Detroit bankruptcy has surprising long-term implications

The bankruptcy court's Tuesday ruling that makes Detroit eligible to become the largest municipal bankruptcy in U.S. history is not likely to have a major impact on the muni bond market, but it certainly won't help. For much of the muni bond market, Detroit's pursuit of bankruptcy as a means of managing its $18 billion in long-term liabilities represents the classic example of headline risk. Combine Detroit's troubles with similar stories in places such as Puerto Rico and other, smaller U.S. municipalities, add the growing concerns over rising interest rates, and you have a “perfect storm in the muni bond space,” according to Roberto Roffo, senior vice president and portfolio manager at Advisors Asset Management Inc. “Everything combined at once and had investors running to the door,” he added. Indeed. Through last week, muni bond mutual funds have experienced 27 consecutive weeks of net outflows, with $34.75 billion being drained. That brings total outflows for the year to more than $50 billion. But while the investor exodus has not helped fund performance, it has contributed to the reality of basic bond math, which means higher yields. The average national long-term muni bond fund, as tracked by Morningstar Inc., is down 4.4% this year, but even the worst-performing funds in the category are generating yields in the 4% range. “We look at this kind of market and know that higher yields translate to better income down the road,” said Ronald Bernardi, a muni bond trader and president of Bernardi Securities Inc. “From our perspective, 27 weeks of outflows isn't necessarily all bad.” In essence, as investors have fled the muni space, the yields have climbed to levels that are difficult to ignore on an after-tax basis. As Mr. Roffo explained, the yield on the average 10-year triple-A-rated muni bond is now equal to that of the 10-year Treasury, at approximately 2.77%. When factoring in the tax advantages of muni bond income, the 10-year Treasury would need to yield 4.1% to produce a comparable yield. “All these outflows in the muni market have caused a relative cheapness in the muni market, and they are extremely attractive at these levels,” Mr. Roffo said. “Anytime you see munis at or cheaper than Treasurys, you should buy munis.” But even with muni yields already at attractive levels, most muni market watchers don't see the pattern reversing anytime soon because of the headline risks and realities associated with a reduction in quantitative easing. “The talk about tapering triggered the first muni fund outflows earlier this year, and from there investors saw better returns in equities,” said Dan Toboja, senior vice president of fixed income at Ziegler Capital Markets. “People are seeing stories like Detroit and Stockton [Calif.], and it is changing the way they feel about the safety of municipal bonds,” he added. “Remember, people buy munis to stay rich, not to get rich.” Mr. Bernardi said he also believes some of the muni fund outflows is proof that many of the investors were not truly there for traditional muni benefits. “I have felt for many months that a lot of the money that had moved into muni funds was hot money,” he said. “It was investment capital that would have been in money market funds or CDs, but in the early part of the year, it went to muni funds and was never consistent with the risk profile of many of those investors.” John Loffredo, executive managing director and co-head of MacKay Municipal Managers, said he doesn't believe investors are particularly focused on situations like Detroit's bankruptcy. But he does think investors are keenly aware of how rising interest rates will impact muni bond mutual funds. “The mutual platforms will continue to suffer because investors are seeing negative returns and rising rates,” he said. “It's more a factor of where rates are going and less a factor of what's happening in Detroit.”