Detroit's Bankruptcy Filing Shows the Importance of Credit Research

For investors in tax-exempt bonds, it was hard not to notice the scary headlines. In July, Detroit became the largest American city to file for bankruptcy.1

Pensioners and bondholders were put on notice that promises made years ago during times of economic plenty might have to be renegotiated in court.

That will be a multi-year process whose outcome is far from certain.

But there’s no uncertainty about Detroit’s finances. The city that gave birth to the Big Three American automakers peaked two generations ago, when its population reached 1.8 million during the industrial boom of the post-war period.2

Since then, the Motor City’s fortunes have plummeted amid urban decay.

Detroit owes about $27,000 for each of the 700,000 residents that remain. More than $9 billion of pledged pension payments are unfunded.3

The city’s tax base contracted as auto production moved out of the state or out of the country. Fewer people making less money caused property tax revenues to plunge 20% since 2008 and income tax collections to drop by 30% since 2002.4

Game changer?
But for investors in the roughly 1 million municipal bonds issued by jurisdictions other than Detroit,5 the question is how much any of this matters.

Less than half of Detroit’s outstanding obligations — or about $8 billion — is in the form of bonds.6 That’s a pittance in a domestic tax-exempt market valued at $3.7 trillion7 with tens of thousands of state and local issuers.

Still, there are concerns that an unsettling precedent would be set if Detroit is allowed to impose a “haircut” on holders of its general obligation (GO) bonds, a sector that comprises about 40% of all municipal debt.8

“Historically, the rest of the tax-exempt market has viewed GO debt as offering the strongest security,” said Adam Shane, director of fixed income research for Northern Trust. “While Northern Trust does not deny the high quality of most GO debt, we typically have favored special or dedicated revenue bonds for the additional security they offer.”

Shane added: “A default on Detroit GOs wouldn’t have a direct impact on most portfolios, but it could muddy the waters in terms of options for other financially stressed issuers and the priority of payments.”

Motown isn’t the only distressed municipal issuer. Puerto Rico also is in deep trouble, and the value of its outstanding bonds is many times greater than that of Detroit.9

To date, there has been no formal downgrade of Puerto Rico’s credit rating to below investment grade. Nonetheless, this summer many fearful investors decided to sell first and ask questions later.

Clear signs
Better that they had asked those questions earlier.

“The credit problems that made headlines this summer had been obvious for years,” said Tim McGregor, director of municipal fixed income management for Northern Trust. “But even assuming a worst-case scenario in which Detroit is allowed to default, we don’t think that municipalities that have the ability to pay will use that precedent to avoid their debt obligations.”

The reason, McGregor noted, is simple: Cities and states require access to the credit market to fund capital projects, meet payroll and provide essential services, like police and fire protection. Defaulting on outstanding debt would effectively end a municipality’s ability to borrow in the capital markets.

According to McGregor, dabbling in the securities of financially distressed jurisdictions like Detroit and Puerto Rico to pick up extra yield is like the proverbial moth flying too close to the flame.

“As portfolio managers in the high-quality, investment-grade muni market, we avoid GO debt whose issuers might not have the ability to make good on their promises,” McGregor said. “It comes down to doing your credit homework with a dedicated in-house staff.”

That’s a process that also applies to evaluating municipal pension and health care liabilities. As of fiscal 2010, there was a $1.38 trillion gap between states’ assets and the retirement benefits promised to public-sector employees. Though recent reforms — combined with investment gains — could shrink the shortfall in coming years, significant challenges remain.10

“The market suddenly has awoken to it, but we’ve had the pension issue as an explicit part of our proprietary credit analysis for many years,” Shane said. “It’s something that we look at in meticulous detail as part of our due diligence on an individual credit.”

Cautious approach
Shane and McGregor emphasize that Northern Trust’s municipal bond funds do not use leverage or derivatives. Instead, the portfolios tend to include special revenue, dedicated revenue and unlimited GO bonds that typically enjoy a stronger legal claim to a specific funding or revenue stream that does not require political reauthorization.

“If we give up some yield in return for what we believe is added security,” said McGregor, “so be it.”

Though Arch King, senior product specialist for Northern Trust, noted that redemptions from Northern Funds tax-exempt offerings have been modest, that hasn’t been the case elsewhere during a summer of disconcerting news.

It wasn’t only Detroit and Puerto Rico making headlines.

The Federal Reserve repeatedly hinted that it would start winding down its third round of bond purchases this fall and end them altogether by mid-2014. That unexpected news pushed yields higher — and prices lower — on virtually all fixed-income securities.

Investors also perceived that risks to the global financial system had receded and, thus, many felt emboldened to move money from fixed income to equities.

Good value?
Those factors caused municipal yields to jump more than their Treasury counterparts. As a result, McGregor thinks the tax-exempt sector is undervalued compared to much of its taxable competition.

Since 1994, the yield on a 20-year Treasury bond has averaged about a quarter percentage point more than that on the Bond Buyer GO 20-Bond Municipal Bond Index, a widely quoted municipal benchmark comprised of 20 GO bonds with 20-year maturities and an average credit rating of AA by Standard & Poor’s.11

After the volatile summer in the muni market, the Bond Buyer Index yielded about 1.25 percentage points more than 20-year Treasurys.12

Some A-rated 20-year municipals yield 5% or almost 1.5 percentage points more than a comparable maturity Treasury, even before factoring in a muni’s tax advantages.13 (Municipal bonds are generally free from federal income tax.)

McGregor says that the redemptions from tax-exempt funds that use leverage, derivatives or invest in sub-investment grade credits also caused credit spreads to widen as riskier funds sold bonds to meet their investors’ withdrawals.

Which, he added, isn’t an altogether bad thing for long-term investors.

