BACKGROUND
Illinois passed what is known as the Pension Intercept Law (Public Act 96-1495) in 2011, but, for several reasons it did not fully take effect until 2016. This law gives pension funds the ability to intercept state shared revenue to fund pension obligations if they are not funded at their minimum requirement. As Illinois prohibits municipal bankruptcies this has caused concern in Illinois as well as many other states as to the priorities of shared municipal revenues relative to their obligations.
Due to fiscal irresponsibility, Illinois, and many of its public entities have failed to make full pension payments for years leaving them severely underfunded. This is compounded by struggling economic conditions in parts of Illinois.
Currently, the City of Harvey, a suburb of Chicago, is the focus of attention as both the police and fire pension funds have made claim to the Illinois Comptroller demanding she withhold state revenue, to be paid to the City of Harvey and redirect it to pension funding. This tied up State revenue sharing pitting various stakeholders (pensions, bondholders, general debtors etc.) against each other making claims as to priority. Recently, July 31, 2018, the City of Harvey, bondholders and both the police and fire pensions came to a settlement agreement that divvies up state-collected tax funds until it can be further decided in the courts.
The pension intercept law currently pertains only to Illinois but, it may have a significant impact on many municipal obligations. Rating agencies have noted in recent reports that if the intercept becomes commonplace it could strain some issuers and that the Harvey crisis illustrates how municipal pensions could be ‘must-pay’ obligations under Illinois law and have greater protection against default than a municipality’s general obligation bonds.
SUMMARY
When selecting municipal bonds for purchase one must understand, not only the fiscal condition of each state/public entity (including pension obligation funding), but their laws for determining priority of revenues and obligations, as well as if the individual state allows for municipal bankruptcies. It is also important to review the form of debt (GO, LTGO, REV, TANS, BANS, RANS, Certificates of Participation, Private Activity Bonds, etc.) relative to source of repayment with attention being paid to the various, and changing, tax laws and their impacts. This includes the strength of a bond insurer if applicable.
APCM OPINION & MANAGEMENT OF MUNICIPAL BONDS
As a conservative bond manager, we tend to invest in bonds that are liquid which often reduces exposure to smaller issuers. We remain up in quality based upon both ratings and financial fundamentals. Because of this we have largely avoided Illinois bonds for many years preferring to invest in areas that have better economic conditions, stronger credit profiles and more diverse revenue streams.
The Illinois Pension Intercept Law is still in its infancy and will continue to evolve. We anticipate there will be unintended consequences, negative for some bond holders while positive for others (prompting them to be more fiscally responsible). This will likely result in a bifurcated market differentiating between issuers subject to similar laws and those which are not.
Further, understanding the specific credit risks, including assumptions as to pension funding, can also create opportunities to capture additional yield on securities which are, in our opinion, mispriced as they are being painted with the same broad brush. It is important to evaluate the relative level of its obligations and their flexibility in meeting them.
Jason Roth
Senior Vice President, Investments
9/5/18
