Pension Obligation Bonds

Defining pension obligation bonds

Public obligation bonds are taxable general pension bonds whose incomes are invested in a pension trust fund. It is a financial instrument that can reduce pressure on the government based on its cash status by substituting for the needed pension contributions. It can also offer cost savings if the bond profits generate more than what was expected of the bond.

However, issuance of the bonds often comes with many risks. For example, pension returns may not necessarily exceed the cost of the bond and as such, flexible pension obligations in the event where payments can be smoothed over time due to inflexible debt and desired annual interest outlays.

Recommendations of Pension Obligation Bonds

The Government Finance Officers Association recommends that local and state governments do not issue the bonds due to the fact that:

Invested bonds may fail to generate more than the desired interest rate owed over the valid term of the bonds. This often leads to increased overall liabilities to the state

They are also complex tools that carry considerable risks. Their structure incorporate the use of guaranteed swaps, investment contracts and in other cases, derivatives that must be scrutinized intensively because they can introduce counterparty risks, interest rate risk and credit risk.

Issuance of debt to fund pension liability also increases bonded debt burden jurisdictions. Additionally, it potentially uses debt capacity that could be employed for other purposes. What’s more, taxable debt is generally issued without essential call options or makes whole calls. This makes it quite difficult to restructure or refund it compared to traditional tax exempt kind of debt.

The bonds are also structured in a different way compared to principal payments or extends repayment period much longer than actuarial amortization period. This increase the overall costs of the sponsor.

Rating agencies in other cases may not see the issuance of pension obligation bonds as credit positive. This is particularly is the issuance of the bond is not part of a highly comprehensive plan to address all shortfalls regarding to pension funding.

Assessing performance of POBs

Accessing performance of POBs is essential for anyone who wants to invest in them. Internal rate of return for the POBs for a given year is calculated based on taxable POBs universe through 2015. The results will clearly demonstrate any risk associated with the plan. The results will indicate a positive or a negative picture and you can decide to invest in the bonds if the picture is fairly positive.

It is however good to note that despite risks associated with bonds, the issuance of POB is not driven by restructuring for a more sustainable plan or careful planning among plans that are well formulated. It is driven by significant financial stress among plans that have not been paying their pension bill. The ideas here is that a government or a state is more likely to issue the bonds if pension plan represents a more substantial duty to the state and if the state has a more substantial debt outstanding. It can also issue the bonds if it is running short of cash.

Given the possibility of bonds issuance and risks involved, I can be quite difficult not to be skeptical especially if there is any entity that is proposing to issue them. As a matter of fact, the bonds are in the air in many states and Colorado, Kansas, Pennsylvania among others are considering issuance of bonds as a way of addressing their pension shortfalls.

The bonds could also be used responsibility by states that are fiscally sound and those that understand clearly risks associated with the bonds. This is because they can easily manage the situation and could play a significant role as a part of a larger pension reform package for a state that is fiscally stressed. Detroit for example issued bonds in 2005 and 2006 when the bond market was fairly positive.

Other findings on POB’s you need to note

Local and state governments issue the bonds to raise money to cater for their pension contribution requirements.

The bonds help governments to prevent increment of tax especially in bad financial times as they could reduce pension costs even if they pose considerable risks.

States that issue the bonds are in many cases fiscally stressed and not in a position to manage investment risk.

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Sources

http://crr.bc.edu/briefs/pension-obligation-bonds-financial-crisis-exposes-risks/

http://www.marketwatch.com/story/be-wary-of-pension-obligation-bonds-2015-04-15

http://www.gfoa.org/pension-obligation-bonds