This piece first published October 5, 2016, Debtwire Municipals
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Alaska’s pension obligation bond (POB) is tentatively scheduled to price on 26 October, resulting in one of the largest POB issuances ever, said Deven Mitchell, Alaska’s debt manager, in an interview with Debtwire Municipals.
Alaska lawmakers first authorized POBs in 2008, but the state never executed the deal, mulling the transaction and shelving it several times since. But favorable market conditions, combined with new financial pressure, prompted the state to finally move forward.
While the POB could free up general fund resources by reducing the state’s annual pension payments, the POB’s security, coupled with the state’s volatile pension returns, present potential problems for both the state and prospective bondholders.
Size and structure
The size of the issuance – between USD 2.3bn and USD 3.5bn, issued by the Alaska Pension Obligation Bond Corporation – relies on market interest, Mitchell said. Citi, Goldman, Sachs & Co. and Merrill Lynch serve as underwriters.
The proceeds will be split between the Teachers Retirement System (TRS) and Public Employees Retirement System (PERS), depositing USD 981m to reach a 90% funded ratio for TRS. PERS will receive between USD 1.3bn and USD 2.25bn. The larger deposit to PERS would bring the system’s funded ratio to 90%.
TRS currently has an unfunded actuarial accrued liability (UAAL) of USD 1.62bn and a funded ratio of 83.3% and PERS’s UAAL is USD 4.47bn and has a funded ratio of 78.3%, as of June 2015, the most recent numbers available, according to POB corporation documents.
Alaska’s POBs appear to avoid some classic criticisms of other similar transactions, but it is a calculated risk given the uncertainty surrounding investment returns, said Lisa Washburn, managing director of Municipal Market Analytics. Other issuers have used POBs to take an ARC holiday or to plug larger gaps, she said.
“With POBs, you don’t know until the debt matures if it was a good bet or a bad bet,” Washburn said. “Many funds today wouldn’t be so distressed without the annual losses of about 20% to 30% during the recession.
The state is sensitive to that risk. If the state pays 5% to borrow but only receives 4% in annual investment returns on the proceeds of the bonds, “the potential economic benefits of the transaction will not be realized and pension costs may increase,” according to corporation documents.
The state expects a true interest cost of 3.7% – a slight premium to the average 3.22% yield on AA taxable debt, a trader said. The state’s two pension systems, TRS and PERS, have almost identical investment mixes and returns. The 10-year annualized return on the state’s two systems was 6.7% in FY15.
But that masks volatile pension returns on an annual basis. In FY16, preliminary investment returns were negative 0.36%, that’s down from a 3.3% return in FY15, 18.5% in FY14, 12.5% in FY13 and 0.46% in FY12.
The deal comes as the state faces new financial pressure, which includes a lost AAA rating from all three ratings agencies earlier this year. The POB aims to help relieve that pressure by lowering the state’s annual pension payment.
As oil prices declined, in just four years, Alaska lost nearly half of its revenue – with USD 4.26bn in spending in FY17, a 44.5% decline from USD 8.81bn in FY14. That decline created a USD 3.2bn FY17 budget deficit – about 80% of total spending.
Governor Bill Walker (R) tried to alleviate the strain on resources by slashing the annual dividend payment in half, to USD 1,000 from USD 2,100, generating USD 700m in savings. But that is now subject to a legal challenge from some state legislators.
“This is not a ‘We have to do it’ situation,” Mitchell said. “It’s an opportunity to replace lower cashflow with higher cashflow — the difference is compelling, with the low interest rate we’re in, there are avoided budgeted costs of USD 3bn (through maturity) on a USD 3.3bn transaction. When you look at the escalation of future costs avoided, in my mind, this leads to better stability for the future of the state.”
Estimates from corporation documents show that through the 2039 maturity, depending on the size of the deal, the transaction creates USD 1.23bn and USD 3.32bn in cash flow benefits, reducing Alaska’s average annual required contributions by USD 81m to USD 130m.
While the POB could free up anywhere between USD 1.6m–USD 400m in general fund revenue each year, depending on the size of the deal and actuarial returns through the 2039 maturity, the state still has to make debt service payments. Annual debt service costs are estimated between USD 92.9m and USD 238.8m, depending on the size of the transaction, according to corporation documents.
With appropriation debt, political risk is a legitimate concern, though a state legislature failing to appropriate debt service costs would be a rare and extraordinary circumstance, said Washburn. And unlike other appropriation debt, POBs often lack a tangible asset for security, she said.
“But it seems they’re looking to provide investors comfort,” Washburn said. “The mechanisms in place show they’re willing to provide additional features – things that show willingness to pay.”
The debt is secured by a funding agreement between the corporation and the Department of Administration (DOA) requiring the state legislature to appropriate debt service costs. The funding agreement requests payments in March and September, ahead of the May and November interest payment due dates.
It includes a covenant and pledge to request payment. If sufficient funds have not been appropriated, DOA must give written notice to the trustee and request a Department of Revenue loan to make or supplement the payment. The chair of the POB Corporation can ask the governor for a special session of the legislature to appropriate debt service, and the governor’s annual budget proposal must include sufficient revenue for the Department of Revenue to complete the loans.
Although appropriation debt carries more risk than bonds with a general obligation pledge, those risks are less pronounced at the state level, said James Mann, municipal credit strategist at RBC Wealth Management.
States better understand the penalty associated with failing to appropriate debt service and the consequence created for all associated issuers — a smaller issuer may not be conscious of those risks, or willing to accept lost market access, he said.
“States are more sophisticated borrowers, with a deeper pool of resources,” Mann said. “People are sometimes not adequately compensated for the risk at the local level, as local issuers may not appreciate the repercussions of not appropriating.”
Eight years in the making
Alaska first contemplated POBs in 2008, establishing the corporation to assist the state and municipalities to issue bonds. The corporation is an instrument of the Department of Revenue and managed by a board of directors. The establishing legislation provided the ability to issue up to USD 5bn in POBs but has not yet exercised its power.
The corporation most recently considered a USD 2.5bn issuance for earlier this year, with an expected 5% interest rate, but shelved the concept.
State POB transactions make up only a handful of the USD 3.7trn municipal bond market. Kansas was the most recent issuer, with a USD 1bn transaction last year. Illinois, Oregon and New Jersey are also among the states with outstanding POBs. Illinois and Oregon issued USD 10bn and USD 2.5bn in 2003, and New Jersey issued USD 2.8bn in 1997.
Oregon lawmakers are exploring another POB issuance, and other states – Colorado, Kentucky and Pennsylvania – also flirted with the concept in recent years.
The State of Alaska is rated Aa2/negative by Moody’s Investors Service, AA+/negative by S&P Global Ratings and AA+/negative by Fitch Ratings.
A USD 9.4m tranche of 5% Series 2016A general obligation bonds due 2034 last traded in odd lots at 120.694 to yield 2.394 on 4 October.
by Maria Amante