Issuer: State of New Jersey
Amount: $2.75 billion
Issue type: Global bond
Launched: June 25
Lead manager: Merrill Lynch
US state governments that are worried about their unfunded pension liabilities and unwilling to risk being kicked out of office by raising taxes to pay for them have found a solution: borrow the money at today’s low rates and let future administrations worry about any problems that crop up. After all, that’s not unlike the position of today’s state leaders, who inherited the cost of generous retirement plans voted in during the 1960s and 1970s.
Government officials like to say they are saving money by borrowing at current low interest rates to invest for tomorrow’s pensioners. New Jersey’s $2.75 billion global bond, issued last month, is the largest offering so far. That will be topped by a forthcoming $3 billion to $4 billion issue lead-managed by Goldman Sachs for the state of Michigan. The first such deal was launched by the state of New York last year, for $770 million.
Some aspects of the financing appear to improve on the status quo. Matthew McDermott, New Jersey’s state treasurer, says the state estimates that it will save about $47 billion by shortening the terms of the payments it is required to make. New Jersey owed its pension fund $4.2 billion. But, since it didn’t have the cash, it was forced to stretch the payments out over 60 years. Including interest payments, the total came to $57 billion. “With the market being what it is, we figured we could issue bonds and save money,” says McDermott. By issuing the bonds, the state shortened the maturity of the debt to 35 years. It was able to do so without raising its annual costs, because the pension fund demanded a higher return to meet its pension obligations than did the bond markets.
“Now all we need to do is pay back the bondholders,” says McDermott. The state has used the proceeds from the bond sale, plus $1.5 billion out of the its pension fund’s extraordinary returns in recent years, to pay off the obligations. A state law had to be changed to allow it to tap the latter surplus.
New Jersey’s deal involved a complicated structure designed to match the debt service to the amortization of its pension liabilities, says Samuel Corliss, who heads municipal finance at Merrill Lynch, the deal’s lead-manager. It included $375 million in current interest bonds targeted at retail investors, with a 35-year maturity, $1.3 billion for current interest bonds sold to institutions and $1.14 billion in a series of zero-coupon bonds. The latter two series were carved into 29 individual tranches to duplicate the cash flows required.
The pension fund had estimated that it would need an 8.75% return to meet its future obligations. As a result of the deal, instead of paying off its pension fund liabilities at the required 8.75% rate, New Jersey will pay bondholders at the rate of 7.64%. “We saved a full percentage point,” claims McDermott. He neglects to mention one big difference. In the past, the state was essentially paying itself (or at least its former employees); now it is paying bondholders. But, says a banker involved in the deal, “the state doesn’t care who it’s paying”.
However, the rating agencies do. The increase in indebtedness raised flags at Standard & Poor’s, which issued a report criticizing the proposed deal in May. A lobbying effort on the part of New Jersey governor Christine Todd Whitman changed the rating agency’s view, allowing the issue to go forward.
One way of understanding the current system, says McDermott, is to view the state as borrowing from its pension fund and paying the fund back at 8.75%. Corliss likens the new deal to refinancing a home mortgage. He explains how you would save money if you took out a home mortgage at 8.75%, then reduced the rate to 7.75%, but kept the monthly payment unchanged and paid off the loan earlier.
The deal generated some controversy in New Jersey, where all 120 seats in the legislature are up for re-election. Critics of the Republican administration of governor Whitman argued that the state was borrowing the money to invest in the stock market. That was a “misconception,” says McDermott, since not all the money goes into stocks. About 40% is invested in debt obligations, including mortgage-backed securities. The state fund has earned an average 12% return for the past 40 years, according to McDermott.
Though municipal bonds, such deals are not tax-deductible because they are being used to finance pensions, and thus are earning an investment return. And while New Jersey’s deal was a global bond, co-managers estimate that 99% was sold in the US. There were no roadshows abroad, as bankers involved in the financing say the expense of such travels can become politically sensitive. Corliss says New Jersey opted for a global structure to make its bonds available to a few important international investors, who bought the current interest bonds.
The deal appears a good one for bondholders. The bonds are appropriation bonds, which don’t require prior legislative or voter approval. Payments are subject to annual appropriation of the legislature. A common municipal financing technique in the past 20 years, they receive a rating one notch lower than general obligation or revenue bonds. To get AAA status, they are insured by MBIA, Ambac and Financial Security Association.
But how will the state pay off the zeros as they come due? Will it have a big payment to make to bondholders later? McDermott confesses he doesn’t know the answer, referring the question to financiers on the transaction. One banker involved in the deal said it shouldn’t create a problem. “They are assuming they can refinance to pay this off,” he says. However, others say that’s not so. The state has been paying off its pension liabilities by drawing from its general fund, and will continue the practice to pay the bondholders, says a banker in the deal. He says the state is betting on continued economic growth to bring in more tax. New Jersey has never raised taxes to pay its pension obligations – and doesn’t plan to do so to pay off the bondholders.
