Detroit’s Legacy Seen in Bondholder Security Demand: Muni CreditBrian Chappatta
Even with the municipal market gaining the most since 2009, a shift is afoot one year after Detroit’s record bankruptcy: More than ever, bonds’ security pledges weigh on investment decisions.
The $18 billion filing prompted a reassessment of general obligations and bondholder treatment relative to pensioners, according to the muni research chiefs at AllianceBernstein Holding LP and Eaton Vance Management.
Revenue bonds are the strongest in about a year relative to general obligations, signaling higher demand for debt backed by charges or dedicated fees. Detroit Emergency Manager Kevyn Orr’s decision to default on obligations challenged the notion that localities would do everything possible to repay debt backed by their full faith and credit.
“Detroit is a reminder that general-obligation bonds are not guaranteed and are subject to risk,” said Joe Rosenblum at New York-based AllianceBernstein, which manages $30 billion in munis. “It’s also understanding politics, because you had different classes of creditors, and clearly they are being treated differently.”
Investors have watched the proceedings in Detroit, which began with the July 18, 2013, court filing, for clues about the recovery rates for different types of municipal bonds in cases of distress. The signs are becoming clearer.
The obligations deemed unsecured by Orr aren’t treated equally in his plan to revive Detroit after decades of population loss and economic decline.
Unlimited-tax bondholders would get 74 percent of the $388 million they’re owed under the plan. Limited-tax debt would recover 34 percent of $164 million, and certificates of participation, typically subject to appropriation, would recoup 11 percent of $1.47 billion.
Pensioners, also considered unsecured, will collect 46 percent of what they’re owed when the reduction of their cost-of-living adjustment is taken into account. When the cut to medical benefits is factored in, the city estimates all retiree obligations would be lowered by 74 percent.
Investors are emerging better than they would have under initial proposals, said James Spiotto, a bankruptcy specialist and managing director at Chapman Strategic Advisors LLC in Chicago. The case has underscored how officials must balance obligations to workers against those to investors, the potential creditors should Detroit seek to sell bonds again.
Bondholders have learned “we should relax, we shouldn’t panic, it’s a process,” he said.
Localities in Michigan faced the fallout from Detroit’s filing: At least three governments -- Genesee County, Battle Creek and Saginaw County -- temporarily postponed a combined $131 million of bond sales in August 2013 as borrowing costs rose. That month was the slowest for issuance in a decade, according to data compiled by Bloomberg.
Offerings from the state in 2014 are down 13 percent from last year, compared with a drop of about 17 percent nationwide. Michigan municipalities have sold $3 billion in long-term debt this year, Bloomberg data show.
In one example of Michigan issuance, investors bought a $185 million deal last month for the Public Lighting Authority, the agency responsible for illuminating Detroit’s streets. It showed the limit of Detroit’s bankruptcy stigma and the focus on bondholder security.
Offering documents made clear the revenue backing the bonds is dedicated by state law, can’t be diverted and is directly deposited with a trustee to pay investors. The debt, graded BBB+ by Fitch Ratings, priced in line with benchmark BBB revenue bonds, Bloomberg data show, defying speculation that the Detroit association might cause it to sell at junk levels.
Even as it has defaulted on unsecured general obligations, Detroit has continued to pay its water and sewer debt, which is backed by the system’s revenue. Investors will likely get 100 cents on the dollar, said Bill Delahunty at Eaton Vance, which oversees about $26 billion in Boston.
“Doing work on what you’re secured by has been extremely important, especially since the Detroit bankruptcy,” he said. “We were never really comfortable with the G.O. pledge in bankruptcy.”
In the eyes of investors, revenue bonds have become safer relative to general obligations.
The extra yield buyers demand to own revenue bonds instead of general obligations fell to 0.79 percentage point July 17, close to the smallest gap since June 2013, Bank of America Merrill Lynch data show. The difference reached a 2014 high of 0.97 percentage point in February.
The revenue backing may not be the only trait luring investors. The revenue index also has a longer average maturity and a lower average credit rating than its general-obligation counterpart, two characteristics that appeal to buyers as muni yields remain close to generational lows.
General obligations have returned 5.5 percent this year, less than the 6.5 percent gain for the broad market, which is off to its best start since 2009.
Based on the 34-cent agreement on limited-tax general obligations, “it would follow that bond investors, hereafter, will be far more careful before lending fresh dollars to local governments” in Michigan, according to a July 14 report from Municipal Market Advisors.
Yet with the market rally, “analysts looking for a better, more disciplined industry response are likely to be disappointed,” according to the report from the Concord, Massachusetts-based research firm.
Detroit’s plan to reduce payments on general obligations will influence investors when considering similar debt from other municipalities with declining ratings, Rosenblum said.
“If you always assume Chapter 9, you’re being too harsh,” he said. “But as a credit deteriorates, those considerations have to come into play.”