Detroit’s effect on the muni bond market

As Detroit goes through its bankruptcy filing, many speculated that it would have a negative effect on the market for municipal bonds. But it seems that even the business media isn’t clear on how the bankruptcy is shaping investors’ willingness to put money into munis.

Bloomberg Businessweek ran a story under the headline, “Detroit’s Bankruptcy Doesn’t Faze the Municipal Bond Market”:

Strange as it may seem, Detroit’s bankruptcy filing—the biggest ever for a U.S. city—doesn’t appear to have unnerved the $3.7 trillion U.S. municipal bond market. Tom Hamilton, finance director of Norwalk, Conn., had no trouble finding buyers for $21 million in general obligation bonds on Aug. 1. Localities from Washington State to Alabama to Massachusetts planned to sell $8.6 billion in debt during the first full week of August, the most since April.

The momentum defies predictions that the muni market would go into a deep freeze following the Motor City’s financial collapse and Detroit Emergency Manager Kevyn Orr’s plan to impose losses on some bondholders. “There’s not a lot of evidence to show this has been the death knell for GO [general obligation] bonds,” says Craig Pernick, senior managing director at Chevy Chase Trust, which oversees about $1.1 billion in munis.

The municipal market has weathered other storms in recent years. Banking analyst Meredith Whitney’s December 2010 prediction of “hundreds of billions of dollars” in municipal defaults in the following 12 months helped propel 29 straight weeks of investor withdrawals from muni mutual funds. The day of reckoning never came.

MarketWatch ran a neutral headline, but said the market was costing investors:

By one estimate, the tally is at least $13.8 billion.

J.R. Rieger, vice president of fixed-income indices at S&P Dow Jones, calculated that number based on the S&P Municipal Bond Index. Since Detroit filed for Chapter 9 bankruptcy protection on July 18, bond prices have fallen, sending yields on the index up 18 basis points to 3.72% on Wednesday. The return on the index has been negative 0.97% during that time period, erasing $13.8 billion of the $1.4 trillion par value of the index.

The index only tracks a portion of the $3.7 trillion municipal market, which means the numerical figure could be higher. But the index tracks fixed-rate municipal debt, which is more impacted by Detroit fears than floating-rate debt, said Rieger.

“There is selling pressure coming from investors moving money out of municipal bond funds,” said Rieger. “The headlines about distress and defaults are beginning to weigh on investors.”

The Wall Street Journal’s story ran under the headline, “Detroit Rattles Muni Market,” and talked about how emergency manager Kevyn Orr was battling investors in the city’s sewer bonds:

Amid a rising number of high-profile bankruptcies and defaults, many financial advisers are counseling greater caution when investors seek to put retirement nest eggs into the debt of local governments and related entities.

“You really break the foundation” of debt markets if municipalities can freely restructure their obligations, said Jim Colby, senior muni strategist and portfolio manager at Van Eck Global.

Front and center in Detroit are the revenues generated by one of the city’s crown jewels—its 177-year old water and sewage system, which draws water from as far as Lake Huron to Detroit proper and 127 suburbs, many much wealthier.

The bondholders and bond insurance companies are talking with Mr. Orr’s team about plans for the system and exactly how much revenue he could possibly divert, said people familiar with the discussions. The talks are in early stages and could fall apart, as few details are yet known about Mr. Orr’s plan. The decision could be made by a judge in a bankruptcy process that could stretch on for months and years, lawyers said.

Thus far, Mr. Orr has resisted pressure to make concessions. He has said he is focused on restoring fundamental services to Detroit and not worried about the bankruptcy’s impact on the broad municipal-bond market.

CNBC’s story began with the premise that obviously Detroit’s filing would have an effect on the markets and was causing many investors to leave the market altogether:

Now, however, investors are reacting to the news from Detroit as if the rest of the muni market also is circling the drain, as star analyst Meredith Whitney predicted would happen only a few years ago.

Some other Michigan communities have had to withdraw or postpone their own planned debt offerings: Potential investors in a proposed $53 million offering of a kind of general obligation bonds by Genesee County wanted higher yields than the county was willing to offer, while the city of Battle Creek has said it will postpone its own $16 million offering until the market isn’t imposing a de facto tax on any new Michigan debt offering.

That’s the problem in a nutshell. In good times, investors are prone to bidding up the value of all kinds of muni bonds, only to recoil from the asset class as a whole in the wake of a headline reminding them of the risks.

Right now, we appear to be in the midst of another such flight: In the week ended July 31, muni debt funds witnessed outflows of $2.2 billion, their 10th straight week of net sales, according to Lipper data. Coming on top of the ongoing anxiety about the timing and extent of a “tapering” of the Federal Reserve’s $85 billion monthly bond buying program, Detroit’s bankruptcy filing was too much for investors’ nerves to withstand, it seems.

So, I’m not totally sure what to believe, but it does make sense to me that a major U.S. city filing for bankruptcy would have some affect on investors’ sentiments. It also stands to reason that Detroit is a special case, posting population and industry declines when other areas were expanding. I think the truth is somewhere in the middle, meaning that like any asset class, it’s important to do research and put your money to work in smart places.