municipal market update may 19, 2015. rbc capital markets 1 table of contents 1.market conditions...

Municipal Market Update

May 19, 2015

RBC Capital Markets2

Table of Contents

1. Market Conditions

2. Green Bonds

3. Pension Funding

Market Conditions

SECTION 1


Macro Market Overview

Global equity markets came under pressure recently, as concerns over Greece and European peripherals resurfaced

Greece and its creditors remain at an impasse over austerity measures/fiscal targets as time runs out ahead of debt service payments

China’s central bank cut reserve-ratio requirements after growth hit the slowest pace in six years

10yr German Bund closed at a record low yield of 0.077% on Friday; UST10 rallied 8bp last week to close at 1.87%

Primary supply in municipal market remains elevated, with $9 – 10 billion pricing weekly

This will mark the seventh week of the year with volume north of $9 billion, and supply is up 81% year over year

The sheer number of deals pricing in a given week is overwhelming investors; reception for smaller deals has become challenging

Credit spread widening over the past several weeks has contributed to a neutral tone in the intermediate/long end of the curve

Investors in the first five years of the curve continue to demand wider spreads, leading to a flatter credit curve

Lighter economic calendar includes existing/new home sales, durable goods, KC/Dallas Fed indices, and jobless claims

RBC’s forecast for fed funds liftoff has shifted to September

10-Apr 17-Apr Change (bp) 10-Apr 17-Apr Change (bp)

UST 5 1.4 1.31 -9 5yr Ratio 87% 93% +6 Ratios



MMD 5 1.22 1.22 0

MMD 10 1.97 1.94 -3 MMD 30 2.84 2.83 -1

Interest Rates Last Week: Ratios Last Week: Supply YTD:

$130.2bn vs. $71.7bn last year at this time (+81.4% yoy)

Supply Last Week:

$9.7bn ($7.1bn negotiated + $2.6bn competitive)Supply This Week:

$9.6bn ($7.0bn negotiated + $2.6bn competitive)

Avg. Weekly Long-Term Supply:

$8.7bn in 2015; $6.0bn in 2014

Visible Supply:

$11.9bn as of this morning

Avg. of past 30 days: $11.7bn

Avg. of past 60 days: $11.0bn


Increased Volatility is Impacting All Global Markets and Issuers

Source: Bloomberg

A number of factors have combined to create increased volatility in all major financial markets:

- Regulatory changes – including increased capital requirements and lower leverage ratios have lowered risk profiles for market participants

- Conflicting central bank strategies – ex. US Federal Reserve and the European Central Bank

- Geopolitical issues impacting exchange rates and the pricing of major commodities such as oil and gas

- The limited ability of central banks to impact intermediate and long-term interest rates without coordinated global action

- Uncertainty regarding the timing of a new US rate increase

The “MOVE Index” measures volatility in U.S. Treasury Bonds (and by extension the overall fixed income market). The Index is a weighted average of 1 month treasury options. Increases indicate heightened volatility

The “Corporate Bond Sector Spreads” chart at right illustrates volatility in corporate bond spreads in March 2015

0

20

40

60

80

100

120

140

04/12/13 08/12/13 12/12/13 04/12/14 08/12/14 12/12/14 04/12/15

bps

“MOVE Index” of Treasury Volatility

Source: Bloomberg / PIMCO

Most Market Participants Expect Volatility to Remain High over the Near to Intermediate Term

Corporate Bond Sector Spreads

March 2015 MTD YTD 2014

Level

MBS 20 + 1 - 8 - 7

Financials 118 + 10 + 2 - 5

Utilities 122 + 13 + 3 - 10

Covered 40 + 13 + 4 - 30

High Yield 500 + 24 - 16 + 105

EM External 410 + 7 + 5 + 77

Change (bps)


Long-Term Market

Equity markets in U.S. continued moving higher last week, with some indices, including S&P 500 Index, ending Friday at all-time highs

S&P 500 Index gained 2% last week, and is up 5% over last two weeks

Market catalysts last week seemed to include cease fire in Ukraine, decent earnings reports from U.S. companies, and negotiations between Greece and its creditors

Oil prices gained during the week, a sign some believe that global oil demand, and by extension global economic growth, is not falling off a cliff like some believed a few short weeks ago

Concern over oil prices caused Treasury yields to increase dramatically in previous two week period

On January 30th, yield on 10-year Treasury was 1.67% and 30-year Treasury was 2.24%

By Friday’s close, yields had increased by nearly 40 basis points on both, to 2.03% on 10-year Treasury and 2.63% on 30-year Treasury

