For long-term readers of the KCS Fireside Chat series, you may recall that we dedicated one of our articles to Pension Obligation Bonds (POBs) (Pension Obligation Bonds: Safe… or Sorry, July 2013). Well, it seems that POBs are once again in the news. I’ve seen reference in the last two days to Houston and Alaska considering using POBs to help close the gap between promises made and funded.
As a reminder, a Pension Obligation Bond is a debt that resides with the sponsoring entity (state, municipality, etc). It is basically a substitute for that entity making up the deficit through contributions, except that there is a carrying cost (interest payment) to the POB.
The hope is that the DB plan can generate a return on the POB’s proceeds that will exceed the borrowing cost. Unfortunately, it doesn’t always work out that way. In fact, a significant percentage of POBs were underwater following the great financial crisis.
Given where valuations are for equities and yields are for bonds. we would be very cautious about taking the proceeds from the POB and placing them into a traditional asset allocation with the HOPE that an excess return will be created. We would prefer that a POB’s proceeds be used to immunize (cash flow match) the plan’s near-term liabilities, thus securing the funding for near-term benefit payments, while allowing the existing assets to benefit from an extended investing horizon.
We would be happy to discuss this approach to securing the victory, instead of subjecting the proceeds of the bond to the same excessive volatility witnessed in traditional asset allocation approaches.