finance Archive

Pension obligation bonds

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Pension obligation bonds are referred to as POB’s in the finance and investment industry. They are basically an instrument of debt which is issued by a government entity in order to finance a portion of or all of UAAL’s (Unfunded Actuarially Accrued Liabilities) for pension purposes and/or other PEB’s (Post Employment Benefits).

In so many words, and from an accounting standpoint, are capable of converting the liability of a short balance sheet to the liability of a hard balance sheet.

The benefits of investing in POB’S

There are three key advantages or benefits to investing in pension obligation bonds that you should be aware of if you are considering investing in these financial instruments:
• the disciplining of budgeting the annual payments of debt services in order to cover the newer obligations of the bonds
• the difference between the interest paid on these bonds and the actuarial assumed returns results in annual funding cost reductions of from 15% to as much as 30%
• cash is provided to the various retirement systems so that they can invest these in order to lower any unfunded liabilities as well as meet benefit payments in the future

The history of pension obligation bonds

In 1985, Orrick created financing for the City of Oakland by developing and issuing “pension bonds” as well as serving as the bond’s counsel. This resulted in a “snowballing” effect of financing and other copy-cats which rapidly followed and were tax-exempt financial instruments.

However, they were driven by the possibility of legal arbitrage occurring in the process. A number of these transactions were patterned after either annuity instalment sales or as lease financing.

Tax legislation relative to the Tax Reform Act that was passed in 1986 put an end to these tax-exempt bonds. Interestingly enough, financial institutions have continued to work on other tax-exempt pension obligation bonds due primarily to special non-arbitrary or rules of transition situations that may exist.

In 1994, a newer, taxable version of POB’s occurred in the state of California, the origination point being situated in Sonoma County.

These were driven by the rate of declining, taxable rates of interest compared to the actual rate of interest that was imputed by certain pension funds on the UAAL (see above). Additionally, needing budget relief and the legal arbitrage risk became opportunities in a much broader array of investments made by most pension funds compared to what the city or county governments had permission to make.

Bond valuation

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bond traders

What is bond valuation and how does this work?

The process of calculating a bond’s fair price is referred to as ‘bond valuation’. However, the theoretical fair price is based on the current value of the cash flow that the bond is expected to generate.

It follows suit then, that the actual valuation of a bond is calculated by discounting the anticipated cash flow to the current time by using the rate of discount that currently applies. Determining the rate, or the ‘pricing’ of the bond, is done with considerable reference to other financial instruments. This information is important to people whose goal is to make money via bond trading.

Once the bond’s price or value has been determined, the price sensitivity can be estimated. The different yields which relate to the bond’s value to the bond’s coupons can be determined as well during the valuation process. This valuation becomes more specialized if ‘embedded options’ exist (options which provide a structure to the bond) and are included in the bond. This more specialized valuation combines the cash flow based approach above with option pricing.

The 2 bond valuation formulas

As was mentioned above, the fair value of straight bonds, or those types of bonds which contain no embedded options, is calculated by using the current discount rate and applying it to the estimated cash flow of those bonds. The applicable formula is calculated in the following manner:

Cash Flows – C = periodic coupon payments,
n = the number of times that coupon payments occur,
F = the face or par value,
and T = the value of the bond which is paid out when it matures.
Discount Rate – r = the required rate of return or yield which is compounded annually and is the current market rate of interest for those bonds with similar risk rankings and terms,
m = the coupons which remain to be paid over the remaining bond’s lifetime (in other words like n above) multiplied by T (see above), and u = (1 + r) 1 / n) which is the accumulation of interest during each coupon period.

Taking the above into consideration, the formula is that the bond price is a combination of the above. Since the value of the bond is the present value of applicable cash flows, an inverse relationship exists between the discount rate and the actual price of the bond. The higher the rate of the discount, the lower the bond price or value that will be attained.

European Central Bank

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ECBThe ECB (European Central Bank) is the central bank of the European Union, established in 1998 Relay to replace the EMI (European Monetary Institute from the Maastricht Treaty).

With a capital of 4 billion euros, this independent statutory body has inherited the entire Eurozone mission previously devolved to the national central banks: issuing currency and defining a monetary policy that the national central banks are then responsible to implement in the various national financial markets.

These interventions of central banks take two forms: the refinancing of banks in the open market, and the provision of bank standing facilities. Refinancing operations, which are loans from the ECB via the central banks to banks, are by tender (for example, the ECB announced that it has 500 million at a minimum rate of  predefined submission ) at a weekly frequency.

Hence the liquidity of banks, and thus the money in circulation in the euro zone, is controlled by the European Central Bank. Its primary statutory mission – maintaining price stability in containing inflation in the Euro zone countries below 2% – is achieved by setting interest rates, the most important of them being precisely the rate of refinancing interest-bearing loans to banks on the open market (2% as of July 15, 2012).

Subject to recurrent political criticism the economic bet assigned to the independent  ECB is that the fight against inflation will also maximize economic growth of the member countries of the European Union and minimize unemployment rates. The European Central Bank also has an advisory function to the EU and national authorities in the areas of its competence, and is responsible for the collection of statistical information needed for its operation via the national central banks.

The European Central Bank is governed by a board of directors which includes its Governor (currently the Italian Mario Draghi), whose six members are appointed by common accord of the Heads of State or Government of the Euro zone countries. The Board of Governors (the national central banks of the euro zone) and the General Council (including the governors of the central banks of countries that have not yet adopted the euro) are the two other decision-making bodies of the ECB.

As inflation has remained weak in Europe in recent years, the ECB did not have to worry on this front, but the persistent recession and the debt problems of countries such as Greece, Spain and Italy have been the focus of its actions, adding liquidity to the financial system to limit the effect of the criss.