Last week of January saw recent lows in price of barrel of oil, with many claiming that the low price was a function of declining demand

Since that time, both oil prices and Treasury yields have increased sharply

Municipal yields jumped higher again during past week, with municipals underperforming Treasuries by increasing in yield more

This might have been a catch up to Treasuries, as municipals did not increase as much in yield as Treasuries the previous week

Municipal yields on Municipal Market Data (MMD) AAA General Obligation curve increased over 10 basis points for maturities 10 years and longer

This followed a week in which yields were up by more than 20bps for maturities of 10-years and longer, creating a sharp two-week increase in yields

Municipal bond mutual funds continued to see strong inflows last week, although less than previous week

Market Overview

U.S. Treasury Yield Curve Changes

Municipal GO “AAA” MMD Yield Curve Changes

Source: Bloomberg and Thomson Municipal Market Data

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Year

02/13/2015 02/13/2014

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 15 yr 20 yr 30 yr

02/13/2015 02/13/2014


Short term interest rates remain extremely low

Short-Term Market

Source: Bloomberg

Market Overview

SIFMA vs. ICE LIBOR

0%

50%

100%

150%

200%

250%

300%

04/

15

/20

09

07/

15

/20

09

10/

15

/20

09

01/

15

/20

10

04/

15

/20

10

07/

15

/20

10

10/

15

/20

10

01/

15

/20

11

04/

15

/20

11

07/

15

/20

11

10/

15

/20

11

01/

15

/20

12

04/

15

/20

12

07/

15

/20

12

10/

15

/20

12

01/

15

/20

13

04/

15

/20

13

07/

15

/20

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10/

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/20

13

01/

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/20

14

04/

15

/20

14

07/

15

/20

14

10/

15

/20

14

01/

15

/20

15

04/

15

/20

15

%

SIFMA vs ICE LIBOR Average


Muni Bonds: 2015 Issuance versus Redemptions

Tax-Exempt Market Dynamics

Source: Bloomberg, Lipper and Thomson Municipal Market Data

2013 – 2015 Municipal Weekly Volume Credit Spreads Remain Tight for Highly Rated Issuers

0

50

100

150

200

250

Jan

-10

Jan

-11

Jan

-12

Jan

-13

Jan

-14

Jan

-15

Bas

is P

oint

Spr

ead

to A

AA

MM

D

AA Spread

A Spread

BBB Spread

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Jan

-13

Feb

-13

Mar

-13

Ap

r-13

May

-13

Jun

-13

Au

g-13

Se

p-13

Oct

-13

Nov

-13

Dec

-13

Jan

-14

Mar

-14

Ap

r-14

May

-14

Jun

-14

Jul-1

4

Au

g-14

Se

p-14

Oct

-14

Dec

-14

$ m

illio

ns

CompetitiveNegotiatedAverage

$0

$10

$20

$30

$40

$50

Par

Am

ount

($B

N)

Actual Supply RBC Forecast Supply Redemptions


2.30%

2.40%

2.50%

2.60%

2.70%

2.80%

2.90%

3.00%

3.10%

3.20%

09/02/14 10/02/14 11/02/14 12/02/14 01/02/15 02/02/15 03/02/15 04/02/15

20-Year MMD

0.90%

1.00%

1.10%

1.20%

1.30%

1.40%

1.50%

09/02/14 10/02/14 11/02/14 12/02/14 01/02/15 02/02/15 03/02/15 04/02/15

5-Year MMD

The Municipal Market Evidences the Current High Level of Volatility

In addition to macro-factors causing increased volatility in global markets, US municipal market has number of additional specific factors that have increased volatility:

- Consolidation has reduced number of active major and regional market makers

- Regulatory changes have reduced liquidity from remaining dealers

- Ineffectiveness of hedging strategies as municipal and UST rates do not move in lockstep

- Many typical new issue market participants do not have capital to deploy in primary or secondary market

- Certain buying classes such as TOBs and rotational accounts have been negatively impacted by regulatory changes and tighter lending practices

- Market indexes are not well geared to gauge/consider current market liquidity level and investor sentiment

- Supply is uneven and periods of heavy supply often create greater investor leverage in pricing process

- Larger dealer positions may negatively impact credit spreads as they are worked down

Given these factors, volatility in municipal market recently includes significant credit spread shifts in addition to movement in MMD

