Category Archives: Reporting

The MERF and the General Fund

Investment returns on the assets in the City’s pension fund have been well below average for the past five years. Poor investment performance impacts the General Fund in two ways.

First, the General Fund will need to make extra contributions to the MERF because of the poor investment performance. The General Fund is a main source of cash inflows for the program. Since Hartford’s pension investments didn’t grow as much as those of other pension funds, the taxpayers have to provide additional support.

Second, poor investment performance diverts scarce resources from the other General Fund priorities. Pension contributions are a top priority. The extra contributions that result from the MERF’s poor investment performance mean that other programs and services need to be cut even further to bring the budget into balance.

Pension contributions are one of the larger line items in the General Fund budget. The table below comes from page 28-1 of the Mayor’s Recommended Budget.

2016-04-18_Recommended-Pension-Funding

The recommended budget calls for just under $42 million in pension contributions this year, and over $47 million in contributions next year. It also calls for $16.5 million in employee concessions.

The table is full of large numbers. It might look a little different if the assets of the pension fund produced investment returns that matched, or exceeded, its peers.

$50 million in estimated MERF underperformance matters.

Pension Investment Performance

The Municipal Employees’ Retirement Fund (MERF) is a $972 million investment portfolio that pays the pension benefits of retired City employees.

The investment performance of the MERF has been poor in recent years. The poor performance is costing the City money, and contributing to the structural budget deficit.

The Fourth Quarter 2015 Investment Performance Analysis report, on the City Treasurer’s website, ranked the fund’s total return over different time periods. The following chart was taken from the “Investment Summary” on page 16.

2015-12-31_MERF-Performance-Return

It reported that over the past 5 years the fund was in the 81st percentile, which meant that 4 out of 5 Public Funds did better than the MERF. Over the last 3 years the fund was in the 91st percentile, so 9 out of 10 Public Funds did better than the MERF.

Underperformance in the short term is understandable. Markets fluctuate, and the MERF does not attempt to mimic the market. However, five years of very poor returns suggests there is something wrong with the MERF’s investment strategy.

It’s difficult to know exactly how much the poor investment performance has cost the MERF. It’s about a $1 billion fund, so 1% of underperformance for 1 year would result in about $10 million in missed opportunity.

The chart above states that underperformance has been 1% per year for five years. That suggests the MERF’s assets are about $50 million lower than if the fund performed at the median Public Fund level. Going a step further, if Hartford had an above average investment strategy, then MERF assets would be even more than $50 million higher than they are right now.

The investment strategy of the MERF has cost the fund tens of millions of dollars. This missed opportunity, in turn, will result in extra contributions from outside the fund.

The Fiscal 2016 Budget

Hartford’s leaders passed a balanced budget for fiscal 2016.

Reports varied about the precise size of the budget gap leaders overcame. The Committee on the Restructuring of City Government reported the gap to be $40.4 million at their first meeting in January. The Mayor’s Message that accompanied the adopted budget noted that leadership mitigated a $48.7 million budget gap. The official press release on May 28th characterized the gap as “more than $40 million.”

Regardless of the exact figure, three primary strategies were used to bridge the majority of the $40+ million gap.

First, “sustainable department cuts” were made that saved $12.8 million. The description that accompanied the dollar figure noted that there would be no cuts in “essential” services. The savings came via increased efficiency and, by implication, cuts to unnamed non-essential services.

Next, the debt was restructured to reduce payments in fiscal 2016 by $12 million. The action was described as the “second phase” of debt restructurings, and it was noted that leadership planned to “gradually increase our existing debt service over the next five years.”

Finally, the City negotiated a deal with the Schools to spend $13 million that had been set aside by the Board of Education. The details of the agreement are not posted on the City’s website with the adopted budget. However, media reports have stated that in exchange for spending the $13 million, the City took on $11 million of school expenses in the capital improvement budget.

This year’s strategies did not include any efforts to address the structural nature of the budget gap.

Instead, the three primary strategies responsible for balancing the 2016 budget are likely to make the structural budget deficit worse in future years.

A recent police staffing report stated that the department is significantly understaffed. The police department is one of the “essential” public safety functions, raising immediate questions about whether department cuts are “sustainable.” The City has begun adding staff to backfill cuts made in this, and previous, budget cycles.

