Municipal Bond Market Spreads Signaling Unfunded Pension Liabilities Are Soft Debt Unlikely To Be Paid In Full: Municipal Retirees In Unfunded Pension States Unlikely To Receive Full Promised Retirement Benefits

Posted by Milton Recht:

From Federal Reserve Bank of Cleveland, Working Paper 13-01, February 2013, "Do Public Pension Obligations Affect State Funding Costs?" by Jean Burson, John Carlson, O. Emre Ergungor, and Patricia Waiwood:

[Y]ears of chronic underfunding of public pensions and the devastating effects of the financial crisis on investment returns on public pension fund assets have resulted in unfunded liabilities that have swelled to amounts that are estimated to be between $750 billion and $4.4 trillion.
***Yet there are also reasons why markets should be shrugging off the pension news. As Rhode Island demonstrated in August 2011, state and local governments have demonstrated a willingness and ability to reduce their pension obligations, thus providing greater capacity to meet other financial obligations. As we discuss in the next section, public pension reform is a complex legal issue, but in principle, when taxpayers are asked to pay higher taxes to preserve the financial wellbeing of public sector retirees, it is conceivable that the interests of the many will prevail even if this entails attempts to rescind the strong legal protections provided to the few.

In this paper, we investigate whether municipal bond spreads are sensitive to unfunded pension fund obligations. If the market views these public pension obligations to state and local government retirees as non-negotiable hard debt, one would expect to observe more indebted states to pay higher spreads. If the market perceives these pension obligations as soft debt, we may not observe any impact on bond spreads.

Our analysis suggests that markets are taking the latter view since the crisis. Before the crisis, states with high unfunded pension obligations paid higher spreads in the primary municipal bond market. After the crisis, we find scant evidence of a relationship between the degree of pension underfunding and yield spreads at issuance.
***V. Conclusion

In this paper, we investigate whether the bond market considers the states’ unfunded pension obligations as a risk factor. We find no evidence that these obligations are priced in as a threat to states’ creditworthiness and propose two possible explanations. First, pension liabilities may indeed not be a risk factor for bondholders. Historically, investor confidence in municipal debt has been well placed. States do maintain the authority to generate additional revenue by raising taxes, however political unpopular. States would also face penalty rates for future borrowing in the wake of default.

Investors might also be speculating that the states facing financial distress will be more likely to uphold their obligations to bondholders than to pensioners. Rhode Island’s elevation of bondholders’ seniority above those of pensioners in 2011 is recent evidence of this possibility. And, while states face high hurdles in reducing future pension benefits for current employees, these actions can be upheld if they are deemed reasonable and necessary for the public interest.