-6 bps

+9 bps

-17 bps +16 bps

-28 bps

-20 bps

+47 bps

+17 bps

+5 bps

-33 bps

+15 bps

-50 bps

+38 bps

-14 bps -21 bps

+12 bps+50 bps

-12 bps

Macro Municipal Market Factors Movement in 5 and 20-Year AAA MMD

Assessment of Secondary Market Liquidity is an Increasing Investor Focus in Primary Market Purchase Decisions


Current Investor Preferences

Insurance companies and bank portfolios have been primary drivers of demand in 15-30 year range

In many instances, banks and insurers have been willing to purchase sub-5% coupons, reducing an issuer’s TIC

Bond funds have experienced positive fund flows and remain active throughout yield curve

Professional retail investors have been reaching further out on yield curve, buying out to 15 years

Term / Maturity (Year)1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Money Market Funds

Corporate Cash Managers

Short-Duration Bond Funds

Municipalities

Professional Retail

Individual Retail

Intermediate Bond Funds

Bank Trust Departments

Insurance Companies

Long-Term Bond Funds

Relative-Value Buyers

Bank PortfoliosTarget high quality GO or essential service credits. Sweet spot is 20-30 years. Can buy sub-5% coupons depending on portfolio needs and credit quality.

Buyer Category Commentary

Active 13 months and in. Main buyers of sealed-bid maturities.

Target is 2 years and in; sometimes out to 5 years. Need high-quality paper with higher yield than agency debt.

Target 15-20 years. Can buy 4% or 5% coupons. Most focused on yield and retail arbitrage opportunities.

Target out to 8-10 years, where bonds are typically non-callable. Prefer par-ish bonds.

12 to 25 years; Are more dollar price sensitive than bond funds. Often will accept 4-handle coupons.

Max yield buyers, focusing on 20-30+ years. More focused on liquidity and deal size than short/intermediate funds. Minimum 5% coupon.

Inside of 5 years. Need high quality credits. Can buy 2-5% coupons depending on maturity.

Target 2-15 years. Need the income and coupon protection of a 5% structure.

Out to 15 years and select maturities in 20, 25, & 30 years. Not sizable on their own but will accept lower coupons.

Target 5-20 years. Often need 5% coupons. Can play in middle-market deals when new-issue volume is light.

Target is 5 years and in. Can buy 3-5% coupons. Are less constrained by deal size than long-end funds.

Current Volatility Levels Require Strong Pre-Sale Investor Dialogue on Issues


Municipal Market Fund Flows

Until Fund Flows stabilize, trading in municipal market will remain volatile

According to data from Lipper, for week ended April 15, 2015, weekly municipal bond funds reported $486 million in outflows, down from previous week’s $33 million of outflows

Long-term muni bond funds saw inflows, gaining $238 million in the latest week, after experiencing inflows of $227 million in the previous week

Four week moving average is currently $(60) million, down from last week’s number of $95 million

Period ended April 15, 2015

Lipper Municipal Fund Flows

($5,000)

($4,000)

($3,000)

($2,000)

($1,000)

$0

$1,000

$2,000

3/11 3/18 3/25 4/1 4/8 4/15($5,000)

($4,000)

($3,000)

($2,000)

($1,000)

$0

$1,000

$2,000

Dec-10 Mar-11 Jul-11 Oct-11 Feb-12 May-12 Aug-12 Dec-12 Mar-13 Jul-13 Oct-13 Feb-14 May-14 Sep-14 Dec-14 Apr-15

Fun

d F

low

($

mill

ions

)

Flow Change

4-Wk Moving Avg


Comparison of Minimum vs. Current vs. Maximum AAA MMD

Source: Thomson Municipal Market Data

2014 & 2015 Comparison Historical Ten Year Comparison

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

5 10 15 20 25 30

%

Min 04/17/2015 Max

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

5 10 15 20 25 30

%

Min

04/17/2015

Max

Current 2014 & 2015 10 Year

04/17/2015 Min Max Min Max

5 1.22 0.94 1.34 0.62 3.97

10 1.94 1.72 2.79 1.47 4.86

15 2.45 2.12 3.50 1.80 5.47

20 2.68 2.35 3.89 2.10 5.74

25 2.78 2.45 4.11 2.42 5.88

30 2.83 2.50 4.20 2.47 5.94


1.000%

2.000%

3.000%

4.000%

5.000%

6.000%

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

10 Yr 20 Yr 30 Yr

Current Municipal Market Conditions: “AAA” MMD

After closing at 2.84% previous week, 30-year “AAA” MMD decreased by 1 bp from April 10 – April 17 to 2.83%