Restructuring the debt to reduce payments in fiscal 2016 and fiscal 2017 increased the payments in the future. Over the next two years Hartford is scheduled to pay off $2.24 million of the $424.9 million the City currently owes. The total owed will increase in coming years. The 2016 – 2020 Capital Improvement Plan that was approved in conjunction with the 2016 budget calls for over $378 million in net borrowing over the plan’s five year life (see page 17).

If media reports about the deal with the Schools to spend money earmarked for post employment benefits are accurate, then effect is two-fold. Taking the $13 million reduced the funding status of the Schools’ benefits program. The $11 million in future debt/payments the City accepted from the Schools repays some value, but doesn’t make the Schools whole. The Schools still have to rebuild the account balance, and they lose out on all the potential investment income that the $13 million would have generated.

On the City side, the $11 million the City added to the Capital Improvement Plan in exchange for access to the $13 million represents additional future costs too. The practical result was that the City borrowed $13 million to spend on this year’s operating expenses, and will repay it over time. One could argue that getting $13 million and repaying $11 million over time is a good deal. For some people, companies, or municipalities, a negative interest rate loan like that would be a good deal (it’s an arbitrage opportunity). For others, those that repeatedly restructure their debt to postpone repayment, borrowing to meet current operating expenses has a negative overall impact. It increased Hartford’s debt burden and decreased Hartford’s financial flexibility.

All three of the primary budget “balancing” strategies involved manipulating expenses to make the 2016 income, expenses, and cash flow work. None of the three strategies will help put Hartford on a more sustainable financial path, and each one is much more likely to make the structural budget gap worse.

Hartford’s Taxable Debt

Municipal bonds are usually tax-exempt. This is an advantage for cities, as interest rates are lower on tax-exempt bonds.

The last two debt issues by the City of Hartford have included a portion of the overall borrowing that did not qualify for tax-exempt treatment, raising the overall cost of borrowing.

The Hartford Stadium Authority issued taxable bonds to fund the construction of the non-public portions of the ballpark. The City itself issued taxable bonds in the July 2015 restructuring used to balance the current year budget.

Treasurer Adam Cloud stated that the City’s debt can only be refunded once with tax-exempt bonds. Subsequent refundings (of the same debt) are required to be taxable.

Hartford has refunded a lot of bonds in recent debt restructuring efforts. The total is $272.5 million in 6 issues since 2009, of which $240.8 million is outstanding. Refunding bonds represent over 58% of the City’s total outstanding debt. As a point of comparison, refunding bonds represented just 20% of the City’s outstanding debt as of June 30, 2012.

How do the maturities of the Refunding bonds compare to the Original issue bonds?

The City’s debt profile can be separated into refunding issues and original issues. In the chart below, the original issues are shown in blue on the bottom. Refunding issues are shown stacked on top in red. For both series, the darker portions of the bar represent scheduled principal payments and the lighter portion represents scheduled interest payments.

2015-07-23 July 15 2015 Original vs Refunding

Each column represents the scheduled debt payment for a fiscal year. The dark blue section with the thick border at the bottom of each column represents the portion of that year’s obligation that could be restructured using tax-exempt debt.

There are virtually no original issue principal payments due through fiscal 2020 that could be restructured using tax-exempt debt.

It is important to note that scheduled interest payments can’t be restructured away. If interest rates are favorable, then interest payments can be reduced by refinancing to a lower rate. Both postponing principal payments into the future, and accepting higher interest rates, will cause near-term interest expenses to increase.

How much higher is the taxable interest rate?

The July 2015 issue included both taxable and tax-exempt bonds. Plotting the market interest rates from the Official Statement allows a rough yield curve to be drawn, comparing interest rates based on maturity and tax classification.

July 2015 Yield Curves

The market charged Hartford a 1.0% higher interest rate on the taxable debt than on the tax-exempt debt.

If Treasurer Cloud’s statement is accurate (and complete), then the sharp increase in refunded debt over the past 3 years has important implications.

The City has very little near-term debt that can be restructured with tax-exempt bonds. And the financial markets charge meaningfully higher interest rates for taxable bonds compared to tax-exempt bonds.

Future debt restructurings will be much more expensive for Hartford than they have been in the recent past.

