Pension funds across the world are facing a significant financial crisis. This is because, for a very long time, they have been investing heavily in equities since the interest rates offered by debt funds were quite low. However, in the recent past, the equity markets have sharply declined. As a result, the asset values of pension funds have dropped sharply while at the same time the liability values of state-funded defined benefit plans have remained the same. This has created a situation where there is a significant shortfall.

State pensions in the United State are almost 20% underfunded on an average! Estimates state that more than $200 billion will be required over the next five years in order to be able to make the required benefit payments.

Usually, state governments fund this gap. However, now since an economic recession may likely be around the corner, no government body is likely to have extra cash to fund this shortfall. Governments want to conserve whatever cash they have and don’t mind raising additional funds from the market. The end result is that many governments are considering issuing pension obligation bonds.

Pension obligation bonds are not new. These bonds have been in existence for a very long time. However, they are one of the most controversial types of bonds that have been under criticism for many different reasons.

In this article, we will try to understand what pension obligation bonds are as well as the reasons behind their unpopularity of these bonds.

What are Pension Obligation Bonds?

Pension obligation bonds are special bonds issued by pension funds. These bonds are taxable as opposed to other bonds issued by such funds. Also, the idea behind the issuance of pension obligation bonds is that the money derived from the sale of such bonds will be used to invest in high-interest-yielding securities. For instance, the pension fund will issue debt at a low cost and will then use the proceeds to buy stocks and other assets which pay higher interest rates.

The difference between the two interest rates will help the pension fund make up for the shortfall. In the end, the pension fund will return the principal and the interest to the investors. However, they will use the additional profit earned to make for the shortfall in the pension fund.

Proponents of pension obligation bonds feel that such bonds can be considered to be an arbitrage opportunity i.e., they allow pension funds to grow their funds without any additional risk. However, this is not true. Most people believe that pension obligation bonds add significant risk to the overall portfolio. This is the reason why most investors are averse to the use of pension obligation bonds.

Disadvantages Associated with Pension Obligation Bonds

The significant disadvantages associated with pension obligation bonds have been mentioned below:

1. Pension obligation bonds can be considered to be purely speculative in nature. This is because of the fact that it assumes that the investments in other assets will yield a higher return than the interest rate being paid on the bond. If the assumption is not met, then there may be additional losses and an already depleted pension fund will have to serve even more debt. The end result is likely to be an increase in the liabilities of the fund.

2. The proceeds of pension obligation bonds are generally invested in high-risk assets. This could mean higher use of derivatives and alternative assets in order to generate a higher return. However, this also introduces the pension fund with a wide variety of risks such as counterparty risks, interest rate risks as well as credit risks. This is against the fundamental principles of pension funds which are supposed to low-risk instruments.

3. Since the pension obligation bonds are issued by the government, the debt is also taken by the government. This is a problem for many governments since there is a limit to the amount of debt that they can undertake.

   If pension obligation bonds consume a part of the debt, then that part is not available to other sectors within the government. This creates resistance within the government machinery against the issuance of pension obligation bonds.

4. The pension obligation bonds are generally structured over a long period of time. The principal payments generally take place towards the end of the tenure. Hence, the pension funds have to pay more interest in order to service these bonds. This ends up increasing their overall cost of capital.

5. Most of the pension obligation bonds which are issued by governments are not callable. Hence, the government cannot refinance this debt even if the interest rate is reduced. Some bonds can be called but the government will have to compensate the bondholder before making such a call. This is what makes the call provision redundant to a large extent.

6. The issuance of pension obligation bonds is considered by credit rating agencies to be a bad sign. This generally results in a downgrade of the rating and finally creates a situation wherein the overall cost of capital of the pension fund increases rapidly.

The bottom line is that pension obligation bonds are very risky financial instruments. Most prudent fund managers avoid using these instruments. However, they are often used by funds under duress as a sure-fire way to raise funds.