Pennsylvania budget impasse creates arbitrage with California

This piece first published September 29, 2015, Debtwire Municipals
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The solution lawmakers reach concerning the Pennsylvania budget impasse and pension trouble will have far more impact on the market than the stalemate itself, said Charles W. Grande, executive director and head of municipal credit research at UBS Global Asset Management.

Market participants have taken a wait-and-see approach to Pennsylvania’s budget impasse and pension problems as they await a political solution that may solve both, Grande said.

The lack of news surrounding the logjam has kept 10-year Pennsylvania, which is rated Aa3/stable by Moody’s Investors Service, AA-/stable by Standard & Poor’s, and AA-/stable by Fitch Ratings, general obligation debt trading at about +50-55bps to AAA MMD for weeks, Grande said.

That’s wider than most 10-year AA rated debt, which trades at +20bps to AAA rated debt, according to FMS bonds. A June Pennsylvania general obligation deal priced about +70bps to AAA MMD, Grande said, but has since tightened — and stopped tightening as the budget impasse continued.

Despite almost identical ratings, Pennsylvania is cheaper than lower-rated California. Ten-year California debt, which is rated Aa3/stable by Moody’s, AA-/stable by S&P and A+/stable by Fitch is +30bps to AAA MMD.

California has tightened relative to Pennsylvania because of its robust economy, structural balance, said Grande. California has done a better job of managing funding levels for its pensions and benefits, resulting in tighter spreads, Grande said.

Playing politics

The Keystone State has gone without a budget since 1 July, the start of the fiscal year. Governor Tom Wolf (D) vetoed a budget proposal from the Republican-majority legislature, and an USD 11bn, four-month temporary budget approved by the legislature early this month, said G. Terry Madonna, director of the Center for Politics and Public Affairs at Franklin and Marshall College.

Further complicating the stalemate is discussion on a solution for Pennsylvania’s troubled pension systems, which have a combined USD 53bn unfunded liability. The two issues go hand-in-hand, Madonna said.

“Clearly the governor and Republican legislature have staked out positions on what they’re looking for,” Grande said. “It boils down to what are the long-term solutions — that will dictate more for the commonwealth. The delay has caused spreads to stop tightening, and the solution will cause spreads to go wider or tighter.”

Every time one side agrees to a compromise, the other side decides to hold back in an attempt to gain an upper hand, Madonna said. Each proposal gives the opposition “something,” but not enough to reach a deal.

“Each side is negotiating for a little bit more,” Madonna said. “The legislature is polarized, with Republicans more conservative and Democrats more liberal, and the Republicans say they must settle both at once.”

Both sides have different spending priorities, and much remains to be reconciled, Madonna said. Wolf is still seeking additional education spending and fewer one-time fixes, and Republicans are holding out for pension reform, he said.

Wolf vetoed a GOP pension proposal, SB 1, that would move new workers to a hybrid plan, effectively halting any additional workers entering the existing defined-benefit plans. New hires would be placed in a 401(k)-style defined contribution plan and offered a separate portable cash balance plan that does not include employer contributions.

Governor’s pension concessions fall flat among GOP caucus

In response, the governor proposed a pension plan that has not been well-received by the Republican caucus, said Greg Mennis, director, public sector retirement systems, at the Pew Charitable Trusts. Wolf’s proposal includes changes to current member benefits and a modification to an existing defined benefit plan for new hires.

Wolf even modified his own proposal, changing the new-hire cap on pensionable salary to USD 75,000 from USD 100,000. Salaries above USD 75,000 would be contributed to a defined contribution plan, or a stacked-hybrid plan.

“That’s still very far from the market-based hybrid that the legislature has proposed,” Mennis said.

Wolf’s proposal resembles a similar plan from former Governor Tom Corbett (R) that was never approved, but has a key difference, Mennis said. The Republican version would have allowed the cap to increase by 1%, lower than inflation and wage growth. Over time, under the Republican proposal, more workers would be subject to the cap as salaries rise, but Wolf’s stacked hybrid is less aggressive.

Wolf’s plan also includes a USD 3bn pension bond, which was one of his budget priorities.

“POBs are a symptom of distress,” said Alan Schankel, managing director at Janney Capital Markets. “Painful reforms of the pension system are needed, and the money will run out at some point if they aren’t, if decisions aren’t made. In general, they want to be as aggressive as they can with the goal of lowering future pension costs.”

Wolf generally has the upper hand with voters, but as both crises continue, he becomes more politically vulnerable, Madonna said. Corbett was haunted by political displeasure from his first budget through his entire term, and lost his re-election bid to Wolfe in 2014.


by Maria Amante and Andrew Scurria


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