Last week, the city of Detroit filed for bankruptcy on approximately $18 billion in long-term liabilities, marking the largest municipal bankruptcy in U.S. history. Municipal bonds are often considered relatively safe and attractive for investors looking for tax efficient investment strategies. So, what will Detroit’s impact be on the municipal bond market, and what will the broader implications of this historic case be for investors?
It is important to understand that the dollar amount of the bonds is not as meaningful to the muni bond market as the precedent that the treatment of these bonds could set for other municipal bond cases. Approximately $9 billion of the $18 billion at stake is in unfunded pension and retiree healthcare obligations – not bonds. Of the remaining $9 billion in bonds, the portion of Detroit’s liabilities that has shaken municipal bond investors and may have implications for the broader market is a comparatively small $369 million comprised of unlimited-tax general obligation bonds.
Perception is the key consideration here. General obligation (GO) bonds are generally thought to be very safe. As compared to revenue bonds, which are backed by a specific project and revenue stream, general obligation bonds are backed by the “full faith and credit” of the municipal issuer, meaning that the issuer can service the debt from any revenue source, including tax revenues, new bond issuances, or even newly raised taxes. Therefore, the likelihood of default for these bonds is very low. However, Detroit’s bankruptcy threatens to change this perception. Detroit’s unlimited tax GO bonds fall into the unsecured bucket of the city’s liabilities, putting these bonds lower in the pecking order of obligations than many investors would have expected. If these bonds are riskier than previously believed, then yields should rise to compensate investors for the additional perceived risk. Because bond yields and bond prices are inversely related, prices of existing bonds in the market will fall as yields rise.
While Detroit is in tough shape, the municipal bond market is a huge market and its overall health is minimally affected by Detroit’s bankruptcy filing. What matters is whether investors believe this will set a precedent for how other GO bonds throughout Michigan, and perhaps even across the country, would theoretically be treated in such a situation. If so, the question is how much additional risk premium investors will demand from these types of bonds as a result.
Detroit is in a uniquely terrible position for a variety of reasons; however, it is fair to point out that it is by no means the only city in the country that is facing an inability to service its long term obligations and eventually has to face the music. So, if Detroit is not the only one, what are the implications for investors’ bond portfolios? First is that diversification is important. Investors who own municipal bonds should recognize that, as with corporate issuers, the risk profiles of municipal issuers vary widely, and some are more fiscally responsible than others. Understanding the risk profile of these investments and how they fit in with the rest of your fixed income assets is critical. The best way to protect yourself against idiosyncratic risks of a single issuer is to take advantage of the huge and fragmented nature of the muni bond market and diversify your holdings.