Today, let’s talk about what I have decided to call time-bomb bonds: securities that blow up in the issuer’s face years or decades after being sold to investors.
The case in point: $1.14 billion of pension bonds that my home state of New Jersey sold in 1997, securities that I came across while working with Cezary Podkul of ProPublica for an article about New Jersey’s finances that was published Saturday by The Washington Post.
These bonds are one of the financial problems that New Jersey Gov. Chris Christie (R) inherited rather than caused. There was no room to discuss them in Saturday’s article. So, with research help from Podkul, I’ll discuss them now.
The Jersey time bombs, part of a $2.8 billion pension bond issue, are zero-coupon bonds. Zeros don’t pay periodic cash interest the way conventional bonds do. Rather, the interest compounds and comes due all at once when the bond matures. The rest of the bond issue consisted of regular securities that pay semi-annual cash interest. The bond proceeds allowed former governor Christine Todd Whitman (R) to top off the state’s pension funds with a $2.75 billion contribution.
At the start, the zeros were an almost free ride for Jersey taxpayers. In 1998, for example, the state shelled out a mere $6.3 million to redeem zeros coming due, while more than $1.1 billion of zero-bond proceeds were at work on the pension funds’ behalf in the then-booming stock and bond markets.
It was an almost free ride in terms of the state budget, too, because of accounting that can be best described as bizarre. A corporation that issues zero-coupon bonds has to count the unpaid but growing accreted interest on them as an expense, even though it isn’t shelling out cash to pay that interest. By contrast, New Jersey (according to the state’s nonpartisan Office of Legislative Services) doesn’t count that interest as an expense. What counts in the budget is the amount of zeros redeemed in a given year.
So in the zeros’ first year, the budget was charged $6.3 million even though the issue ran up about $75 million of accreted interest (by my horseback estimate).
But now, almost two decades after they were issued, these time-bomb bonds are blowing up Jersey’s taxpayers and the state’s budget.
Because the interest on the longer-term zeros has been compounding relentlessly for 18 years, the original $2.8 billion taxpayer obligation when the bonds were issued in 1997 has metastasized into almost $4 billion, according the state treasurer’s office. That’s because the $1.14 billion zero obligation is more than double its original size, even though the state has shelled out $1.36 billion (according to the treasurer’s office) to redeem the ones that have matured.
What’s more, the zeros are starting to come due in serious size — $219 million this past February, all of which was charged to the state’s 2015 budget. In two years, it will be $274 million. In seven years, $384 million, and it will stay at that level through 2026.
That’s serious money in a state budget in the $32 billion range. To his credit, Christie has banned new issues of zeros.
Robert Willens, a prominent accounting expert, was shocked when I told him how New Jersey (and I suspect many other governments) treat zeros for budget purposes. “I’ve never heard of any system that would countenance accounting [for the interest accruing on zeros] only at maturity of the bonds,” he wrote me in an e-mail. “That makes no sense to me.” Or to me, either.
Back when the bonds were issued, U.S. stock and bond markets were booming, and naifs thought that would continue. Even though the zeros carried effective interest rates of up to 7.65 percent a year — and the regular bonds carried rates in the 7s — that was way less than the 19 percent a year that the S&P 500-stock index had returned since August 1982, and the 11.2 percent that the Barclays Aggregate U.S. bond index had returned.
But since the bonds were issued, the S&P has returned only 6.9 percent annually, and bonds 5.7 percent. (These numbers are from AJO, a Philadelphia money management firm.)
Someday, I hope to discuss why pension bonds in general are a terrible idea for government issuers. And why zero-coupon pension time-bomb bonds are mega-terrible. Any entity tempted to issue those hideous securities should remember three words: boom boom boom.