July 2015 Debt Restructuring

The City of Hartford began the 2015-2016 fiscal year with a $78.06 million debt issue intended to help balance the current year budget by deferring payments.

The chart below compares the scheduled debt payments before and after the restructuring. The City’s projected debt profile as of June 30, 2015 is shown in the rear in green. On top of that series, the purple bars show the City’s new debt profile after the restructuring.

Columns with green tops represent reductions in scheduled debt service payments. Columns with purple tops represent increases in scheduled debt service payments.

2015-07-22 July 2015 Bond Issue

The primary goal of the restructuring was to dramatically lower debt service payments in fiscal 2016 and 2017. The Hartford Citizen model shows cash savings of over $15 million and $16 million for the two years, respectively. Cash savings are projected to be more modest in fiscal 2018 – 2020. Again, the green tops on the bars represent savings.

In exchange for reducing the near-term debt service, the City took on additional payments of between $4 million and $6 million in each year from 2021 through 2034. Those are the bars with purple tops in the chart. The change to 2035 was negligible, and no debt was added for fiscal 2036.

Note that the Hartford Stadium Authority’s debt has not been included in this calculation. The Stadium Authority is structured as a financial pass-through, where the City makes lease payments that exactly match the Authority’s debt payments. The City will be required to pay an additional $4.26 million per year in lease payments from 2017 through 2042.

$20.8 million of the $78 million in debt raised in July 2015 was issued as taxable bonds. When asked why the bonds didn’t qualify for tax-exempt status, City Treasurer Adam Cloud stated that IRS tax law only allows tax-exempt bonds to be refinanced one time with tax-exempt bonds. Further refinancings are required to be done with taxable debt.

The July 2015 debt restructuring provided the City of Hartford financial relief in fiscal 2016 and fiscal 2017. At the same time, it continued a recent trend of postponing debt, and highlighted an additional cost for future restructuring efforts.

Stadium Authority Debt

In October 2014, the Hartford City Council approved the construction of a minor league baseball stadium as part of the Downtown North redevelopment project. The Hartford Stadium Authority was created in January 2015 to oversee the facility, and was empowered to issue debt.

The Hartford Stadium Authority raised $63.4 million via two bond issues in February 2015 to fund construction. Taken together, the debt was structured to be repaid in annual installments of about $4.26 million until the City’s fiscal year that ends in June 2042.

2015-06-30 Hartford Stadium Authority Debt Profile

The debt is backed by a lease that the City of Hartford signed with the Stadium Authority. Scheduled rent payments, as shown in page 12 of the Official Statement, are intended to match up exactly with debt payments.

Two series of bonds were issued to fund construction because a portion of the costs did not qualify for the tax-exempt status that municipal governments usually receive. Tax-exempt bonds totaled $39.1 million in face value, and were issued at yields of between 1.23% and 4.15%. The remaining $23.4 million in face value was determined to be subject to federal taxes, and was issued at a yield of 5.625%.

When asked why a portion of the debt was issued as taxable, City Treasurer Adam Cloud explained that the public infrastructure created during stadium construction is tax-exempt. However certain things, like luxury boxes/suites, are private use and are required to be financed on a taxable basis.

Debt service on the stadium is structured as a fully amortizing loan. The City, via the Stadium Authority, will make equal payments every year until the construction costs have been repaid. Although the underlying bonds have a wide range of maturities and yields, the overall strategy is directly comparable to how individuals finance residential real estate purchases.

Converted to the terms of a fixed rate mortgage, the City borrowed $62.45 million, using a 27 year loan, with an interest rate of 5.0%.

Overlapping Budgets

It’s budget season in Hartford, and both the Schools and the City have released their proposed budgets.

Dr. Schiavino-Narvaez, Superintendent of the Hartford Public Schools, released her proposed budget on April 7, 2015 showing $429 million in revenue.

Pedro Segarra, Mayor of the City of Hartford, released his proposed budget on April 20, 2015 showing $534 million in revenue.

Although the two proposed budgets are separate, they overlap. The chart below shows the revenue sources that are included in each proposal.

2015-04-20 Overlapping Budgets

The total combined revenue is $679 million once the double counting is eliminated. $429 million is to be spent on the school system, while $250 million is to be spent on non-education programs.

Also of note is that over 76% of the proposed funding for the school system comes from State and Federal grants.