“AAA” MMD January 1, 2007 to Present Shift in “AAA” MMD Since April 2014

Source: TM3, Thomson Reuters10, 20, and 30 year “AAA” MMD shown to represent different average lives of municipal transactionsRates as of April 17, 2015

1.500%

2.000%

2.500%

3.000%

3.500%

4.000%

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr

April 3, 2014 to Present10 Year 20 Year 30 Year

Maximum 2.470% 3.330% 3.610%

Minimum 1.720% 2.350% 2.500%

Average 2.120% 2.837% 3.072%

January 1, 2007 to Present

Maximum

Minimum

Current

Shift in 30-year "AAA" MMD

2008 2009 2010 2011 2012 2013 2014

0.790% -0.900% 0.520% -1.130% -0.740% 1.330% -1.340%

30 Year

5.940%

2.470%

2.830%

10 Year

4.860%

1.470%

1.940%

20 Year

5.740%

2.100%

2.680%


Bond Buyer 20 General Obligation Bond Index

54 Year Historical Perspective

Today’s 3.45% level is lower than 91.74% of historical rates since January 1961

Source: Bloomberg as of April 16, 2015 Weekly yields and indexes released by the Bond Buyer. Updated every Thursday at approximately 6:00pm EST. 20 Bond General Obligation Yield with 20 year maturity, rated AA2 by Moody's Arithmetic Average of 20 bonds' yield to maturity.

Bond Buyer 20 GO Index since January 1961 % of Time in Each Range Since 1961

Yield Range

Less than 3.50% 8.93%

3.50% - 4.00% 7.02%

4.01% - 4.50% 11.33%

4.51% - 5.00% 10.66%

5.01% - 5.50% 14.86%

5.51% - 6.00% 10.34%

6.01% - 6.50% 8.01%

6.51% - 7.00% 7.31%

7.01% - 7.50% 6.60%

7.51% - 8.00% 3.88%

Greater than 8.00% 11.05%

Total 100.00%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0% Bond Buyer 20 GO Bond Index

Today's Rate at 3.45%


Bond Buyer Revenue Bond Index

36 Year Historical Perspective

Today’s 4.18% level is lower than 99.46% of historical rates since September 1979

Source: Bloomberg as of April 16, 2015 Weekly yields and indexes released by the Bond Buyer. Updated every Thursday at approximately 6:00pm EST. 25 Revenue Bond Yield with 30 year maturity, rated A1 by Moody's and A+ by S&P Arithmetic Average of 25 bonds' yield to maturity.

Bond Buyer Revenue Index since September 1979 % of Time in Each Range Since 1979

3.5%

5.5%

7.5%

9.5%

11.5%

13.5%

15.5% Bond Buyer Revenue Bond Index

Today's Rate at 4.18%

Yield Range

Less than 3.50% 0.00%

3.50% - 4.00% 0.00%

4.01% - 4.50% 4.31%

4.51% - 5.00% 13.52%

5.01% - 5.50% 21.98%

5.51% - 6.00% 13.47%

6.01% - 6.50% 9.11%

6.51% - 7.00% 3.83%

7.01% - 7.50% 6.73%

7.51% - 8.00% 5.39%

Greater than 8.00% 21.66%

Total 100.00%

Green Bonds

SECTION 2


Overview, Proceeds, Principles and Certification

Green Bonds are standard bonds dedicated to financing projects with clearly identified environmental and climate benefits

Green Bond Principles (GBP) recognize broad categories of Green Projects:

– Renewable Energy

– Energy Efficiency (including efficient buildings)

– Sustainable waste management

– Sustainable land use

– Biodiversity conservation

– Clean transportation

– Clean water and/or drinking water

GBP recommend that all designated Green Project categories provide clear environmental benefits that can be described, assessed, and quantified

For buildings, LEED (Leadership in Energy and Environmental Design) Certification generally achieves Green Bond criteria of being in top 15% of energy efficient buildings

– Must be approved by U.S. Green Building Council, which assigns points to projects based on levels (Silver, Gold, and Platinum) of achievement in improved environmental performance

Municipal Green Bond Issuance

Green Bond Principles and Certifications

Green Bonds: Definition

Green Bond Use of Proceeds


Green Bonds Have Risen to Prominence in Municipal Sector

15 Series of Green Bonds have been issued since June 2013 by:

– Water and Sewer issuers such as City of Venice, FL, District of Columbia Water and Sewer Authority, East

Central Regional Wastewater Treatment Facilities Operations Board (Palm Beach County), The

