Municipalities consider pension obligation bonds
Some municipalities seeking to lessen the burden of pension liabilities are considering issuing taxable bonds specifically intended for that purpose. They issue taxable bonds and invest the proceeds. This capital markets arbitrage can be successful for municipalities assuming an attractive realized spread and, of course, that investors are willing to purchase the bonds in the first place.
Recent market dynamics have been favorable on both fronts, based on my conversations with industry participants.
There are two spreads to consider here. First is the spread between issuance rates for non-taxable and taxable bonds. In part due to investor appetite for yielding securities, that spread has been compressed to historically low levels. (Pension obligation bonds must be taxable, as they would otherwise run afoul of IRS rules on use of non-taxable bond proceeds.)
The second spread to consider is the difference between what municipalities pay for the taxable bonds and what they expect to earn by investing the proceeds. The larger this spread, the more the municipality can offset its pension obligations. Industry consultant Public Agency Retirement Services (PARS) recently estimated this cost vs. earnings spread at approximately 2.5% to 4.5% for municipalities entering into pension obligation bonds.
Pension obligation bonds are not without risk, and municipalities should consult with their financial and legal advisors as part of any active consideration. Given recent investor receptivity and spreads, this may be a strategy more municipalities actively pursue.
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