Detroit’s bankruptcy has led some investors to bet that Emergency Financial Manager Kevyn Orr’s plan to give bondholders less than 20 cents on the dollar won’t hold up in court.
Some city limited-tax bonds maturing in April 2020 traded July 19 at an average price of 74 cents on the dollar, up from 68 cents earlier in the week, data compiled by Bloomberg show. The debt, insured by Ambac Assurance Corp., was one of at least 10 series of Detroit general obligations that traded at a higher price after Orr sought court protection from creditors on July 18.
The price fluctuation reflects the unprecedented nature of Detroit’s Chapter 9 filing. Stockton, California, previously the biggest U.S. city to seek protection, doesn’t have general obligations. While bondholders were repaid about 96 cents on the dollar after municipal defaults during the Great Depression, today’s investors should expect a 50 percent recovery rate, similar to company debt, Moody’s Investors Service said in May.
“Just on the face of it, the Chapter 9 filing could be viewed as a mild positive for G.O. bondholders” because the bankruptcy judge has more control, Vikram Rai, a fixed-income strategist at Citigroup Inc. in New York, wrote in a report the day after Detroit filed.
“It is still early in the process to predict recovery rates,” Rai said. “There is no precedent for a large city with this level of financial distress.”
Detroit’s filing last week came after decades of decline left the city too poor to pay billions owed to bondholders, retired police officers and city workers. Too few creditors would accept a plan that Orr offered to repay $11.5 billion in unsecured debt -- including unlimited-tax and limited-tax general obligations -- with $2 billion in borrowed money.
Bankruptcy lawyers are divided about whether general obligations, which are backed by the taxing power of a local government, can be treated as unsecured debt, forcing investors to take less than full repayment. No municipality has used bankruptcy to force such bondholders to take a cut in principal.
By classifying the obligations as unsecured and with no collateral rights, Orr is arguing that a federal judge has the right to impose losses on bondholders.
“This filing will be the first major case in which G.O. bonds are likely to be challenged,” Peter Hayes, head of munis at New York-based BlackRock Inc., the world’s biggest money manager, said in a report last week. “Chapter 9 bankruptcy is not well understood, partly because it happens so infrequently.”
At least 37 series of general-obligation bonds traded the day after the filing, Bloomberg data show. The average price rose only in about one of every four trades, indicating that more buyers wanted extra yield to own the city’s debt after Orr’s filing. Prices move inversely to yields.
Hedge funds were among those buying Detroit obligations, according to a report today from Concord, Massachusetts-based Municipal Market Advisors.
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