Metropolitan District, Hartford County, Metropolitan Water Reclamation District of Greater Chicago

– Higher education institutions such as MIT, University of Cincinnati, and Indiana University

– State-level issuers such as California, Indiana Finance Authority (SRF), NY Environmental Facilities Corp and

Massachusetts

Total par amount of $2.3 billion

In corporate bond market, Green Bond issuance was $36 billion in 2014, $14 billion in 2013 and $2 billion in 2012

Green Bonds Designation Implies Commitment to Environmental Standards

Use of Green Bond proceeds have clearly stated environmental benefits

Green Bond issuers may have reporting requirements on use of proceeds

Municipal Green Bond Issuance


The Bond Buyer: Green Bond Funds Take Interest in Municipals

On September 16, 2014, The Bond Buyer published article titled “A Flood of Green Debt Stands Out”

According to article, muni managers are turning to Green Bonds to meet rising demand from investors

Municipal green bonds account for 1.83% of Standard & Poor’s Green Bond Index

Fund managers have found that interest in green funds is generally result of investors motivated by desire to promote conservation or help offset global warming, not just prospect of earning a return

No green bond funds have yet been devoted entirely to municipal debt – the ones in existence include corporate and asset-backed bonds

Municipal issuers recently issuing green bonds have been able to attract new investors to their credit, and in some cases, municipal bonds as a whole

Bond funds have also been able to increase and diversify the type of investors in their funds by going green

Green Bond funds have attracted new investors without outperforming benchmark municipal or corporate bond funds with similar maturities

Pension Funding

SECTION 3


Rating Downgrades and Outlook Changes Increasingly Driven by Underfunded Pension Levels

Rating agencies have increased emphasis on pension liabilities when rating an entities’ credit

Issuer Rating Agency Date Rating Action Rating Commentary

City of Chicago

Moody's

FitchS&P

02/27/2015

11/08/201309/13/2013

Aa3 before 7/17/13, downgr to Baa2 by 2/27/15AA- to A- (neg)A+ (outlook revised to neg)

Baa2 GO rating incorporates expected growth in already highly elevated unfunded pension liabilities and continued growth in costs to service liabilities, even if recent pension reforms proceed and are not overturned in legal appeal.

Pension concerns overshadow recent improvement in other aspects of city's credit profile.Outlook change reflects view of risks involved in how city will address upcoming, large pension payments.

Wayne County (MI)

Moody's 02/06/2015 Baa3 to Ba3 (neg)Ba3 rating also incorporates weakened economic environment that we expect will continue to limit prospects for revenue growth, as well as above average exposure to unfunded pension liabilities.

PennsylvaniaMoody's

Fitch07/21/201409/23/2014

Aa2 to Aa3 (stable)AA to AA- (stable)

Expectation that large and growing pension liabilities coupled with modest economic growth will limit ability to regain structural balance in near termFunding levels of pension systems have materially weakened as result of annual contribution levels well below actuarially determined annual required contribution (ARC) levels

New JerseyMoody's

S&P 05/13/201404/09/2014

Aa3 to A1AA- to A+

Combined with sluggish economic recovery and ongoing pressure of statutorily scheduled pension contribution increases, state will be challenged to restore its weak liquidity position.Future pressures include growing debt, pension, and other post-employment benefit (OPEB). Debt and Liability profile is 3.8 on scale of 1 to 4 (4 being weakest).

Kansas Moody's 04/30/2014 Aa1 to Aa2 Pension under-funding remains a significant challenge for state.

New Orleans Fitch 09/30/2013A- (outlook revised to neg)

Pension funding levels overall are weak, with firefighter plan severely underfunded. City has contributed less than required amount to fire plan in recent years due to litigation and concerns about plan administration, but has been ordered to resume full contributions.

Omaha (NE) S&P 09/13/2013 AAA to AA+ (stable)Overall, S&P does not view city's pension reforms to date as sufficient to address weak funded position of pension plans, particularly given management's expectation that plans will not be fully funded for another 45 years.

Jacksonville Fitch 08/27/2013AA (outlook revised to neg)

Negative Outlook reflects uncertainty as to how city will resolve large unfunded pension liability and rapidly rising pension contributions.

Cook County (IL)

Fitch 07/24/2013AA- (outlook revised to neg)

Overall debt burden is moderate; however, unfunded pension liabilities are concerning, and statutory framework of annual funding remains significantly lower than actuarial funding requirements.

