The amount borrowed this year through new sales of so-called pension obligation bonds (POBS) is set to be at its lowest since 2001, according to Thomson Reuters data. In the first seven months of 2012, there were just 14 deals worth $604 million, against $4 billion issued in 2011.

The drop in pension bond deals shows fewer municipal governments are being reckless by mortgaging their employee pension funds and opening their finances to additional risk, according to some municipal leaders, although concerns that the stock market rally is getting long in the tooth may be another reason.

"It is the worst tool that the industry has come up with since derivatives," said John Rodstrom, mayor of South Florida's Broward County, which includes the city of Fort Lauderdale.

Pension bond proceeds are often invested in equities and other assets, exposing issuers to possible outsized losses, he said. In his view, they are little more than a bet by a local government that it can earn more from investing in the markets than it will pay in interest on the bonds.

Rodstrom, who is also head of public finance at an investment bank, opposes a planned $300 million pension obligation bond issue to be voted on September 5 by Fort Lauderdale's city council. Officials are pushing a risky bet they would never take with their own money, Rodstrom said.

First launched in the 1980s as an arbitrage tool, taxable pension obligation bonds - there are now $64 billion outstanding - allow municipal issuers to profit if the money raised is invested when there is a bull market in equities or other assets.

The temptation to use the bonds as a quick fix is there given that U.S. public pension plans have unfunded liabilities of anything between $750 billion and $4.6 trillion, depending on which estimate you believe.

There are, though, a number of major risks.

Firstly, issuers are replacing pension promises to public employees with tougher, legally more binding commitments to creditors in the bond market, reducing financial flexibility. Secondly, there is a danger the strategy will lead to losses - and this could worsen an already weak financial position. And it is also a red flag to credit analysts and investors, who see localities and states increasing debt to finance public pensions as worse borrowers than those issuing bonds to finance bridges or schools.

A study by researchers at Boston College in 2010 showed that only pension bonds issued before 1996 or those issued during dramatic stock market downturns have produced positive returns. Some of the others "may end up in being extremely costly for the governments that issued them," the study found.

MORE PENSION BONDS WHEN EQUITIES PRICES ARE LOW

A lot may depend on whether equities are at low valuations as they were in 2009. Issuing pension bonds then and putting the money in stocks would have been a winning strategy.

Indeed, pension bond deals peaked in 2003, when issuers were trying to take advantage from the bursting of the dot.com bubble and the collapse in stock prices.

But with the S&P500 hitting a four-year high this week, this may not be one of those times.

An August report by investment consultant Wilshire Associate showed public pension funds had a median return of just 1.15 percent in the last year. That value, resulting from investments in equities, bonds and other securities, is 6.32 percent over the last 10 years, but still much less than the investment return assumptions of 7.0 percent to 8.5 percent that most funds are based on.

"Barring any other drastic market crash, I would not expect to see a flurry of new POB issuance," said Jean-Pierre Aubry, Assistant Director of State and Local Research at the Center for Retirement Research at Boston College. "If the economy continues to be steady, pension funds will do better and government revenues will stabilize. So, there will be less need for many new pension obligation bonds."

There are a number of examples of local governments suffering big losses from the strategy over the years.

According to a city audit, California's City of Oakland lost $250 million from a 1997 pension obligation bonds sale and subsequent investment strategy, although city officials said the assessment was based on hypothetical calculations and the city had no other viable options. Indeed, Oakland issued another $212 million pensions bonds in July 2012.

"Issuing pension bonds is a potential signal to the market of credit weakness," said Daniel Berger, senior market strategist for Municipal Market data, a unit of Thomson Reuters. He noted that since 2002, pension bonds have been issued mainly by three states, Oregon, Illinois and California - the latter two have had major budget problems in recent years. In February, 2011 Illinois issued a $3.7 billion pension obligation bond in an attempt to finance the nation's most underfunded state retirement system.

FORT LAUDERDALE

But pension obligation bonds do have defenders, including officials in Fort Lauderdale, who liken the city's proposed $300 million pension-obligation bonds to a debt restructuring.

A coastal tourist attraction near Miami with a population of 166,000 and a lot of yacht owners, Fort Lauderdale is not acting under duress, according to City Manager Lee Feldman. The city expects to sell the bonds at taxable rates below 4 percent, reducing an existing $400 million liability in the city's two pension funds.

"We already have the debt," Feldman said. "We are not incurring new debt. When you look at it from a 20-year perspective, we have a reasonable certainty we can earn more than the bond rate" from stocks and other investments.

Local supporters of the pension bonds proposal, including the South Florida Sun-Sentinel newspaper, pointed out that the city's pension funds have for more than a decade produced investment returns topping the deal's anticipated average cost.

And some smaller California cities are considering pension bonds to pay off fixed debts, known as side funds, to the California Public Employees' Retirement System, known as Calpers. Cities would not be exposed to the same market risk as traditional pension bonds, because the debt is cancel led once paid off.

That means if a California city can issue bonds at a rate below the 7.5 percent that Calpers charges, it saves money without increasing market risk.

For most, though, issuing new debt to finance a pension liability and assuming more risk has become politically toxic. Taxpayers are much more likely to pressure lawmakers to reduce their pension promises to employees.

"Pension system reforms carry a lot more certainty of success in improving funding ratios than issuing pension bonds," said Doug Offerman, an analyst at Fitch.

Also, enticed by very low interest rates, local authorities are more focused on rushing to refinance more of their mainstream debt at lower yields. Such refinancing shot to $89.3 billion in the first seven months of the year, up from $34.6 billion in the same period in 2011.

"In the past, there was a perception that market returns would make the issuance of pension bonds worthwhile over time," said Offerman. "Going forward, it seems less likely that pension investments can provide steady, strong growth."

(Reporting by Tiziana Barghini and Michael Connor. Additional reporting by Peter Henderson. Editing by Martin Howell and Andre Grenon)

By Tiziana Barghini and Michael Connor