Michigan Scorned as Schools Pay 14 Times AAA Yield: Muni Credit

Investors’ insistence on a yield 14 times higher than the AAA benchmark on $92 million of Detroit school notes is the latest example of municipal-bond market contempt for Michigan after the city’s record bankruptcy.

Yesterday’s deal by the Michigan Finance Authority, the first tied to the Motor City since Emergency Manager Kevyn Orr sought protection from creditors July 18, had securities maturing in August 2014 priced to yield 4.375 percent, data compiled by Bloomberg show. That compares with a 0.32 percent rate on top-grade munis due in one year.

Orr, 55, appointed by Republican Governor Rick Snyder in March, surprised the $3.7 trillion muni market by considering unlimited-tax general obligations as unsecured debt in his June plan to avert bankruptcy. The state’s tacit endorsement of the proposal has led investors to demand interest rates so high that at least three localities have postponed sales since the filing.

“His proposals basically to lump in lease debt with general obligations is obviously affecting the market for any type of bonds in the state of Michigan,” said Tom Spalding, who helps manage $10 billion of munis at Nuveen Investments Inc. in Chicago. “It’s going to impact everyone who needs to borrow.”

Michigan Morass

Snyder said after Detroit’s bankruptcy that he expected bond buyers would be “sophisticated investors” and separate the city’s situation from other municipalities, such as the independent school district. Orr said in an interview last month that it would be a “reduction to the absurd” to think other cities should be punished as a result of Detroit seeking court protection.

The yield penalty on the school notes, which investors including Gary Pollack at Deutsche Bank AG’s private-wealth unit said is among the biggest in years, shows Snyder and Orr were wrong.

Last week, the finance authority sold revenue bonds for Ypsilanti Community Schools, about a half-hour drive from Detroit, with 10-year debt yielding 4.29 percent, data compiled by Bloomberg show. That’s about 1.33 percentage points more than benchmark munis. Similarly rated revenue bonds averaged an interest rate just 0.59 percentage point more than AAA debt.

The Ypsilanti sale came after three other issuers in the state -- Genesee County, Battle Creek and Saginaw County -- postponed offerings because proposed interest rates were too high.

‘Punitive Behavior’

Sara Wurfel, a Snyder spokeswoman, said the postponed sales shouldn’t cause alarm and that “ultimately it should all work out.” Orr said last month that it wasn’t his job to worry about repercussions of seeking court protection.

“I understand the irrationality of behavior that may even bleed over into punitive behavior,” Orr said. “They want to send a shock to the system.”

Terry Stanton, a spokesman for Michigan Treasurer Andy Dillon, didn’t respond to a voicemail and e-mail seeking comment on the schools sale. A voicemail left at the office of Jack Martin, Detroit Public Schools’ emergency manager, wasn’t returned.

Cash Flow

Proceeds from the sale will help cover the autonomous district’s anticipated cash-flow deficits for the fiscal year that ends in June, according to offering documents. Standard & Poor’s rates the one-year Detroit school debt SP-1, its second-highest grade on short-term securities. The notes have first claim to state-aid revenue for repayment.

The yield penalty has become steeper for Detroit’s school district since it sold state aid revenue notes in August 2010. Those one-year securities were priced to yield 3.875 percent, compared with a benchmark AAA interest rate of 0.29 percent.

Even when compared with school districts tied to similarly distressed cities, the Detroit notes had a bigger penalty.

The school district in Stockton, California, which was the biggest U.S. city to seek court protection before Detroit, sold $36 million of eight-month notes in February with a yield of 0.6 percent, data compiled by Bloomberg show. That was 0.33 percentage point more than AAA munis maturing in a year.

Niagara Falls City School District in New York, with the same short-term debt rating from S&P as the Detroit school notes, issued $45.5 million of one-year general obligations in June with a yield of 0.9 percent, data compiled by Bloomberg show. The city’s rating dropped to one step above junk this year amid a cash crunch.

Possible Disruptions

While some investors may require additional yield because of Orr’s plan, the 4.375 percent interest rate also takes into account possible disruptions in state funding for the schools, said Wells Capital Management’s Lyle Fitterer, who plans to buy a portion of the note sale.

“We don’t know if there will be a temporary interruption of cash flows,” said Fitterer, who helps manage $31 billion of munis at the Menomonee Falls, Wisconsin-based company. “We don’t think there would be, but investors are saying, ‘We need to get compensated for that.’”

S&P said there’s “limited risk” of substantial delays in state school-aid appropriations. Enrollment at Detroit public schools could decline by as much as 33 percent and state aid would still fully cover debt service payments, according to S&P.

Different Entities

The district and the city are “unrelated legal entities created and existing under different laws of the state,” according to offering documents. The district was Detroit’s fourth-biggest employer last year, with about 7,350 workers, the documents show.

Across the country, education debt is set to underperform the broader market this year for the first time since 2010. Debt sold for public schools and higher education has lost about 5.7 percent through Aug. 19, the most since 1999 and more than the 5 percent loss for the muni market, Bank of America Merrill Lynch data show.

Charlotte, North Carolina, and Dallas’s water and sewer system are among issuers offering debt this week amid $4.6 billion in sales, data compiled by Bloomberg show.

At 3.05 percent, yields on benchmark 10-year munis are the highest since April 2011. The interest rate compares with 2.82 percent for similar-maturity Treasuries.

The ratio of the two yields, a gauge of relative value, is about 108 percent. The figure has been above 100 percent since July 8, signaling that munis are cheap compared with federal securities.

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