July 24, 2013
As if rising interest rates weren't upsetting enough to individuals losing money in municipal bond funds, Detroit's bankruptcy has now intensified the sense of insecurity over munis.
When Detroit filed for Chapter 9 bankruptcy last week, it disrupted the tranquillity that attracts many risk-averse individuals to the $3.7 trillion municipal bond market.
Detroit is one of the few U.S. cities to file for bankruptcy and by far the largest. And with Detroit's move to avoid paying some of its debts, investors are forced to question whether they can rely on cities and other local governments that promise to do whatever it takes to pay every investor who purchases what are known as general obligation municipal bonds.
Once a judge rules on what happens to Detroit's bond investors, people may take a different view of the safety they assume is guaranteed in general obligation bonds.
Typically, investors have considered general obligation bonds from local and state governments among the safest of investments — second only to Treasury bonds in safety. That's because no matter how painful it might be, a city or state is supposed to raise taxes, if necessary, to cover all the promises they've made to bond investors. It's a legal pledge that is considered so valuable, investors settle for relatively low interest payments in munis in exchange for knowing they can count on getting their money back, plus interest.
Yet, that promise is open to question now — at least as far as Detroit is concerned and maybe other distressed cities too, depending on court rulings related to the Detroit case. The court decisions are not likely to arrive for months or years.
Rather than wait for years of litigation, squeamish investors have been selling municipal bonds.
The move for the exits shows up in the flow of money out of municipal bond funds, which are tracked weekly. Although investors have been yanking money from a wide variety of bond funds lately because rising interest rates are causing large losses in most bond types, it's clear there is more of an exodus out of municipal bonds.
Over the last week, investors pulled about $1.2 billion out of municipal bond funds, which was substantially more than the $302 million weekly average for intermediate bond funds that invest in a variety of bonds, according to a report by JPMorgan analyst Peter DeGroot. For the year so far, investors have pulled $16.4 billion out of muni bond funds.
The concern over municipal bonds also has been apparent in the yields on the bonds. Typically, yields for munis are lower than for Treasury bonds because people get a tax advantage from owning municipal bonds. But now, investors are anxious over munis and consequently demanding more yield — 2.67 percent on the highest-rated 10-year munis compared with 2.48 percent for Treasury bonds, DeGroot said.
Generally, cities avoid bankruptcy because they don't want to destroy investor confidence and risk higher borrowing costs in the future. But cities have faced insurmountable financial pressures lately. Some are based on long-standing mismanagement, like failing to fund pension promises made to government employees. But there also are newer issues, like falling home prices and declining tax bases.
Recent bankruptcies have ranged from San Bernardino to Stockton in California and now Detroit.
Some analysts worry that with Detroit's bankruptcy, the stigma of filing will be lifted and municipal bond investors will face more insecure investments. Yet, Matt Fabian, managing director of Municipal Market Advisors, says Detroit is a unique case of a city facing "overwhelming issues" and he "finds it hard to expect that other large cities or counties across the country will follow Detroit's example."
While investors are expected to shy away from municipal bonds while the bankruptcy filing is fresh, many analysts don't expect the concern to be ongoing. With time, DeGroot thinks investors will be more worried about rising interest rates than bankruptcy.
Yet, the key for the future will be how the court rules in the Detroit case and whether other large cities, such as Chicago, get better control over their financial problems. Chicago was one of several cities downgraded on its bond rating by Moody's last week due to what Moody's called "very large and growing pension liabilities and accelerating budget pressures associated with those liabilities."
A key part of the Detroit bankruptcy case will be seeing how the court treats the "clash between retiree benefits and securities protection," Wells Fargo analyst Natalie Cohen said in a report.
Both retirees with pensions and bondholders have been given promises by the city. And each considers those promises rock solid. Yet, Cohen notes that investors have failed to recognize language in most bond prospectuses carries a caveat that "bondholders remedies may be limited by certain events such as bankruptcy."
As investors have wondered about general obligation pledges, some investors are putting more trust in what are known as "essential service" municipal bonds. These bonds go for services people must have, such as sewer and water. And since the payments homeowners and businesses make for those services are pledged to go to bondholders, investors typically consider the bonds relatively safe.
Yet, Marilyn Cohen, chief executive of Envision Capital Management, warns investors that there are no longer any simple decisions to make on municipal bonds. While essential services can be a good bet, she notes if an area has a lot of foreclosures, even payments for sewer or water can be insecure.
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