Although a municipality filing for bankruptcy protection is rare, you still ought to be paying attention to what happens to bondholders in the case of Detroit.
The city’s Chapter 9 filing will likely set some precedents including how investors and/or their investment advisers view municipal bonds, also known as munis.
“I think that the potential risks to the municipal bond market are serious,” said David D. Tawil, co-founder and portfolio manager for Maglan Capital, which specializes in distressed assets. “At the very least, municipal bonds will no longer be considered a risk-free asset.”
Detroit’s filing comes at a time when the Securities and Exchange Commission is increasing its investigations of municipalities that aren’t being upfront about their finances in disclosures about their bonds.
Earlier this month, the SEC charged the city of Miami and its former budget director with securities fraud related to several municipal bond offerings. The SEC alleges that misleading financial information was given to investors.
Municipal bonds have significantly lower rates of default than corporate or foreign government bonds. “Nevertheless, municipal bonds can and do default,” the SEC said in a report last year.
As Detroit’s bankruptcy progresses and other municipalities face greater scrutiny over their lack of disclosure, it could affect the reputation and cost of municipal bonds, some experts believe. But even if that doesn’t happen, watch and learn more about an investment you might have in your portfolio but may not really understand.
When states, cities, counties and other governmental entities need to raise money to build roads, hospitals, schools, sewer systems or other public projects, they may issue bonds or debt obligations. Investors lend the municipalities money to pay for the projects in exchange for a promise that they will get back their principal at a specified maturity date plus interest paid at a specified time. The appeal of many munis is the state and federal tax exemption on the interest.
Investors get paid depending on the type of the bond. “In some cases, an issuer may promise to make payments out of any funds it has available, including funds available through its power of taxation,” explains the Municipal Securities Rulemaking Board. “These are generally referred to as ‘general obligation bonds’ or ‘full faith and credit bonds.’ ”
In other cases, investors who buy “revenue bonds” are paid from income generated by a specific facility or system. The board says, “When only a specific source is pledged to pay the bonds, the issuer generally will not be obligated to use any other source to repay the bonds if the pledged source proves to be inadequate.”
It’s important to understand the distinction between general obligation bonds and revenue bonds. Detroit had proposed paying general obligation bondholders pennies on the dollar. “Detroit simply cannot raise enough revenue to meet its current obligations, and that is a situation that is only projected to get worse absent a bankruptcy filing,” Michigan Gov. Rick Snyder said in a letter supporting the filing. The city wants to treat the bonds as unsecured debt even though the bonds are supposed to be backed by tax revenue and guaranteed by Michigan’s Constitution.
“No one has really tested whether general obligation bonds are better or worse than revenue bonds,” Maglan Capital’s Tawil said.
At the end of 2011, there were more than 1 million different municipal bonds outstanding in the principal amount of more than $3.7 trillion, the SEC says. Individuals, or “retail” investors, directly or indirectly hold more than 75 percent of these municipal securities.
The people who own munis tend to be older, safety-conscious investors looking for current income, said Ric Edelman, chairman and chief executive of Edelman Financial Services.
“How safe are munis really?” he asked. “There are so many unknowns because all of this is so new. We are not recommending muni bonds for our clients and haven’t for many years. And I see no reason to change that.”
In the Detroit case, there could be an ugly showdown in court over promised benefits to city retirees and bondholders. In its report, the SEC was concerned about investors not fully understanding whether cities had unfunded pensions and how the lack of funds or revenue to meet all their obligations can affect the safety of their bonds. The agency said the adequacy of disclosure by municipal securities issuers should be a concern for legislators and investors.
So yes, what happens in Detroit may not stay in Detroit.