This ‘Insanity’ May Be the Muni-Bond Market's Next Big Thing

(Bloomberg) -- It’s a "considerable risk," a "bad idea," or, as one expert put it, "insanity." And it may be the next big pitch Wall Street bond underwriters make to states and cities desperate to cover ballooning health-care costs..Dearborn, Michigan, the 94,000-resident city that’s home to Ford Motor Co., tested the waters this week by selling $35 million of bonds to chip away at the $161 million it needs to cover the medical bills of workers who will retire in the years ahead. The city is betting that by investing the proceeds it will earn more than it will pay in interest, with the profits helping to cover health-care expenses..Many states and cities have used the same strategy for their pensions, and Chicago Mayor Rahm Emanuel Wednesday proposed a $10 billion debt sale for the city’s ailing retirement system. Some have came out ahead. Others were burned by stock market losses or because the temporary boost allowed governments to cut their annual pension payments. Illinois, New Jersey and Puerto Rico borrowed billions only to see the large shortfalls reappear..The tactic has been used far less for health-care costs, but it isn’t unprecedented. Over a decade ago, five Wisconsin school districts plowed borrowed funds into collateralized debt obligations, the toxic investments that blew up after the housing market crash, with the intent of spending the earnings on health care. They lost the money instead.."These are expenses that should be paid for out of the budget -- not bonded out," said Thad Calabrese, an associate professor at New York University who studies public financial management and called such deals "insanity." "It’s surprising it hasn’t been done more and I’m thankful it hasn’t.".Governments are eager for ways to cover the health benefits that they’ve promised retirees, which, unlike pensions, are usually funded out of their annual budgets on a pay-as-you-go basis. S&P Global Ratings said the costs are a "growing" concern, with states alone facing $678 billion of unfunded liabilities. New York City’s $98 billion unfunded liability for retiree health care is bigger than its bond debt and its pension-fund shortfall..The Government Finance Officers Association recommends against selling bonds to finance those medical costs, citing the "considerable risk." That’s because there’s a chance they will earn less than it cost to borrow, leaving them deeper in the hole, which has been the case with governments that sold pension bonds just before stock market routs..Wixom, Michigan, also turned to the bond market this year to address legacy costs with retiree health care. Such a step has been allowed by Michigan lawmakers, who are considering a bill that would extend this year’s deadline for localities to sell bonds to pay off health and pension liabilities until 2023..Dearborn paid yields of 4.6 percent or less on the bonds it issued this week, well below the 7 percent or more that pension funds typically expect to earn each year on their investments. The injection of cash will bolster a health-care plan that was already about 29 percent funded as of fiscal 2016, bond documents say. That’s higher than the statewide average for localities that offer such benefits, James O’Connor, director of finance and treasurer for the city, said in an email.."Unlike most municipalities in the state, the city of Dearborn has been prefunding its OPEB Trust Fund for some time," he said. The bond sale is part of an effort to reduce the liability that includes closing the plan to new hires, he said..Municipal Market Analytics said in a report this month that it’s possible that more cities could follow Dearborn, in part because Wall Street underwriters will be looking for ways to drum up business given the lackluster pace of bond sales..But the company said that -- like pension bonds -- they’re "a bad idea, maybe worse.".--With assistance from Danielle Moran..To contact the reporter on this story: Amanda Albright in New York at aalbright4@bloomberg.net.To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, William Selway, Michael B. Marois.©2018 Bloomberg L.P.

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This ‘Insanity’ May Be the Muni-Bond Market's Next Big Thing

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