Kansas Bondholders Showing No Aversion to Leverage: Muni Credit

Kansas, which dedicated casino proceeds to pension relief last year, is considering another gamble as lawmakers debate borrowing $1.5 billion to bolster the nation’s 11th-weakest state retirement plan.

A state senate committee advanced a bill last week authorizing the taxable municipal bonds as such debt is close to the strongest since at least 1994, data compiled by Bloomberg show. Investors who don’t benefit from the tax exemption have favored taxable munis for their extra yield.

As U.S. localities face retirement-funding gaps after the 18-month recession that ended in 2009, they are issuing pension bonds at the fastest clip in five years. Led by Orange County, California, sales have tallied about $280 million in 2013, after about $1 billion worth last year, the most since 2008, Bloomberg data show.

“If you’re going to sell pension bonds, now is as good of a time as any to do it,” said Jean-Pierre Aubry, assistant director of the Center for Retirement Research at Boston College in Chestnut Hill, Massachusetts. “But over the long haul you’re still going to have to make more on investing the proceeds than you pay in interest.”

Tax Hit

Kansas cut income taxes this year and first-term Republican Governor Sam Brownback has pushed to eliminate the levy. It is one of nine states prohibited by their constitutions from issuing general-obligation bonds.

The bonding will go to the full state Senate when lawmakers return May 8. The House approved the bill March 26. The measure would turn part of a $9.2 billion unfunded liability into debt with scheduled principal and interest payments. Kansas has failed to make required pension contributions for more than 10 years, said Aubry. The funding ratio for its three systems, which have 281,757 members, was 59 percent on Dec. 31, 2011, according to the state’s financial report.

The issuance is a gamble that investment returns will move as expected relative to borrowing costs, said Chris Mier, managing director with Loop Capital Markets in Chicago. Pension bonds are taxable because proceeds are invested to earn a profit, a practice that violates federal law with tax-exempt debt.

No Denial

“I don’t think you can deny that there is a risk,” said Mier. “Things don’t always work out the way you had hoped.”

Last year, cities from Fort Lauderdale, Florida, to Oakland, California, sold $980 million of the securities. That was up from $670 million in 2011.

States’ unfunded public pension liabilities total $2.8 trillion, Alexandria, Virginia-based State Budget Solutions reported in August. The group advocates changes in state spending patterns to include lower taxes and prioritize areas such as education and public safety.

U.S. state retirement plans had a median funding ratio of about 72 percent in 2011, down from 74 percent the year before, Bloomberg data show. More than 30 had less than 80 percent of assets needed to meet obligations, leaving the plans below the threshold considered sustainable. Illinois, with a $97 billion pension-system shortfall, sold the largest pension bond, a $10 billion issue in 2003.

Trodden Path

Kansas has been down this path before. The state sold $500 million of the bonds in 2004 when yields were higher. Proceeds invested brought a return of 6.4 percent on a borrowing cost of 5.4 percent, for a gain of $320 million, according to data from the Kansas Public Employees Retirement System.

Kansas expects to save $744 million through 2045 by borrowing, Alan Conroy, executive director of the retirement system, said in an e-mail. The system’s board “strongly supports” improving pension plan funding, including issuing debt, he said.

Under the proposal the House passed, the state would borrow through the Kansas Development Finance Authority and the borrowing cost authorized would be capped at 5 percent. The estimated annual $86.3 million of debt service would be paid from the state’s general fund, according to legislative documents.

“The near historic low interest rates on bonds provide a very favorable opportunity to realize market gains from investments,” Conroy said in his statement.

Below Average

Yields on 30-year benchmark munis that are exempt from taxes fell to a one-week low of 3.21 percent yesterday, compared with an average of about 4 percent for a Bloomberg index that started in January 2009.

Kansas is rated AA+ by Standard & Poor’s, the second-highest level.

Investors get an extra 0.39 percentage point on 10-year taxable debt rated AA rather than similarly rated tax-free securities, down from a gap of about one percentage point a year ago, Bloomberg data show. The taxable munis also offer about 0.9 percentage point more than benchmark Treasuries.

Kansas’s 2004 pension bonds, which are insured, have traded at a premium to face value, Bloomberg data show. Yields for bonds maturing in May 2034 have ranged from 4.18 percent to 5.15 percent this year.

Investors generally get higher yields on pension bonds than other taxable munis because there is a perception of greater risk because payments on the pension debt are typically subject to appropriation, said Gary Pollack, managing director with Deutsche bank AG’s private-wealth unit in New York. He oversees about $6 billion of munis.

Revenue Slide

Kansas faces reduced revenue starting this year because of the income-tax cut and scheduled reductions in sales taxes, according to a November 2012 report on revenue estimates from the Kansas Legislative Research Department.

Last year, the only state that owns casinos was the first to dedicate gambling receipts to retirement plans. The state also made changes such as not guaranteeing specific benefits to new state workers.

The governor “will carefully review and consider the bill should the legislature vote to send it to him,” said his spokeswoman, Sherriene Jones-Sontag.

Muni issuers are offering about $10.7 billion of debt this week, the most since June, led by California’s $2 billion tax-exempt deal and a $2 billion taxable Florida Hurricane Catastrophe Fund Finance Corp. sale.

Local debt is the cheapest in close to seven months relative to Treasuries. At 1.93 percent, yields on 10-year benchmark munis compare with the 1.75 percent interest rate on Treasuries with a similar maturity, Bloomberg data show.

The ratio between the two yields, a measure of relative value between the two asset classes, is about 110 percent, after reaching the highest since August last week. The higher the figure, the cheaper munis are compared with Treasuries.

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