Detroit’s 86-Cent Water Debt Seen Delivering Profit: Muni CreditBrian Chappatta
Detroit’s bankruptcy is providing a buying opportunity in the city’s $5.4 billion of water and sewer debt as investors bet that bonds trading at the deepest discount since 2011 will get paid in full.
The biggest Chapter 9 filing in U.S. history is scaring individuals away from the obligations, creating a chance to profit, said Tom Metzold at Eaton Vance Management and Paul Mansour at Conning. Detroit securities guaranteed by water and sewer fees would be refinanced and fully repaid under Emergency Financial Manager Kevyn Orr’s pre-bankruptcy proposal, unlike some general obligations he deemed unsecured.
Investors still accept less than 100 cents on the dollar to part with the debt. Two series of water bonds backed by units of Assured Guaranty Ltd. and MBIA Inc. traded July 19 -- the day after Orr filed -- at 86 cents, the lowest since 2011, data compiled by Bloomberg show. Both companies said they would make full and timely payments to bondholders if Detroit doesn’t.
“The chances of not getting paid 100 cents on the dollar, even for uninsured people, is as close to zero as possible,” said Metzold, who helps oversee about $28 billion of debt as co-director of municipal debt at Eaton Vance in Boston.
The debt is “one of the single-best values in the entire bond market right now,” Metzold said in a telephone interview. The company owns about $100 million of Detroit water and sewer obligations and is buying more, he said.
Confidence in Detroit’s revenue bonds contrasts with views on its general obligations. Orr’s plan to avert Chapter 9 included the unprecedented step of classifying more than $530 million of such securities as unsecured, even though they are backed by the city’s taxing power. He offered holders of such borrowings less than 20 cents on the dollar.
Investors holding about $900 billion of general obligations from issuers nationwide are debating whether Orr’s plan will hold up in court. No municipality has used bankruptcy to force such bondholders to take a cut in principal.
While Detroit can stop paying some liabilities under court protection, the water and sewer system will probably continue to pay investors, said David Kudla, chief executive officer of Mainstay Capital Management LLC in Troy, Michigan. Moody’s Investors Service said on July 18 it doesn’t expect bankruptcy to prevent utility-bond holders from collecting debt service.
“Water and sewer, we’re going to honor those,” Orr said yesterday in an interview at Bloomberg’s New York headquarters. “They are unimpaired, they are paid according to their terms, and we are current on all our obligations with our secured debt.”
There are few legal precedents from Chapter 9 cases on which Detroit investors can rely.
In the bankruptcy of Jefferson County, Alabama, a judge ruled the county had the right to collect legal fees related to bankruptcy, and possibly other costs, before warrant holders are paid. Sewer warrant holders failed to persuade U.S. Bankruptcy Judge Thomas Bennett that the county could only pay the normal operating costs listed in the debt contracts.
Detroit’s filing came after decades of decline left the city of 700,000 too poor to pay billions owed to bondholders, retired police officers and city workers. The municipality this week obtained federal protection from lawsuits while in bankruptcy, setting the stage for a hearing near the end of the year over whether the case belongs in court.
Orr sought protection from creditors after too few would accept a plan he offered to repay $11.5 billion in unsecured debt with $2 billion in borrowed money.
That portion of obligations didn’t include water and sewer bonds, which Orr classified as secured. The plan called for forming the Metropolitan Area Water and Sewer Authority, which would oversee operations previously handled by the Detroit Water and Sewerage Department. The new agency would also be able to issue municipal bonds.
Investors have already shown demand for the water bonds at 86 cents. The debt, backed by Assured Guaranty Municipal Corp., traded July 24 at an average of 90 cents. The securities changed hands this week the most in a month. Standard & Poor’s rates the securities BB- without insurance, three levels below investment grade.
The rating companies haven’t expressed the same confidence as investors in full repayment on the utility debt.
S&P on July 19 said Detroit sewer bonds could have their rating cut to CC, 10 steps below investment grade, on the possibility of a restructuring or negotiated exchange.
Jefferson County was previously the biggest U.S. municipal bankruptcy, filing in November 2011 as officials sought to spare residents from ballooning fees needed to pay off debt that financed a sewer project. The locality had $3.14 billion of sewer borrowings when it sought court protection.
The county last month filed a plan to end its bankruptcy by cutting $1.2 billion in principal payments to investors holding defaulted sewer-related debt. Some warrant holders were given a choice of either collecting 65 cents on the dollar and filing claims against insurers, or 80 cents on the dollar and waiving the insurance.
Bondholders won’t be forced into such an agreement in Detroit because the water and sewer system is self-sufficient and has adequate revenue to make debt payments, said Mansour, head of muni research at Hartford, Connecticut-based Conning.
“The big difference between Detroit and Jefferson County is this water and sewer system is a solid credit,” Mansour said. His company manages $9 billion in munis, including Detroit utility debt. “It’s not the problem. It has the potential to be part of the solution.”
Patrick Stoffel at Wells Fargo Advisors and Thomas McLoughlin at UBS Wealth Management said in July 19 reports that precedents set in Jefferson County and other Chapter 9 cases that uphold bondholders’ right to dedicated revenue should protect Detroit utility investors.
Even if the bonds are handled differently, having insurers backing the debt justifies holding the water and sewer bonds, Stoffel said.
“I don’t think the insurance is even going to come into play on the water and sewer bonds -- it’s just superfluous,” said Eaton Vance’s Metzold. “Uninsured or insured, either one is a great investment.”
In the $3.7 trillion municipal market, issuers including Chicago O’Hare International Airport are set to sell a combined $4.6 billion next week, down from $6.4 billion this week, as rising yields slow issuance.
At 2.92 percent, yields on benchmark 10-year munis are close to the highest since April 2011. The interest rate compares with 2.57 percent for similar-maturity Treasuries.
The ratio of the yields, a gauge of relative value, is about 114 percent, compared with an average of 93 percent since 2001. The greater the figure, the cheaper munis are compared with federal securities.
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