LOS ANGELES -- The legal security for pension obligation bonds in California is strong, but the lack of unlimited taxing power to secure the debt means ratings usually will only equal those for a strong lease, Moody's Investors Service said yesterday.

A new wave of pension financing is likely, Moody's said, so it prepared the three-page comment to provide an overview of its rating approach for such bonds in California.

Many counties and cities in California are considering selling pension obligation bonds, Moody's noted, and issues elesewhere are studying similar financing vehicles.

Bond proceeds provide another method of financing an issuer's estimated unfunded pension liability. Issuers also can make annual contributions to amortize the liability over time.

Debt sales for this purpose currently are in vogue because interest rates on the borrowings are lower than the amortization rates used by actuaries for setting the annual contribution, even though the pension obligation bonds are being sold on a federally taxable basis.

In California, "the credit strength of pension bonds derives from the fact that a legal structure is created so that the obligation of a local government to fund its pension system is effectively assigned to the benefit of the bondholder," the Moody's report says. "The requirement to meet the pension obligation is typically of the highest order."

The legal structure for converting unfunded liability into pension bonds relies on a legal theory that is not commonly used in the credit markets, Moody's says. California courts have found that payment of "an obligation imposed by law" does not constitute indebtedness subject to a constitutional debt limit. Pension bonds fall within that legal theory, Moody's explains, and therefore do not require voter approval.

Since the principal court cases relating to this exception date back to 1919, "judicial validation has been an important feature of Moody's analysis" in examining pension bonds, the report says. Judicial validations provide a test case to ensure that a proposed debt issue is legal.

Pension bonds in California function much like a limited tax general obligation bond in other states, Moody's says, because they represent a superior lien on revenues.

Accordingly, the credit quality of a pension bond is stronger than a lease obligation, but ranks below a general obligation bond because there is no unlimited tax levy to support the debt, the agency says.

"Because there is usually only a single rating level difference between a general obligation bond and the highest-rated lease debt of an issuer, it can be difficult to fully reflect the hybrid nature of this debt in the rating level," Moody's says. "The rating on a pension bond will usually reflect the lack of unlimited taxing power, and be equivalent to a strong lease rating unless extraordinary revenue flexibility or other unique factors distinguish the obligation."

Moody's recently carried this policy out in practice when it rated a Sonoma County, Calif., pension transaction at the same level as the county's certificates of participation. Standard & Poor's Corp., by contrast, rated the pension bonds a notch higher.

Moody's said its analysis also involves examining the investment strategies of a retirement system since "the lump-sum reinvestment of pension bond proceeds exposes the system to a higher degree of risk from current market events."

Overall ratings of an issuer should be unaffected by such pension obligation bond sales, as long as the instrument is used modestly and accompanied by a "a prudent, risk-managed reinvestment program," Moody's concluded.

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