For a long time, the municipal bond market was considered a safe haven — an asset class that offered dependable after-tax returns, with low yields appropriate to the relatively low risk of default by publicly funded issuers. More recently, headlines in municipal finance have been dominated by Detroit’s 2013 bankruptcy, Puerto Rico’s debt crisis and rising budget deficits in Illinois and other states. Chicago, facing a massive budget shortfall, offered yields of more than 5.5 percent on tax-exempt bonds and nearly 8 percent on taxable bonds sold in July.
Does this mean the nature of the $3.7 trillion muni market is changing? With as many as 80,000 issuers, the vast majority of municipal bonds remain investment-grade credits for well-managed public entities. But the rise of pension liabilities over the past 15 years has emerged as a critical factor in municipal finance.
Pension liabilities carry risk that can, in worst-case scenarios, threaten debt repayment. Here are five key points:
• Pensions, like debt, are a liability of the municipal entity paid from general revenues. Unlike debt, however, pensions are not a truly fixed cost. Board members, often officials from the government sponsor, determine assumptions that drive pension liability calculations and funding practices. These assumptions, including the amortization of liability, life expectancy and market returns, can have huge impacts on liability and funding calculations and can be misaligned with actual outcomes.
• Pension liabilities are growing at an unprecedented rate, with current unfunded liabilities as reported at the state level four times the liability reported a decade ago.
• Whereas most state and local governments have limits on the amount and structure of debt they can incur, very few similar limits exist for pension liabilities.
• Pension liabilities fluctuate, subject to stock market volatility.
• It is still unclear which should take a priority position in a stress situation: bonds or pensions. But generally, pensions have been treated more favorably in recent high-profile bankruptcies.
Many state and local entities are now in the precarious position of funding enlarged liabilities in an era of sluggish economic and revenue growth. Pension contributions, along with wages, programs, other retirement liabilities, infrastructure investment and debt service are all paid from the same source of tax revenues — revenues that have not increased at nearly the rate of pension contribution requirements. As a result, we at Northern Trust Asset Management see pensions cannibalizing some state and local budgets, whereas others continue to underfund the system.
To gain a solid understanding of how pensions affect credit profiles, at least four factors should be taken into consideration:
The burden of the unfunded liability. Look at the absolute value of the liability in relation to government revenues, the tax base and factors such as reserve funds, overall municipal debt and the strength of the economy and demographic profile.
Funding practices. Is the pension liability affordable under the current tax and budget structure? Funding below the actuarial required contribution indicates the current burden is unaffordable and will grow at a compounding rate.
Actuarial assumptions related to the amortization schedule of the liability, life expectancy, retirement age and discount rate. All can cause huge swings in liabilities, funding ratios and annual costs. In some cases, these assumptions can serve to understate the liability, thus delaying necessary funding or reform.
Ability to reform. Does the entity have flexibility to adjust the liability and avoid competition with core municipal services? States with constitutional limitations on benefit adjustments include Alaska, Arizona, Hawaii, Illinois, Louisiana, Michigan and New York.
Beginning with 2015 audits, new government accounting standards will require increased transparency of plan liabilities and funding practices. This intensified scrutiny might bring to light more burdens on pensions than previously presented. We view this as a positive change for municipal bond investors.
Pension reforms have the potential to increase budget flexibility and stabilize liabilities. Since 2008, all 50 states have instituted some level of pension reform, including increased employee contributions, reduced or eliminated retiree cost-of-living adjustments or an extension of the retirement age. Although the reforms have been effective in some places, the measures remain politically challenging or prohibited by constitutional or statutory restrictions.
In the absence of systemic reforms, pension plan insolvency will become a very real concern for certain credits in the next decade. We do not expect a material increase in the number of municipal bankruptcies in the foreseeable future. In extreme examples, in which pension obligations have become oppressive and further reform is not feasible, though, restructuring could be deemed the last option. In these cases the treatment of bonds versus pensions remains unclear. A conservative approach should include the assumption that unsecured bonds will be impaired to a greater extent than pensions.
We expect it will remain politically unpalatable to impose cuts on employee and retiree benefits without including cuts for unsecured bondholders. The interpretation of recovery between bonds and pensions as a conflict playing out between Wall Street and Main Street will inevitably affect the restructuring process. In such a political environment, a market-imposed haircut on municipal bond investors may be preferable to an angry workforce.
The municipal bond market has never been so sleepy or dangerous as it may seem to outside observers. It is an inefficient market that rewards active investors who have the capability to analyze and assess the liabilities at stake. Unfunded pension liabilities represent a growing risk in the municipal bond markets, although with growing awareness, we can analyze and properly manage the risks.
Adam Shane is director of fixed-income research; and Stephanie Woeppel is team leader, municipal research; both at Northern Trust Asset Management in Chicago.
See Northern Trust Asset Management’s disclaimer .
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