Detroit's bankruptcy filing was expected, but it may cause ripple effects for advisers, particularly in the muni bond market.
Thursday's Chapter 9 bankruptcy filing by the city of Detroit is expected to cause ripple effects across at least the rest of Michigan and could represent the last straw for nervous municipal bond investors.
On the heels of Detroit's June 13 debt payment default, bankruptcy was seen by many as inevitable, even if it wasn't expected to happen this soon.
The city's $18 billion in debt obligations makes Detroit's the largest municipal bankruptcy in U.S. history — more than four times the size of the second-largest filing by Jefferson County, Ala., in 2011.
“I think this will definitely help add to the stampede out of muni bonds,” said Theodore Feight, owner of Lansing, Mich.-based Creative Financial Design.
“It brings one thing to mind to me now, and that's that Detroit has had very poor management for at least 30 years, so it makes me wonder if this will shake up the people who run Detroit,” he said. “But we should also be paying attention to a lot of the smaller cities around Michigan.”
The news comes at a time when muni bond investors have already been jumping ship.
June marked the fourth consecutive month of net outflows from muni bond mutual funds, totaling nearly $20 billion over the period, according to Morningstar Inc.
“I hope it's not the case that this causes more investors to flee muni bonds because I think Detroit is an outlier and a special case,” said George Papadopoulos, who runs an eponymous advisory firm in Novi, Mich.
Clinton Struthers, owner of Struthers Financial Services in Midland, Mich., thinks that muni bond investors will be hurt by Detroit's bankruptcy and that they will continue to abandon munis, “but I guess I'd have to wonder why folks would still be holding that paper when the handwriting has been on the wall for several years.”
Detroit's bankruptcy filing still has to be approved by a bankruptcy judge and could take years to sort out, but the muni market already is bracing for the ultimate fallout.
In addition to anticipating that debt financing will cost more for all Michigan municipalities, the muni market is paying close attention to the way the bankruptcy filing is attempting to treat Detroit's unlimited general-obligation bonds.
Detroit's total debt load includes a vast blend of pension and retiree health care obligations, as well as a raft of muni bonds, including at least $530 million that fall into the category of unlimited general-obligation bonds.
The treatment of the general-obligation bonds is of particular interest to the muni market because Kevyn Orr, the appointed emergency manager for Detroit, trying to lump them in with all the other debt obligations.
This is an unprecedented strategy, considering that in the muni bond world, general-obligation bonds are viewed as roughly equivalent to U.S. Treasury bonds, in that they are supposed to be the top priority and should be honored even it if requires raising taxes to do so.
Detroit's bankruptcy filing proposes to spread the pain evenly across all debt obligations, which would give holders of general-obligation bonds about 10 cents on the dollar.
“Co-mingling of different types of muni bonds is different than anything that has ever happened in other Chapter 9 filings, so this has potentially broad implications on the muni market and future debt issuance, particularly in Michigan,” said Jim Colby, a senior muni bond strategist and portfolio manager at Van Eck Global.
Mr. Orr's generic treatment of the city's vast and diverse debt load appears to have the support of Michigan Gov. Rick Snyder.
“There are a lot of good credits in the state, and Michigan has traditionally been supportive of bond holders, but Gov. Snyder's support for this plan has been surprising,” said Ronald Bernardi, a muni bond trader and president of Bernardi Securities Inc.
“We've stepped back from Michigan munis until we can see some clarity, because right now it's a pregnant question and it's unfortunate for a lot of places in Michigan,” he said. “Maybe this is just a negotiating strategy, but an unlimited general-obligation bond is supposed to be a guarantee backed by the full faith and credit of the municipality, and that's the most bothersome thing right now.”