Tucson (AZ) Moody's 05/29/2013 Aa2 to Aa3 (stable)Outlook takes into account that city will continue to be challenged to improve overall financial position given trend of growing pension and OPEB costs and increased mass transit subsidies.

Fulton County (GA)

Fitch 04/19/2013 AA+ to AA (negative)Partially influenced by annual pension contributions which have increased $11 million or 33% since 2008. This will likely continue to consume higher proportion of resources given retirement system's weak funded ratio.

Kentucky S&P 01/31/2013AA- (outlook revised to neg)

Outlook revision reflects our concern over pension funded levels, which have declined and are likely to continue declining due to lower-than-actuarially required funding of pension liabilities and budgetary pressures associated with funding post-employment.

Kansas City (MO)

Fitch 03/01/2012AA (outlook revised to neg)

Included among key drivers for outlook revision is that in aggregate, city has not made full annual pension cost (APC) to pension plans for at least past six years.


Recent Pension Reform Efforts

California and Illinois continue to try to alter pension systems

California

Governor Jerry Brown signed pension reform bill on September 12, 2012

The California legislature previously passed pension reform measure, Bill AB340, on August 31, 2012 with strong bipartisan support

California’s pension reform includes:

- Retirement age: Raises retirement age to 67 from 55 for most new employees to get full benefits, and 57 from 50 for new public safety employees

- New formula: Changes benefit calculation formulas for new employees

- Pension caps: Caps benefits for new public employees who make more than $110,100; or those who make more than $132,120 but don’t get Social Security

- Spiking: Eliminates pension “spiking,” or inflating salary in years before retirement to increase pension

- Double dipping: Eliminates most double dipping, or drawing pension while working another government job

- Felons: Forbids felons from collecting pensions

Illinois

Pension overhaul delivered December 3, 2013 estimated to trim $160 billion off state payments owed to system, with goal of reaching fully funded status in 30 years

Changes will reduce $21 billion of state's unfunded liability and $1.5 billion from upcoming annual payments

Illinois’ pension reform includes:- COLA: Reduces annual cost-of-living increases for retirees - Retirement Age: Raises retirement age for workers 45 and

under - Salary Based: Limit on pensions for highest-paid workers- 401(k): Employees will contribute 1% less out of paychecks,

while some will have option to contribute to 401(k)-style plan- Benefit Calculation: Caps salary level for pension calcuation

and raises retirement age for younger workers, in some cases by five years

- State Involvement: Increase state payments into system by $60-$70 billion

On December 10, 2013, S&P improved outlook on A- Illinois GO bond rating to “developing” from “negative”

Illinois short term bonds traded 10-15 basis points lower during week after overhaul (December 9-13, 2013)


Rhode Island Example

Renegotiated Reform could preserve most of $4 billion UAAL reduction over next 20 years

Pre-reform Situation

UAAL of $7.3 billion

Funded ratio of 47%

Exponential increase in ARC

Projected insolvency of plan

Pressure on General Fund and Taxpayers

Economic and tax revenues lagging region and US

New State Treasurer, New Governor

Required education and public relations campaign on crisis at hand

Reality check with Legislature about effect on current and future budgets

Initial Reform

All accruals through July 1, 2012 preserved (including accumulated benefit multiplier)

COLAs suspended until solvency reaches 80%, then subject to excess 5-year annualized return over 5.5%, with cap of 4% and only apply to first $25K of benefit

Retirement age increased proportionately (but accruals preserved through July 1, 2012)

Reduced definition of salary and averaging period (3-5 years) but preserved minimum as calculated on July 1st

Reduced benefit multiplier accruals beginning July 1 (to 1% in most cases)

Mandatory conversion to hybrid plan for new and existing employees, reduced version of existing defined benefit with new defined contribution with employer matching

Employee contributions remain constant, but now broken down among plans

Reduced UAAL to $4.3 billion (funded ratio now 60%) and amortized from existing 19 to 25 years

Current employer contribution reduced from $689 to $384 million to DB and $30 million to DC for FY13, with lower future trajectory

Expected savings of $4 billion over long term

Renegotiated Reform

Settlement announced on Feb. 14, 2014, scales back some provisions of Rhode Island Retirement Security Act, a 2011 law that reduced benefits for active employees by shifting to hybrid system combining DB and DC plans and limiting COLA for retirees

Pension benefits to be calculated based on both inflation (CPI) and pension fund’s investment returns - On April 2, 2015 settlement was reached

resolving 6 out of 9 lawsuits against reform and locking in 90% of reform’s savings

