(Bloomberg Opinion) -- Chicago should be cheering on the recent decline in U.S. technology stocks.
The city, like many across America, is staring down huge budget shortfalls in the coming years after shutting down the local economy to slow the coronavirus pandemic. Mayor Lori Lightfoot last week estimated that the fund that accounts for most of its services will have a deficit of almost $800 million in 2020 and $1.2 billion in 2021, with Covid-19 related revenue losses accounting for 65% of the gap.
That’s bad enough for any U.S. city. For Chicago in particular, it’s devastating given its highly precarious financial situation even before the pandemic. Moody’s Investors Service downgraded the city’s credit rating to junk more than five years ago, sending shockwaves across the $3.9 trillion municipal-bond market and forcing investors to consider whether it was destined to be “the next Detroit.” Instead, former Mayor Rahm Emanuel made some politically tough decisions to help put its four underfunded retirement plans on a path to solvency and veer the city toward so-called structural balance by 2022.
Before Emanuel left office in May 2019, he proposed selling up to $10 billion in pension-obligation bonds to bolster the assets available in the retirement funds. As I wrote at the time, it was a needless gamble, particularly because part of his pitch was that rising interest rates would soon close the window of opportunity to issue the securities. In reality, it was clear the economic expansion was long in the tooth, and benchmark 10-year Treasury yields fell from 2.9% at the time to 0.68% now. Chicago’s own borrowing costs haven’t fallen quite as much, but they’re still lower than they were in December 2018.
I bring all this up because it sounds as if Chicago might give pension-obligation bonds another go.
In an interview last week with Bloomberg News’s Shruti Date Singh, Chicago Chief Financial Officer Jennie Huang Bennett floated the idea of issuing the securities, though added it was premature to discuss whether the deal size could approach $10 billion like under Emanuel’s plan. “Everything is on the table,” she said. “We’ve spent time analyzing a pension obligation bond, what the pros and cons are and have had a number of conversations about what that could mean for the city.”
The pros and cons are fairly straightforward for pension bonds. It’s a winning strategy if the funds’ investments deliver stronger returns than the interest rate on the taxable municipal securities; it’s a foolish endeavor if asset prices don’t steadily outperform. As I noted in an October 2019 article for Bloomberg Markets magazine, this tends to make POBs an intriguing option for local officials who think they can time the financial markets.
For instance, imagine if a highly rated U.S. state or city had issued long-term taxable bonds at a 3% yield in mid-April, after the muni market calmed down, and invested all the proceeds in the Nasdaq 100 Index, which counts Apple Inc., Amazon.com Inc., Microsoft Corp., Facebook Inc., Alphabet Inc., Tesla Inc. and Netflix Inc. among its 10 biggest members. From April 15 through Sept. 2, the index delivered a 45% total return on the way to a record high. Recent losses have pared its advance, but the gain since mid-April still stands at about 30%. That’s a giant net windfall for that hypothetical government that went all-in on big tech.
In practice, municipal finance officers aren’t of the same ilk as Dave Portnoy at Barstool Sports or other day traders. A quote from Matt Fabian at Municipal Market Analytics sums up the POB dilemma nicely: “If there’s a correction in the stock market, and you can time it at the bottom, sure,” he told me a year ago. “But think about the political will at that point. That’s when you do it, but that’s also when you don’t do it.” States and cities simply don’t have money to wager on bankrupt companies or out-of-the-money call options.
As the past week has shown, financial markets can’t defy gravity forever. U.S. equities, and especially the so-called FAANGs, are much cheaper than they were at the end of August. If the Nasdaq 100 simply returned to its all-time high from Sept. 2 in the near future, it would represent a more than 11% gain for anyone who invested at the close on Thursday.
For Chicago, which has a $30 billion unfunded retirement liability, that’s probably not enough. Its largest series of taxable bonds, which mature in January 2044, traded this week at a yield of about 6%. That’s likely close to the best interest rate it could hope for on a new series of POBs. With stock prices still lofty by historical standards and bond yields low by every measure, it’s hardly a guarantee that the city can manage better-than-6% returns from current levels.
And yet it might just be worth setting the POB process in motion should markets continue to weaken. Make no mistake, the city should tread carefully before going through with its sale. But it also might benefit from thinking partly like a day trader, as well as a long-term investor. Chicago’s complete budget proposal will be released in October, meaning that the offering would probably come after the U.S. elections on Nov. 3, which promise to be a volatile event for markets. If Chicago can somehow issue POBs and invest the proceeds when asset prices are in flux, that could put its pension plans on a better long-term footing.
Yes, that’s a lot of “ifs” to get the city back on track. But the alternative isn’t much better: Hiring slowdowns, changes to procurement and contracts, some other revenue sources, and, as a last resort, raising property taxes. Without federal aid, and without a wager like POBs to juice retirement-fund returns, the city seems certain to face an unrelenting squeeze in the coming years.
Chicago might not be the ideal candidate for a pension-obligation bond experiment, but it certainly could use a long shot more than most cities. An even bigger stock-market correction before its debt sale would only improve its chances.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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