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HOT TOPIC: Motor City Meltdown — What Happens Now to the Muni Bond Market?

By October 28, 2013March 1st, 2014No Comments

On July 18, 2013, the city of Detroit filed the largest public-sector bankruptcy in U.S. history.1 Though not entirely unexpected, the move unsettled the municipal bond market and generated widespread interest in the precedents it might set for other cities and future bond sales.2 It could take years for Detroit’s fiscal issues to be sorted out, but here are some key points you may want to consider as an investor.

Municipal Obligations

At the time of the bankruptcy filing, Detroit faced total liabilities of about $18 billion. The reorganization plan calls for cutting $11.5 billion in debt down to $2 billion, offering investors and other creditors — including city retirees — an average of just 17% of what they are owed.3

For investors, the most basic question may be the treatment of general-obligation bonds, which represent about $530 million of Detroit’s debt but could have much larger ramifications. Because they are backed by current and future tax revenues, general-obligation (G.O.) bonds have been considered a relatively low-risk investment. However, Detroit officials — pointing out that taxes are already at the state-mandated limit — plan to treat general-obligation bonds as unsecured debt, with no priority or “seniority” over other unsecured debt. If this plan receives legal approval, it may change the risk perception of general-obligation bonds and increase borrowing costs for other cities and counties.4

In contrast to general-obligation bonds, revenue bonds (“essential-purpose” bonds), such as those used to fund water and sewer utilities, are typically funded directly by revenues from the specific project and are unlikely to be affected by bankruptcy proceedings.5 Investors have generally considered these bonds to carry somewhat higher risk than G.O. bonds and thus expect a higher yield to purchase them. Given this perception, one might expect the yield spread between G.O. and revenue bonds to have narrowed after the Detroit filing, but the spread actually increased to 0.97% on August 6, the highest level since February 2012.6 This suggests that investors still see G.O. bonds as more secure.


The Michigan Effect

The S&P Municipal Bond Index — which represents almost 40% of the municipal bond market — lost about $13.8 billion of its $1.4 trillion par value in the first three weeks after the Detroit filing, with a corresponding increase in yields.7 After the initial shock, however, the muni market appeared to stabilize.8

The effect on new bond sales has so far depended on locality. At least three Michigan municipalities delayed bond sales due to concerns that investors would require higher interest rates, while other local governments in the Detroit area scrambled to assure potential investors that they are fiscally sound.9 Outside of Michigan, however, sales of new bonds have been steady, with $8.6 billion in municipal debt sold during the first full week of August, the highest weekly level since April.10

Pulling Pensions

Much of the debt reduction sought by Detroit would require cuts in pension and retiree health-care benefits.11 This is unprecedented — no previous municipal bankruptcy has included involuntary cuts to retiree benefits — and could be devastating for current and retired city workers.

Employees of bankrupt private-sector businesses typically receive a minimum level of pension benefits from the Pension Benefit Guaranty Corporation, whereas public-sector employees do not enjoy the same protection.

Detroit’s reorganization plan to cut benefits could take years to resolve in the courts and might have broad implications for municipal investment and fiscal strategy.12

Looking Forward

Some analysts caution that the outlook for municipal bonds may be uncertain for some time due to the increased perception of risk and the potential for rising interest rates in general.13 Others believe that higher yields — resulting from the same risk and interest-rate concerns — offer an opportunity as long as investors do their homework.14–15

The primary lesson of the Detroit bankruptcy may be simply that all bonds carry a risk of default, even when backed by tax revenues. A study released two months before the bankruptcy revealed that the average annual default rate for municipal bonds tripled since 2008 but still remained low at 0.03%.16

Interest paid by municipal bonds issued by your state or local government is typically free of federal income tax. If a bond was issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. Some municipal bond interest could be subject to the alternative minimum tax. If you sell a municipal bond at a profit, you could incur capital gains taxes. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost.

Because municipal bonds generally offer lower yields than other bonds, the tax benefits tend to accrue to individuals with the highest tax burdens. To ensure a worthwhile tax savings, you should select bonds carefully.

1, 3, 12) CNNMoney, July 18, 2013
2, 7) MarketWatch, August 8, 2013
4) The Wall Street Journal, July 26, 2013
5, 15) MarketWatch, July 29, 2013
6, 10) Bloomberg Businessweek, August 8, 2013
8, 14) The Wall Street Journal, August 14, 2013
9) The Wall Street Journal, August 8, 2013
11) CNNMoney, August 2, 2013
13) MarketWatch, August 5, 2013
16), May 7, 2013

The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2014 Emerald Connect, LLC
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