Detroit Case Scrutinized by $900 Billion G.O. Market
The fate of a 2 percent sliver of Detroit’s obligations is drawing scrutiny from investors holding a $900 billion chunk of the U.S. municipal-debt market.
Before filing the largest U.S. municipal bankruptcy yesterday, Detroit Emergency Financial Manager Kevyn Orr tried to persuade holders of $369 million of unlimited general obligations, which are supposed to have the full backing of taxpayers, to accept less than 20 cents on the dollar. The borrowings are part of $17 billion in debt and long-term liabilities Orr sought to restructure.
The approach by Orr is fueling debate about the value of a market segment that investors have considered the safest state and city debt, and could signal higher bond costs for some issuers, starting with about $19 billion from Michigan borrowers. Localities from California to Massachusetts use the bonds to borrow for roads, schools and other infrastructure.
“Investors and analysts are going to rethink the general-obligation pledge and what it really means when an issuer is under financial stress,” Ben Watkins, Florida’s director of bond finance, said in an interview. The bonds “have been the gold standard of the municipal-bond market.”
The segment of debt in question makes up almost 25 percent of the $3.7 trillion municipal market. Lower-rated governments in particular may be penalized, Michael Zezas, chief muni strategist at Morgan Stanley in New York, wrote in a report after the filing.
While debt repaid with an unlimited pledge on tax revenue has been viewed as a haven, Detroit’s filing may change that, said Robert Amodeo, who helps manage about $30 billion of debt, including Detroit securities, at Western Asset Management Co. in New York.
“Detroit has the potential to be precedent-setting,” Amodeo said. “Looking ahead, people understand that they should be compensated for the potential additional risk. There will be a tiering of demand, and with that there potentially could be wider spreads between the different types of general-obligation debt.”
Detroit, where officials struggle to provide public safety and street lighting, joins Jefferson County, Alabama, and California cities Stockton and San Bernardino in seeking bankruptcy to reduce debt. With about 700,000 residents, it’s the most-populous U.S. city to seek court protection from creditors.
In trading today, investors demanded the highest yields in almost two years to buy some of the Detroit debt. Unlimited general-obligation bonds maturing in April 2025 traded with an average yield of 5.65 percent, the highest since August 2011, data compiled by Bloomberg show. The bonds are insured by Assured Guaranty Municipal Corp.
Orr’s spokesman, Bill Nowling, said in an interview before the filing that the city doesn’t have any more capacity to increase taxes, and that even if it did, more residents would leave, making it more difficult to generate revenue.
Michigan Governor Rick Snyder, a Republican who appointed the 55-year-old Orr in March, said he authorized the filing “as a last resort to return this great city to financial and civic health,” according to a letter to Orr yesterday.
State officials are “washing their hands out of Detroit and investors will remember that,” Richard Larkin, director of credit analysis at Iselin, New Jersey-based Herbert J. Sims & Co., said in an e-mail after the city sought protection. Previously, Michigan “had a good reputation of a state helping out its localities when they were in difficulties,” he said.
“Investors will begin exacting a premium from any borrower that has Michigan’s name on it,” said Larkin. “From this point, Detroit’s name in the muni market is probably mud.”
An additional 0.25 percentage point of yield on $19 billion of debt would cost issuers in the state $47.5 million a year, according to data compiled by Bloomberg.
Brodie Killian, executive director of business services for the Plymouth Canton Community Schools, with 18,000 students 50 miles west of Detroit, called the city’s filing “an isolated incident.”
The district stands behind the unlimited general-obligation pledge that backs 95 percent of its $280 million of debt, he said. Its bonds are rated A+ by Standard & Poor’s, fifth-highest. ’
Communities around Detroit will have to pay more when they borrow, he said.
“There will be some tough days ahead for Michigan issuers,” Killian said. “The state of Michigan as a whole and many of its municipalities outside Detroit are very strong credits and the national market shouldn’t be afraid of Michigan issuers.”
No one knows how Detroit’s bankruptcy will affect the general-obligation market, said Adam Stern, director of municipal research at Breckinridge Capital Advisors in Boston, which manages about $18 billion.
“The fact that G.O. bonds would be impaired is not too surprising,” Stern said. “What’s surprising is the extent of the impairment,” he said. “The market believes that the proposal that’s been presented is a starting point.”
General obligations have been beating the rest of the municipal market amid the steepest losses for local debt since 2010. G.O. debt maturing from seven to 12 years has lost 2.6 percent this year, while the broader market has lost 3.2 percent, Bank of America Merrill Lynch data show.
As a growing economy fueled bets the Federal Reserve will slow its bond buying, benchmark 10-year muni yields last month reached the highest since April 2011.
Individuals have pulled an unprecedented $15 billion from all municipal-bond mutual funds in the past four weeks, Lipper US Fund Flows data show.
In the week ahead, issuers from Michigan have about $20 million of borrowings scheduled. Localities in the state have sold about $3.5 billion of debt this year, down from $7.2 billion at this point in 2012.
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