Prices on some Detroit debt reached a three-month high on bets Emergency Financial Manager Kevyn Orr’s plan to give bondholders less than 20 cents on the dollar won’t hold up in bankruptcy court.
Orr’s proposal to avert last week’s Chapter 9 filing, a record among U.S. municipalities, classified more than $530 million of general obligations as unsecured debt that would get the same treatment as pensions and retiree health benefits. The approach threatened a basic tenet of the $3.7 trillion local-bond market: that cities will raise taxes as high as needed to avoid default.
The possibility that the bankruptcy judge will view the pledge differently than Orr has helped boost some city securities. Unlimited-tax bonds maturing in April 2014 traded yesterday at an average price of 100 cents on the dollar, up from 97 cents before Orr filed on July 18, data compiled by Bloomberg show. The debt hasn’t traded that high since April.
“Orr put together the simplest reading possible -- if you don’t have the word ‘revenue’ or ‘pledged’ in the indenture, then you’re totally unsecured,” said Bart Mosley, co-president of Trident Municipal Research in New York.
The price fluctuation reflects the unprecedented nature of Detroit’s 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.
Decades of decline have left Detroit too poor to pay billions owed to creditors such as bond insurers, investors and city workers. Too few would accept Orr’s offer to repay $11.5 billion in unsecured debt -- including unlimited-tax and limited-tax general obligations -- with $2 billion in borrowed money.
The insurers, including units of Assured Guaranty Ltd. (AGO) and MBIA Inc. (MBI), are on the hook for at least 95 percent of the $2 billion of unsecured Detroit debt that wasn’t issued for city utilities. That includes most of the general obligations that Orr targeted for losses.
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, causing investors to take less than full repayment. No municipality has used bankruptcy to force such bondholders to take a cut in principal.
The approach of Orr, a former bankruptcy lawyer who was appointed by Michigan Governor Rick Snyder in March, brought scrutiny to the $900 billion segment of the municipal market.
The debate over the value of a general-obligation backing stems from the relative rarity of local-government failures. Only 648 municipal issuers have filed Chapter 9 since 1937, according to James Spiotto, a partner who leads the bankruptcy group at Chapman & Cutler LLP in Chicago.
Investors betting on repayment by Detroit include hedge funds, according to a report yesterday from Concord, Massachusetts-based Municipal Market Advisors. Detroit’s unlimited-tax bonds have a C rating from Standard & Poor’s, 11 levels below investment grade. The city is the first in Michigan to seek court protection.
“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.”
At least 37 series of Detroit general-obligation bonds traded the day after the filing. The average price rose in about one of every four trades, indicating that the bulk of purchasers wanted extra yield to own the city’s debt after Orr’s filing. Prices move inversely to yields.
In an example of the price volatility, unlimited-tax bonds maturing in April 2019 traded yesterday at an average of 89 cents on the dollar, down from 98 cents in June. The debt, like the series trading at the highest since April, is backed by National Public Finance Guarantee Corp.
“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. “Chapter 9 bankruptcy is not well understood, partly because it happens so infrequently.”
In the municipal market this week, sales are set to dive about 20 percent after Detroit’s filing.
Issuers such as Maryland plan to offer $6.8 billion in debt, down from $8.6 billion last week, Bloomberg data show.
The ratio of the yields, a gauge of relative value, is about 111 percent. The figure has averaged about 93 percent since 2001. The greater the percentage, the cheaper munis are compared with federal securities.
The municipal market has lost about 0.8 percent this month, compared with a 0.1 percent gain for Treasuries, Bank of America Merrill Lynch data show. Munis are on pace to trail their federal counterparts for the second straight month.
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