- Settlement must be implemented by May 18, 2015

Proposed agreement favors veteran employees: reduce retirement age for many current workers to 65 from 67, increase frequency of COLA, and restore traditional DB plan for workers with 20 years or more

Would give employees 2% COLA after legislation passed and then one every four years until system 80% funded - Increases tied to mix of fund

performance and CPI


Kentucky Example

Multistep reform geared toward ensuring predictability and sustainability

Pre-reform Situation

UAAL of $26.2 billion in 2012, approximately double annual tax revenue

Funded ratio of 50%

Exponential increase in ARC

Skipping pension payments while local governments struggling to keep up with their required contributions

Cities in Kentucky Retirement Systems—such as Louisville and Lexington—had been making required pension contributions in full each year

- However, their funding gap continued to grow because each year state-mandated COLAs were not paid for, and cost was added to unfunded liability

- From 2006-2011, unfunded COLAs added $1.8 billion to Kentucky's state and local government pension debt

2008 pension reform legislation supposed to remedy system’s gaping funding deficiency, but only after long ramp-up

State not required to make full payments until 2024

Key Aspects of Reform

New pension plan for anyone hired after January 1, 2014

Future COLAs have to be paid for before given (instead of occurring automatically)

Accompanying legislation passed to raise additional $100 million annually to help pay estimated $131 million a year to make up gap in pension contribution

Commitment to immediately begin paying full amount owed

New cash-balance retirement plan where new workers accumulate retirement savings from employer and employee contributions, receive guaranteed minimum 4% investment return, and retire with lifetime benefit based on account balance

- New plan also more equitable to short- and medium-term workers by providing more portable benefit

New hybrid approach provides more predictable cost structure than current plan by reducing number of assumptions to accurately project costs

- Assumptions about employee turnover and salary growth not required in cash balance plan, because employee benefits accrue smoothly and are not based on formula

Similar reform failed to pass with Teachers’ Retirement System this year

Source: The Pew Charitable Trusts, Kentucky’s Successful Public Pension Reform, September 27 2013.


Pension Funding Bond Issues

PFB Issuances

Issuer Sale Date Par Issued Objective

Illinois Jun 2003 $10.0 bn Reduce large UAAL; achieve budgetary savings

Oregon Oct 2003 $2.1 bn Reduce large UAAL

Wisconsin Dec 2003 $850 mmFund UAAL of pension and accrued sick leave (OPEB) plans; achieve budgetary savings

Puerto Rico Jan 2008 $1.6 bn Increase funding of closed pension systems with few assets

Connecticut Apr 2008 $2.3 bn Reduce large UAAL; implement reforms for COLA calculation

Denver Public Schools Apr 2008 $450 mm Reduce UAAL to enable merger into statewide system

Chicago Transit Authority Jul 2008 $1.9 bnSecure reforms negotiated with unions to significantly reduce benefits and increase employee contributions; also OPEB bond issue to remove employer obligation to fund retiree healthcare

Milwaukee County Mar 2009 $400 mmFund large UAAL and create pension stabilization reserve to absorb volatility from future UAAL as result of sub-par investment returns

Kentucky Aug 2010 $468 mm Refinance Commonwealth loans to Retirement Systems at lower rate

Fort Lauderdale Sep 2012 $338 mmReduce large UAAL; establish ordinance requiring full funding of benefit enhancements at time benefits granted

Baltimore County Nov 2012 $256 mmFund UAAL created as result of reduced investment return assumption


State Pension Funding Bond Issuances

8 states have issued pension bonds totaling $21 billion since 2000. Several other municipal authorities and cities have also executed similar transactions totaling over $30 billion during that period.

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Illinois $10.0 bn June 2003

Oregon $2.1bn Oct 2003

Puerto Rico $1.1 bnMay 2008

Wisconsin$800 mmMarch 2008

Connecticut $2.3 bn April 2008

Puerto Rico $1.6 bnJan 2008

Wisconsin$1.8 bnDec 2003

Puerto Rico $300 mmJune 2008

Kentucky$468 mm Aug 2010

Kansas $500 mm Feb 2004

Kentucky$270 mm Feb 2011

Kentucky$153 mm Feb 2013

Indiana $184 mm Dec 2003


Colorado

State Treasurer issued FA RFP to securitize revenues and issue $4 billion in bonds to reduce unfunded liability for State’s Public Employees Retirement Association (PERA)

Legislation currently being drafted for 2015 session to authorize bonds

State also considering issuing $8 billion of pension bonds to fund unfunded liability associated with School Division of PERA

Kentucky

Kentucky lawmakers considered bill to issue $3.3 billion in pension funding notes for underfunded teachers' pension plan- However, bill did not pass and talks on hold

Bill proposed bonds issued by Kentucky Asset Liability Commission (ALCO), which has split ratings notched lower than state in part because notes subject to payments through lease financing agreements and biennial appropriation by General Assembly

Moody’s and S&P currently rate ALCO’s appropriation ratings as Aa2/AA with S&P providing a Negative outlook

S&P states, “…the negative outlook reflects our view of Kentucky’s substantially underfunded pension liabilities and the long-term pressures the state faces unless these are managed.”