Back to reality
There is starting to be a healthy differentiation in pricing related to credit quality,” he said. “Spreads had been grinding tighter since 2008, and though they’re not back to normal levels, they have widened in a typically inefficient manner.”

That inefficiency, McGregor noted, could reveal attractive buying opportunities throughout the next several months.

Though McGregor thinks the bulk of the sell-off in tax-exempt bonds is done, he expects volatility to remain elevated as other issues take center stage.

“We think the market already has priced in the Fed getting out of the bond-buying business, whenever that might be,” he said. “But there still are questions about what it will do with the bonds it already owns.”

Ironically, that uncertainty has been working to the advantage of equities rather than the traditional safe haven of fixed income. In part, that’s because a normalization of monetary policy — higher benchmark and market interest rates — only would happen if the economy or inflation took off.

McGregor thinks that an end to the Fed’s third round of bond buying (known as quantitative easing) might actually be a positive development for bondholders.

“During the near term, fears of Fed tapering has pushed rates higher,” he conceded. “But longer-term, there should be lower inflation and moderate economic growth with the Fed out of the picture — and that’s a good environment for bonds.”

More demand, less supply
Aside from redemptions, McGregor thinks that technical conditions in the municipal market are mostly positive.

The supply of new tax-exempt bonds is down from last year and refinancing activity virtually dried up as interest rates rose during the late spring and summer.

“States haven’t needed to borrow as much as in previous years,” McGregor said. “They aren’t hiring many new workers, and the number of capital projects could be lower than investors expect.”

Meanwhile, there’s been rising demand for municipal securities from non-traditional fixed-income investors like insurers, pensions and taxable mutual fund companies. Foreign institutions also have shown interest.

Those “crossover” investors don’t need the tax advantage that municipal bonds could provide, but they like the sector anyway because of its relatively attractive yield and capital gains potential in a high-quality credit sector.

For McGregor, the most compelling opportunities are at the 7- and 15-year portions of the municipal yield curve. Speculation about less accommodative Fed policy pushed intermediate- and longer-term yields sharply higher while leaving short rates mostly unchanged.

Drilling down
Troubling headlines from Detroit and Puerto Rico, combined with endless “taper talk,” obscured other positive trends in the muni market as well.

State revenues, for instance, have increased for 13 consecutive quarters.14 In fiscal 2013, 41 states reported year-over-year revenue growth.15 Despite the Great Recession and its dreary aftermath, defaults remain relatively rare.

Of the roughly 16,000 municipal credits rated by Moody’s Investors Service, defaults averaged just 1.3 per year between 1970 and 2007 and 4.6 annually from 2008 through 2012.16

Since 1950, only about 60 municipal issuers have filed for bankruptcy protection.17

The solid recovery in the domestic housing market also could enhance local credit quality. Property taxes account for about two-thirds of local tax collections.18

Finally, threats to remove the tax-advantaged status of municipals have receded. “That conversation is never going to go away entirely,” acknowledged Shane. “But it has been pushed to the back burner with an election coming up.”

Overall, the outlook for municipal bonds might be significantly brighter than that implied by headlines about problems in Detroit and Puerto Rico.

“The market for municipal bonds is huge, the after-tax yields are compelling and there are many sound credits to choose from,” McGregor said. “Once you get past those headlines, there’s still much to like.”

Assuming you read the rest of the story.

Past performance is no guarantee of future results.

Diversification does not guarantee a profit nor protect against a loss.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

High Yield Risk: Although a high yield fund’s yield may be higher than that of fixed income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk that a high yield fund’s share price will decline.

Interest Rate Risk: Increases in prevailing interest rates will cause fixed income securities, including convertible securities, held by a Fund to decline in value.

Tax-Free/AMT Risk: Tax-exempt funds’ income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.

The general meaning of the credit ratings AAA, AA and A are expressed in Standard & Poor’s nomenclature: AAA — Are judged to be extremely strong capacity to meet financial commitments (highest rating), AA — Are judged to be of very strong capacity to meet financial commitments and A — Are judged to be of strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

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1 “Detroit’s bankruptcy: Can Motown be mended?” The Economist. July 27, 2013

2 “Detroit’s bankruptcy: Can Motown be mended?” The Economist. July 27, 2013

3 “Detroit’s bankruptcy: Can Motown be mended?” The Economist. July 27, 2013

4 “Detroit’s bankruptcy: Can Motown be mended?” The Economist. July 27, 2013

5 “Detroit casts a shadow on munis.” The Washington Post. Michelle Singletary. July 23, 2013

6 “Which muni bond funds hold Detroit bonds?” Detroit Free Press. Susan Tompor. June 13, 2013

7 “Detroit casts a shadow on munis.” The Washington Post. Michelle Singletary. July 23, 2013

8 “Detroit bankruptcy case could bring unwanted change for muni market.” July 26, 2013

9 “Puerto Rico cuts planned debt sales after bond sell-off.” September 10, 2013

10 “The Widening Gap Update.” The Pew Center on the States. June 2012

11 The Bond Buyer

12 Federal Reserve data

13 “Rates over Time — Interest Rate Trends.” www. September 12, 2013.

14 “State Revenue Report.” Lucy Dadayan & Donald J. Boyd. The Nelson A. Rockefeller Institute of Government. August 2013

15 “State Budget & Tax Actions: Preliminary Report.” National Conference of State Legislatures. August 2013

16 “Municipal bond defaults have increased since financial crisis, but numbers remain low.” Moody’s. May 7, 2013

17 “Billions in Debt, Detroit Tumbles Into Insolvency.” Monica Davey, Mary Williams Walsh. The New York Times. July 18, 2013

18 “State Revenue Report.” Lucy Dadayan & Donald J. Boyd. The Nelson A. Rockefeller Institute of Government. August 2013

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