Public pension funds have stabilized since the Great Recession thanks to improving equity markets and benefits cuts for new employees. But the vast majority of public pensions remain underfunded and continue to experience shortfalls moving into 2016.
These dynamics could create problems for the municipal bond industry as they represent potential conflicts with interest payments in the event of a bankruptcy or other adverse event.
In this article, we will take a look at how pension liabilities impact municipal bonds and why investors should consider them before investing.
Quantifying the Problem
Pension liabilities represent a substantial and growing risk to many municipalities throughout the country. California’s state and local pension debt stands between $300 billion and $1 trillion, depending on earnings assumptions, but several other states, including Illinois, New Jersey and Connecticut, have significant issues as well. Many of these states could face problems closing those gaps with higher taxes and with the financial markets remaining stagnant.
Although pensions have a widespread impact, the impact on the municipal bond sector is limited in a number of ways. Revenue bonds such as toll roads, water/sewer and public power have limited amounts of labor expenditures, which means that they don’t have much pension-related exposure compared with general obligations bonds. Pensions will have the greatest impact on state and local governments, which represent about 35% of the municipal marketplace.
In general, most analysts believe that the majority of state general obligation bonds and unlimited tax local general obligation bonds will be able to withstand the pressure of pension liabilities, but local appropriation bonds, limited tax local general obligation bonds and state general obligation credits with lacking pension liability management could be the most vulnerable to the rising levels of debt facing many public pension funds nationwide.
Assessing the Impact
A number of municipal bankruptcies have arisen from increasing pension liabilities, including cases in California and Michigan. Although some bondholders have speculated that municipalities may pursue Chapter 9 to reduce pension costs, most analysts agree that such actions could be difficult to accomplish from a legal standpoint. The majority of municipalities are likely to continue pursuing reforms of their pension liabilities instead.
Vallejo filed for bankruptcy in 2008 due to rising labor and pension costs, and a court ended up dissolving one of its labor contracts. Although this set a precedent, the municipality opted to avoid a fight with CalPERS and restructure its other labor contracts without cutting its pension. Stockton’s bankruptcy was similar in that it did not impair the pensions of current workers, but instead renegotiated labor contracts to save money in other ways.
Detroit intended to include the pensions of its current employees and retirees when it filed for bankruptcy protection in 2013, but the judge ruled that pensions are contracts that could be impaired in bankruptcy. After emerging from bankruptcy, the city’s current and retired workers agreed to pension cuts amounting to roughly 4.5%, and COLAs were largely eliminated. These changes helped bondholders recover between 34% and 74% of par value on their bonds.
The Bottom Line
Pension liabilities have been a big problem since the 1990s when municipalities began promising more than they could afford or more than financial markets could justify. After the 2008 financial crisis, a series of bankruptcies highlighted that these pensions could be on the chopping block during reorganizations. The rising liabilities could prompt bankruptcies in the future, but most analysts believe that reforms are likely to be the preferred solution.
