NASHVILLE, Tenn. - The $16 billion Tennessee Consolidated Retirement System used its financial muscle to provide liquidity backing a $250 million notes offering by the state of Tennessee. This was the largest credit enhancement by a pension fund.
The fund will act as a standby purchaser of the so-called bond anticipation notes issued by the Tennessee State Funding Board. In the event the Tennessee fund is forced to step in as a standby purchaser of the notes, it has agreed to provide up to $250 million in principal and 34 days interest.
In turn, the state would be required to pay a higher rate to the pension fund than what noteholders would have earned. Tennessee Consolidated is the first pension fund to receive the highest long-term and short-term issuer credit ratings from Standard & Poor's Corp., New York.
The Tennessee fund's deal is significant not only for its size but also because it represents the acceleration of a trend. Cash-rich public pension funds increasingly are filling a void in the capital markets, as fewer commercial banks have the capacity and credit quality to provide liquidity for municipal offerings.
One observer cautioned that despite the strong credit quality of the state, the Tennessee fund is exposing itself heavily to a single entity. Defaults are uncommon but not unprecedented. A few years ago, the Oregon Public Employes' Retirement System, Salem, had to step in and purchase bonds issued by the Port of Portland. The Oregon system was the guarantor on the deal.
Steve Curry, director of the Tennessee retirement system, said a default is unlikely given the strong credit quality of the state. The notes will be issued in several tranches over a period of five years, and all will be due on July 2, 2001.
The fund will receive an annual fee of 7.5 basis points for acting as a standby purchaser. Under the standby purchase agreement, if noteholders decide to put the notes back to the state and the state cannot remarket the securities, the Tennessee fund would act as the purchaser of last resort and receive a higher rate - prime plus 75 basis points.
"The incentive is there for those notes to remain in the market's hands, not our hands," said Mr. Curry.
The first tranche of $65 million was issued May 1. The interest rate adjusts weekly but could be converted to a daily, monthly, quarterly, semiannual, annual or long-term interest rate adjustment mode.
The next tranche, in an amount to be determined, will be issued in late June, according to Ann Butterworth, director of bond finance. Smith Barney Inc. is the investment banker.
In the past, Tennessee used its own $2 billion short-term cash management pool as a standby purchaser without paying any fee. But as cash resources diminished, state officials decided it was inappropriate to use the pool, which is composed of state cash flows and the short-term investment pool of local governments.
"Before we were doing self-liquidity. But the pot of money available was not anticipated to be kept for long periods of time," Ms. Butterworth said.
The cost of paying a standby agent was less than the cost of maintaining the short-term reserves the state needed to secure the highest short-term credit rating, she said.
The pension fund now has at least $700 million in cash and short-term investments, but the figure ranges from $500 million to $1 billion. Mr. Curry said, "$250 million would be no problem for us to raise, particularly since we have to be given five business days notice" under the agreement.
Facilitating the deal required a legislative change and adoption of new policy guidelines by the pension board.
Proceeds of the deal will be used to provide short-term financing for capital projects.
Tennessee got a sweet deal from the pension fund for several reasons. Few entities would be willing or able to provide $250 million in liquidity in one fell swoop; few would be willing to do so for five years; and few would be able to provide $250 million without having to parcel out pieces of the deal to other financial institutions. Plus, Ms. Butterworth said, the state would prefer to deal with one party as standby agent.
Some say Tennessee's deal was too large for a first-time foray into the credit enhancement arena.
"The Tennessee fund is providing all of the liquidity," said Jeffrey C. Heckman, managing director of CIBC Wood Gundy Securities Corp., the brokerage arm of Canadian Imperial Bank of Commerce, Toronto. "It will use an inordinate amount of their total capacity. It is a (highly rated) state, but you're giving 50% of your liquidity to one entity. It should be diversified within the state and eventually nationally. It's a good use of the state's assets, but not at that level," Mr. Heckman said.
Despite his caution, Mr. Heckman remains an advocate of credit enhancement programs for public funds and is talking to a number of state plan sponsors about the idea.
He likened the risk of credit enhancement programs to that of securities lending programs, but with much higher returns. "Our fees are probably much better than the spreads on securities lending," he said.
CIBC worked with the California State Teachers' Retirement System, Sacramento, which completed the first transaction under its credit enhancement program on June 30, 1994.
The fund provided $25 million of a liquidity guarantee for a Port of Long Beach expansion project.
To date, the fund has issued letters of credit on debt issues with a total principal amount of about $150 million. The fund participated by wrapping its guarantee around its partner bank, CIBC, concentrating its financial exposure to A credit quality banks. In the future, the fund may provide credit enhancement for multifamily housing, according to Standard & Poor's, to generate off-balance sheet income. As an added bonus, the debt guaranteed under the program has helped create or preserve about 3,000 jobs in California, according to the S&P report.
The California fund has only scratched the surface since the total size earmarked for the program is $1 billion, according to Parry Young, director of the public finance department of Standard & Poor's.
Deals are also taking place abroad. In March 1994, the Electricity Supply Pension Scheme became the first U.K. pension fund to receive a credit rating from S&P and Moody's Investors Service Inc., New York. The rating enabled the fund to back a $105 million commercial paper program issued by its U.S. real estate subsidiary, Eastern Realty Investment Corp., Washington (Pensions & Investments, May 16, 1994).
While the California program has been "an unqualified success," according to S&P, others have not been so positive.
The Oregon bonds were issued by the Port of Portland on behalf of a startup aircraft maintenance company that ceased operations in 1993. After depletion of reserves, the retirement fund began payment of debt service of approximately $5 million annually on the 20-year bonds in October 1994. Any recovery value will depend on whether the facility can be re-leased or sold, according to S&P, which raised its rating on the $50 million in taxable special obligation revenue bonds in March to AA from AA-, based on the ongoing financial strength of the guarantor, the nearly $20 billion Oregon system.
Mr. Young of S&P noted it was a $50 million deal for a very large fund. The Oregon fund will have to pay $5 million in debt service on the 20-year bonds per year. Or the fund may sell or lease the facility or dispose of the bonds, he said.
Pension funds have been getting credit ratings for about three years. The benefits of credit enhancement program ratings are numerous. They generate ongoing fee income from the entities that receive the guarantee, which enhances total yield because it does not affect investment income - the same asset is used to produce two separate revenue streams, said an S&P report.
The deals also advance local and state goals by providing more options for additional and more competitive credit enhancement.
"Enhancement programs allow for exposure to different types of entities, broadening a fund's base while risk parameters may be set at thresholds tailored to a fund's requirements," the S&P report said.
Public funds, with their huge asset bases and generous cash levels, are well suited to credit enhancement. Terms can be quite favorable because of continuing demand in the public and private sectors for high-quality credit enhancement in the face of declining credit quality of traditional credit providers such as commercial banks, the report said.
"Pension funds can provide some staying power in the event of a recession. Historically, commercial banks are not always there. Pension funds have a time horizon not matched by commercial banks," said CIBC's Mr. Heckman.
S&P's Mr. Young said: "We think there will be more of this throughout the U.S. Obviously it probably makes more sense for larger funds, which have greater resources to deal with this from an administrative standpoint. But in states with a need for credit enhancement, smaller funds could also benefit," he said.