Issuers Currently Considering Pension Funding Bonds

Other states and cities such as Kansas, Kentucky, Colorado, Jacksonville and Riviera Beach are considering PFBs

Source: Bond Buyer’s “Kentucky Eyes POBs to Fix Teachers' Pension Fund” dated February 18, 2015; Bond Buyer’s “Kansas Lawmakers Approve Pension Bonds” dated April 6, 2015; Wall Street Journal’s “Risky Pension-bond Strategy Considered in Kansas” dated February 5, 2015

Kansas

Kansas lawmakers approved $1 billion pension funding bond issue to close funding gap in Kansas Public Employees Retirement System (KPERS)

- State has successfully issued pension obligation bonds in past (2004: $500 million issuance)

- Bonds expected to be issued in series of $350 - $450 million

- KPERS estimates issuance will improve funded ratio to 66% from 60%

Proposal is attempt to maximize investment returns and reduce cost cutting pressure on other programs in State

- The proposal is also backed by State Treasurer Ron Estes who says “There are pros and cons to it..[but] it’s a reasonable burden”

Vice President of Kansas’ Senate states “Pension-obligation bonds, given near historically low interest rates, are an increasingly good option to manage debt.”


Points of View When Considering Pension Funding Bonds (PFB)

A Pension Funding Bond (PFB) introduces external leverage into funding source for pension plan

Bond proceeds are transferred to pension plan for investment

− Bond interest and principal are required obligations of plan sponsor

Introducing External Leverage into System

PFB proceeds are co-mingled with all other assets of pension fund

Investment expectations should be consistent with overall pension fund

Caution should be taken as to when to invest bond proceeds given potential size of deposit

− Professional investment advisors will likely “feather” in long term investments to minimize market risks and/or use bond proceeds to pay current expenses without liquidating existing positions

Investment Expectations Based on Overall Pension Fund

Improving funding ratios gives best opportunity for plan to maintain required levels going forward, reducing volatility and required investment risk

The more dollars held by plan and invested, the easier to keep funded ratios high, regardless of investment return

− Even with exceptional returns, it is difficult to shrink unfunded ratios as liabilities grow

− Further action must be taken outside of achieving solid returns

Plans that meet or exceed their actuarial rate of return can still lose ground

Stronger Funding Levels Outperform During Periods When Investment Returns are Less than Actuarial Rate

Economic



PFB proceeds are managed similar to all other funds within pension, and assumed rate of return is actuarial rate for pension

Actuarial Rate Defines Unfunded Liability

As long as bond rate is less than actuarial rate, issuer's net payments to fund pension obligations (ARC, if any, plus bond principal and interest) will be reduced

PFB Rate Relative to Plan’s Actuarial Rate Creates Value

Actual investment results for entire fund over time are important, but impact of introducing PFB proceeds to reduce or eliminate an Unfunded Liability has net positive impact on funded ratios and Annual Required Contribution, even if investment returns are below bond rate going forward

PFB Proceeds Have Net Positive Impact on ARC and Funded Ratio

Actuarial



If projected contributions are not sufficient to fully fund UAAL over expected term, GASB 68 calculation will cause increase to reported UAAL

GASB 68 requires discounting future pension liabilities in out years after assumed fund balance falls below zero at lower of actuarial rate or issuer's long term cost of capital (tax- exempt, high quality municipal bond rate)

GASB 68 Potentially Creates New Blended Discounting Rate

GASB 68 may impact size of unfunded liability that will be required to be disclosed on sponsor’s balance sheet

Unfunded Liabilities May Increase Significantly With GASB 68

Issuing PFB will greatly reduce amount of unfunded pension liability required to be disclosed on balance sheet by immediately improving plan’s funded ratio

PFB Now Has Greater Impact on Unfunded Liabilities

Balance Sheet


Disclaimer

municipal market update may 19, 2015. rbc capital markets 1 table of contents 1.market conditions...

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