Motor City's Pain May be Fund Investors' Gain
Twenty square miles of vacant and abandoned land. Thousands of broken streetlights. Police that take an hour on average to respond to calls. Worst in the nation in employment growth from the first quarter of 1995 through the first quarter of this year, according to the Bloomberg Economic Evaluation of States. Not least, the largest federal bankruptcy filing – ever.
In this grim Detroit Thomas Metzold still sees good investments. The co-director of municipal investments at Eaton Vance Corp. is not only happy to hold Detroit bonds in the funds he oversees but has been snapping up the city’s water and sewer bonds. He now has his entire personal portfolio in muni bonds, including some closed-end muni funds.
At the other end of the spectrum are those who say Detroit’s woes will come back to haunt buyers of its bonds. The bankruptcy is unprecedented not only because of its $18 billion size but because of the city’s likely inability to recover, they say.
“People aren’t so concerned if a large rich area gets into financial trouble like New York City did in the 1970s -- they can fix it,” says Scarsdale Investment Group founder Stan Richelson, who has been managing muni portfolios for 25 years. “Detroit can’t be fixed.”
And Detroit’s bonds? “Garbage,” says Richelson.
Talk like that is what some money managers love to hear because it means they may be able to pick up assets cheap – it’s the old ‘buy when there’s blood in the streets’ philosophy. Detroit’s emergency manager Kevyn Orr provided managers like Metzold such an opportunity when, before filing for bankruptcy, he proposed giving some bondholders of Detroit’s more than $530 million in general obligation (GO) debt less than 20 cents on the dollar. That sent prices down on a range of Detroit bonds; when the bankruptcy petition was filed, and removed some uncertainty, their prices moved up.
Metzold’s water and sewer bonds, which are backed by revenues rather than by taxing power like GOs, are now trading for 85 to 90 cents on the dollar and he expects to be made whole. He’s confident most bondholders will win out over pension plans in the bankruptcy battles among creditors to get paid.
That confidence stems in part from the fact that the areas covered by the water and sewer bonds extends well beyond Detroit into richer suburbs. But Metzold's main argument is very simple: “A lot of people have made a big deal of this, but it’s just a plain-vanilla federal bankruptcy,” he says. Though the promise to fund worker pensions is part of the state of Michigan’s constitution, such guarantees are not part of federal bankruptcy law, which puts bond creditors first in line to be paid. “Federal law trumps state law,” Metzold says.
The battle between the Detroit bulls and the bears is perhaps most visible in closed-end muni bond funds. These funds, which issue a fixed number of shares and trade like stocks, are like the canary in the coal mine, sensitive to the slightest whiff of trouble.
The shares react to market sentiment quickly because they trade independently of underlying portfolio values or net asset values (NAVs). Share prices rise to premiums of NAV when investors are bullish and fall to discounts when they’re fearful. That’s why the Eaton Vance Michigan Municipal Bond Fund (MIW), which holds Detroit bonds, trades at a 13.4 percent discount. Though the value of portfolio has fallen 8.6 percent in the past year, shares of the fund have fallen 22 percent because of fears over Detroit.
Such discounts could spell opportunities for aggressive investors. At a price of $11.22 a share, the Eaton Vance Michigan fund yields a tax-free 6.5 percent. That's the taxable equivalent of 10 percent for those in the highest income-tax rate bracket of 39.6 percent.
Even a more diversified closed-end muni fund like the Nuveen Quality Income Municipal Fund (NQU) has a 6.4 yield -- a taxable equivalent of 9.8 percent at its current 12.5 percent discount. That tops the 3.7 percent yield on long-term Treasury bonds and the 6.5 percent on high-yield bonds in the Bloomberg Global High Yield Corporate Bond Index (BHYC).
Clearly, there are risks to investing in closed-end funds that conservative muni bond investors like Richelson normally never face. Because of their price swings from premiums to discounts, shares of the average closed-end muni fund are about twice as volatile as comparable municipal bonds, according to Morningstar data. Adding to the risk is the fact that funds often use leverage that amplifies both their gains and losses.
Bryn Torkelson, co-manager of the Matisse Discounted Closed-End Strategy Fund (MDCEX), thinks that Detroit’s woes are already priced into funds trading at steep discounts. His fund usually avoids muni funds because the discounts are too narrow, but because of the selloff he's increased the fund's exposure from zero to 7 percent. Funds he’s invested in include the Nuveen Dividend Advantage Municipal Income Fund (NVG) and Nuveen Maryland Premium Income Municipal Fund (NMY), according to Morningstar and shareholder reports.
Torkelson's analysis of closed-end funds shows how much work can go into investing in them. His research includes looking at how many securities are in a portfolio, what bond issue and state hold the largest positions in the fund, what types of bonds the fund favors (general obligation or revenue bonds, for instance) and the credit rating of the overall portfolio. Finding a fund trading at a discount, he says, is just a starting point.
(Lewis Braham is a freelance writer based in Pittsburgh.)
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