Chicago hears the POB siren song

15 August 2018

Two of Chicago’s pension funds recently announced higher discount rates, resulting in significantly lowered pension liabilities. The city is now considering pension obligation bonds (POBs) of up to USD 10bn, which, if issued, would further decrease liabilities of one or more city pension funds.

 

Chicago’s business and civic leaders are understandably eager to address the city’s inadequate pension funding. The underfunding is a persistent topic in coverage of the city by both the general and financial media, and can concern investors and prospective residents and businesses. In addition, Mayor Rahm Emanuel (D) and his administration are in an ongoing effort to provide adequate levels of city services even as pension contributions increase.

 

City officials might want to be wary, however, of issuing POBs in any amount. A Debtwire Municipals research report earlier this year found that funding ratios of the borrowers we studied tended to decline rather than increase after they issued POBs.

 

And from an investor’s perspective, as Debtwire noted in our September 2017 bankruptcy study, bonds and other securities that are issued to fund pension liabilities tend to fare poorly during bankruptcy. Three of the four entities in our 2017 report issued such obligations, and the recovery rate for them in each such case was below 50%.

 

These comments are not intended to imply that Chicago will file for Chapter 9 bankruptcy, especially given that state law does not allow Chapter 9 filings. State law can be changed, however, and Chicago’s financial problems indicate that a bankruptcy is not out of the question at some point in the future.

 

In addition, if Chicago issues POBs those bonds are likely to have enhanced security features that were not part of debt issues cited in our bankruptcy study. However, the evolving nature of municipal bond security, as evidenced by court decisions and other events in Puerto Rico, present for investors uncertainties that did not exist even two years ago.

 

Analyst Takeaway:

 

The table below, and accompanying notes, show the extent of the city’s pension problem. Also worth noting are recently announced changes to discount rates for the Municipal Employees’ Annuity and Benefit Fund (MEABF) and the Laborers’ Annuity and Benefit Fund (LABF).

 

The funded rate of the MEABF, the city’s largest, increased to 28.0% as of 31 December 2017 from only 19.1% as of 31 December 2016, with the change due primarily to the higher discount rate. For the same reason, LABF funding increased in 2017 to 48.2% from the prior year’s 31.6%.

 

The other two funds in the table are the Policemen’s Annuity and Benefit Fund (PABF) and the Firemen's Annuity and Benefit Fund (FABF).

 

In the table, we show, all else being equal, the impact that USD 10bn of POB proceeds would have on the city’s pension funds. We assume that the entire amount of bond proceeds, USD 10bn, is available, and allocated that amount pro rata to each of the four funds, based on their Plan Net Position as of 31 December 2017.

 

Pro forma funded percentages are shown in the final column. Even with USD 10bn in bond proceeds, the LABF in this example would be well-funded but other funds would still be underfunded. City officials have not yet indicated where any bond proceeds would be deposited, and any decisions it makes are likely to differ from the pro forma presentation in the table.

 

 

by Greg Clark