How pension debt drives down borrowing costs

The Wall Street Journal reported this morning that favorable conditions in the muni market have allowed World Trade Center developer Larry Silverstein to issue tax exempt bonds to finance his thinly-leased new building. At $1.6 billion, the deal will set a record for unrated debt. Like bankrupt Detroit’s “highly oversubscribed” tender offer in August, this is yet another instance of risky credits being warmly welcomed by the market. Coverage of these deals has emphasized investors’ appetite for higher yield, which points in the direction of the Federal Reserve’s monetary policy, and low supply.

One big factor behind low supply is the state and local pension problem. Though normally thought of as a source of negative pressure on the muni market, elevated pension debt is pushing down bonded debt levels, making it an issuers’ market even for the sketchiest credits. 

As the Volker Alliance’s William Glasgall recently noted, state and local bonded debt is projected to decline both this year and next. Why issuance is down, despite improving economic conditions and historic low interest rates, is perhaps the most perplexing, and to some, infuriating, topics of debate in public finance circles today. But clearly one reason is pension-related “crowd out.” Examples of muni market analysts who have argued for a “crowd out” connection between pensions and muni issuance are Loop Capital Market’s Chris Mier and Janney Montgomery Scott’s Tom Kozlik.

As government pension (and retiree healthcare) contributions continue to rise, often at a rate above revenue growth, even officials of creditworthy governments are not comfortable taking on new debt commitments. This means they are not reinvesting in infrastructure at a time when interest rates are as low as they have been in half a century. Of course, diminished supply of quality credits is great for other issuers who ordinarily might have trouble gaining market access.

This perverse development runs counter to two lessons supposedly taught by the financial crisis’ fallout: one, that high profile defaults and bankruptcies such as Detroit should cause investors to be more discriminating about where they park their money and two, pensions will increase borrowing costs.

Two is still true for particular governments, if not universally so for the state and local sector as a whole. Increased pension scrutiny by credit rating agencies, GASB, and the media continue to make life difficult for pension reprobates. The three states which are now having the rockiest time with Moody’s are Pennsylvania, Illinois and New Jersey, in each case because of pension mismanagement. Iliya Atanasov notes that, on a relative basis, Illinois is trading at junk levels though it’s technically still investment-grade.

Theoretically, governments define their policy priorities through the budgeting process. Backfilling underfunded pension systems rather than issuing new debt may be the fiscally responsible choice to make at the moment, but it’s still painful. It’s difficult to properly support infrastructure without borrowing, but governments can invest in human capital without taking on long term obligations. All debt is not equal.

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