Detroit: Teetering domino of the municipal bond market?
This summer, the news that the city of Detroit – once the automotive capital of the world – was seeking bankruptcy protection hit the municipal bond market hard, causing many observers to worry that Detroit’s bankruptcy filing was just the first of many high-profile municipal defaults to come. In the following article, Pioneer’s Jonathan Chirunga, a municipal bond credit analyst and a portfolio manager, offers his thoughts on Detroit and the impact of the city’s potential bankruptcy on the municipal bond market.
Pundits have been calling for a sort of “Municipal Armageddon” since the financial crisis of 2008. A combination of runaway debt issuance, plummeting tax receipts, massively underfunded pensions and, in some cases, outright corruption, were all elements of the plotline. At the end of 2010, in fact, a now-notorious declaration on national television by a respected municipal bond analyst predicting default for hundreds of billions of dollars in municipal securities, with cities and municipalities collapsing in domino-like fashion, sent the municipal market into a tailspin. Just recently, the municipal market took another hit – this time as a result of a violent retreat in Treasury bond performance as investors (ironically) began to see a greater risk in a faster-than-expected economic recovery.
Thus, the question remains: Is Detroit’s bankruptcy filing the beginning of a larger default wave? In which case, could municipal securities get slammed from both a simultaneous rise in interest rate risk and credit risk?
Detroit’s situation is no surprise
While the recent bankruptcy of the City of Detroit was not a surprise to the bond market (the city’s bonds were rated Caa by Moody’s and CC by Standard & Poor’s, signifying tremendous credit stress), concerns over which city might be next have surfaced. A careful analysis suggests that Detroit is, indeed, a special case. Detroit’s sickly credit profile stems from a decades-long decline of the city’s population from over 1.8 million residents in the 1950s to 714,000 residents in 2012. In the past five years, Detroit’s tax base has deteriorated sharply, dropping from a high of $14.1 billion in 2009 to $9.4 billion in 2013, a 33.0% decline. The end result is a city with extraordinarily high debt levels and an unemployment rate in excess of 18%, greater than two times the national average. The table below neatly sums up the uniqueness of Detroit’s situation.
Thus, we find it unreasonable to closely compare Detroit to other large cities.
Other city managers will watch Detroit’s example on pension obligations
The more nuanced concern over Detroit’s situation is that a key reason to file for bankruptcy was to renegotiate the city’s pension obligations. Unfunded pension liabilities are estimated to be at least $5.7 billion, or 50% of the city’s unsecured liabilities.
A Chapter 9 bankruptcy proceeding is being viewed by Detroit’s city managers as a way to reduce or even eliminate these “unfunded” liabilities that would continue to strain city finances. The risk is that (if successful) the elimination or offloading of pension obligations could provide an attractive option for other cash-strapped obligors. While that’s a possibility, we have a different take.
The silver lining of the Detroit situation may be that it will cast more light on the need for employee funds and municipalities to renegotiate what are, in many cases, untenable benefit programs. In our view, it is very likely that municipalities will transition to deferred contribution pension programs such as 401(k) plans. Thus, a successful abrogation of unfunded liabilities could break the deadlock that so many cities, municipalities and states find themselves facing with their current and future retirees.
In conclusion, while there clearly are risks in the municipal bond market, we don’t think a cascade of defaults occurring, in light of Detroit’s situation, is something investors should lose sleep over.
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