$36.4 Million Bond Issue of November 2014

Shortly after issuing $82 million of bonds in October of 2014, the City brought another round of debt to market in November of 2014.

Hartford raised $40.5 million total, with a face value of $36.4 million and premium of $4.1 million. The purpose of the issue was to refinance previous debt, and the Official Statement noted specifically which existing bonds would be refunded.

In a press release that accompanied the two late 2014 issues, Treasurer Adam Cloud stated that the November 2014 issue was “expected to produce approximately $2 million in debt service savings.”

The chart below shows the impact of refinancing on the scheduled debt payments. Unlike the April 2013 restructuring, the before data (green) and after data (purple) line up almost exactly. There was no obvious impact of the refinancing at the big picture level.

2015-02-16 November 2014 Bond Issue

The table below compares the annual maturities side by side. The approach of this refinancing was to substitute new bonds of approximately the same face value, but with different coupon interest rates. Green font in the table signifies new issues with a more favorable term; either a lower face value or a lower coupon rate. Red font signifies a less favorable term for the new issue.

2015-02-16 Maturities in the November 2014 Bond Issue

The impact of the refinancing is difficult to calculate with precision. There is subjectivity in how to treat debt payments that extend more than a decade into the future. Treasurer Cloud felt the offering would save the City “approximately $2 million” over 12 years.

The Hartford Citizen’s analysis of Hartford’s General Obligation debt was performed using a spreadsheet created to match the information shown in the annual audits (Comprehensive Annual Financial Reports). The model estimated total debt service savings of about $1.2 million over 12 years.

The estimate included the additional $485,000 in principal payments added to the debt, and summed future cash flows without discounting them (which maximized the value of future savings). The estimate did not include the $327,000 in underwriting fees paid to the investment bankers, which would bring the estimated savings below $1 million.

$82 Million Bond Issue of October 2014

Hartford raised two rounds of General Obligation debt in the fourth quarter of calendar 2014.

The first round was in October, when the City raised $95.1 million in an issue with $82 million in face value and $13.1 million in premium. According to the Official Statement, the proceeds were earmarked for “various public improvement projects” and “the City’s portion of various school projects.”

A press release issued by Treasurer Adam Cloud about the pair of bond offerings stated that the City received “its lowest borrowing cost in decades” at an effective interest rate of 3.11%.

The chart below compares the City’s scheduled annual debt payments (principal plus interest) before and after the debt issue. The green bars in the foreground show the debt profile as of June 30, 2014, while the purple bars in the background show the debt profile as of October 31, 2014.

2015-02-15 October 2014 Bond Issue

The purple tops of the bars show the amount of this issue to be repaid in each fiscal year. Payments were extended by two years, and about $6.5 million in annual debt service was added to fiscal years 2017 through 2035. If the bonds were held to maturity, the City would repay $130.8 million over 20 years.

Hartford’s Long-Term Debt as of June 2014

As of June 30, 2014, the end of the City’s fiscal year, Hartford’s General Obligation debt included scheduled payments through the fiscal year ending in 2033.

2015-02-14 Debt Profile as of 2014-06-30

There was no public debt issued by the City during the fiscal year that ended in June of 2014. However, the projected debt payments have changed since the June 30, 2013 long-term debt analysis.

The 2014 Comprehensive Annual Financial Report (CAFR) shows a $10.25 million debt issue from March 2013 on the table on page 65 of the pdf.

That issue was not included in the June 30, 2013 analysis because it was not included in the 2013 CAFR.

The table on page 70 of the 2013 CAFR shows the $124.6 million March 2013 issue that Hartford used to restructure City debt. The table does not show the $10.25 million March 2013 issue. In addition, there is no public offering statement available on the EMMA website.

Hartford Treasurer Adam Cloud stated that the $10.25 million issue was a private placement with Bank of America that did “not require an official statement” on the EMMA website, and that the funds were used for “various capital projects.”

Note that the Comprehensive Annual Financial Report for 2014 shows both the refunding bonds and the refunded bonds from the $124.6 million 2013 debt restructuring. This overstates the amount of debt the City owes by over $100 million, making some of the CAFR’s tables and exhibits misleading. There is an accounting technicality involved that is explained in Note 8 on page 64 of the pdf.