonds since 2003, is benefiting as investors buy the taxable municipal securities for yields more than two percentage points above federal debt. The yield penalty on the state’s retirement bonds due in five years has shrunk as much as 11 percent since their 2011 sale. At the same time, the extra yield on 10-year taxable munis over tax-exempts is close to the lowest since 2008.
The funding gap “is one of the biggest vulnerabilities in the muni market, and therefore to make headway in reducing this liability number will substantially help long-term credit quality,” Richard Ciccarone, managing director at McDonnell Investment Management LLC in Oak Brook, Illinois, said in an interview. The company handles $8 billion in munis.
Localities are curbing the growing cost of pensions to help balance spending and revenue as their fiscal outlook rebounds from the 18-month recession that ended in 2009. The debt is taxable because the borrower can invest the proceeds for a profit as they use the money to fund retirement plans.
For some issuers, bond ratings are at stake. New Jersey last year had its grade lowered by the three major rating companies, which cited pension costs. Standard & Poor’s in April said it may cut Illinois’s rating from A+, fifth highest, by more than one level without progress on its budget and “significant” retirement liabilities.
Illinois’s 45.4 percent 2010 funding level was the weakest among U.S. states, according to a Bloomberg Rankings analysis.
The pension funding ratio for states and cities fell to 75 percent last year from 76 percent in 2010, according to a Center for Retirement Research at Boston College analysis released this month. It’s the lowest level since at least 1994.
To address the gap, 18 states have passed laws this year regarding pension funding and 25 are working on such measures, according to the National Conference of State Legislatures.
“We’ve seen a lot of different approaches, but as long as the approaches are taken, investors feel better about the bonds,” said Peter Hayes, a managing director at New York-based BlackRock Inc. (BLK), which oversees about $105 billion of municipals.
Ten-year taxable munis rated AA, third-highest, yield about 1.23 percentage points above top-grade tax-exempts. The difference is close to a three-year low touched in March, data compiled by Bloomberg show.
The taxable bonds are following a rally in federal debt, Hayes said. Investors seeking shelter from Europe’s debt crisis pushed 10-year U.S. federal yields as low as 1.69 percent last week, within 0.01 percentage point of a record.
Investors demanded about 2.3 percentage points above Treasuries as of May 22 to buy five-year Illinois pension bonds, about 0.2 point less than when the state sold the debt. The $3.7 billion February 2011 pension issue was the biggest sale of retirement securities since Illinois’s $10 billion deal in 2003, according to Bloomberg data.
To help meet rising obligations, issuers from California to Florida sold $4.96 billion of pension bonds in 2011, the most since 2008, according to data compiled by Bloomberg.
The only U.S. state that owns casinos, Kansas will be the first to dedicate gambling receipts to retirement plans, said Keith Brainard, research director for the National Association of State Retirement Administrators.
Kansas will make other changes, such as creating a system for newly hired workers that doesn’t guarantee specific benefits. The state in 2010 had 64 percent of assets to cover projected retirement obligations, down from 71 percent in 2008, according to Bloomberg Rankings data.
Michigan’s Senate last week passed a measure that would place new public school employees in a 401(k)-style plan rather than a defined-benefit pension. House members are working on the bill. South Carolina lawmakers are considering boosting annual employee contributions.
“There is definitely a sea change in terms of the intensity of the political dialogue going on now with pensions compared to the past,” Ciccarone said.
Following are descriptions of coming sales:
ALASKA HOUSING FINANCE CORPORATION will sell as soon as today $196 million of revenue bonds to refund debt and buy mortgage loans, according to sale documents. The deal includes $50 million of federally taxable variable-rate bonds. S&P rates the bonds AA+, second-highest. (Added May 24)
VIRGINIA TRANSPORTATION BOARD plans to borrow $600 million of revenue debt as soon as this month via competitive bid. Proceeds will help finance capital projects, according to documents from the board’s April 18 meeting. (Updated May 24)
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