How Detroit’s Bankruptcy Threatens Municipal Bond Markets

Although it probably didn’t come as much of a surprise for many observers, earlier this month the city of Detroit filed for bankruptcy protection making it the largest city to ever do so. Detroit was once the fourth largest city in the United States, with a population of just under 2 million residents. For a multitude of reasons (government corruption, manufacturing downturns, the flight to suburbia, and inflexible government/union relationships among others) there has been a steady exodus out of the city for the past five decades, and today the population of Detroit stands around 700,000.

The bankruptcy filing threatens to affect multiple stakeholders. Retirees who worked for the city of Detroit could see their pensions slashed significantly. Current city employees could see their labor contracts cancelled and pay cut. City residents could see higher taxes. And bondholders holding debt issued from Detroit might only receive pennies on the dollar in debt repayment. But beyond the impact the filing has on the immediate stakeholders, Detroit’s bankruptcy is sending shock-waves through the municipal bond market.

Municipal bond markets had already been reeling from comments made by Ben Bernanke in May concerning future moves by the Federal Reserve. Investors have been steadily pulling billions of dollars out of the municipal bond fund markets since the spring. Detroit’s bankruptcy brought about a new level of concern for municipal bond investors.

Shortly after the bankruptcy filing, Detroit’s Emergency Financial Manager, Kevin Orr, indicated he would treat general obligation bondholders as unsecured creditors, indicating that there were no explicit guarantees on the municipal bond debt. This stance is a departure from the traditional handling of general obligation municipal bond debt. And this change is causing alarm among municipal bond investors, even though many municipal bonds are backed with insurance.

Some analysts see this as a game changer for the industry. General obligation bonds are backed by the taxing authority of the municipality, and not a specific revenue source or project. These bonds have traditionally been thought of as the safest forms of municipal debt, because they aren’t reliant on one source of revenue, like a water plant for example. With Detroit’s example, other municipalities could consider similar measures of forcing bondholders to take pennies on the dollar in times of financial duress.

So what does this mean for owners of municipal bond funds and individual municipal bonds? Muni bond fund holder may want to review their funds and their reasons for holding these types of funds. If the bond funds are producing a steady stream of income, then the bond fund owner may want to keep the fund and not worry so much about the recent sell-off in bonds. Similarly, individual bond holders may decide to hold on to their bonds until maturity, especially if it seems extremely unlikely for the municipality to default on their debt payments.

Not sure what to do with your municipal or taxable bond investments? Give us a call at 419-878-3934 to schedule some time to review your bond holdings or your overall investment portfolio.

Sources: InvestmentNews, Wall Street Journal