Defaults & the Muni Bond Market: What Investors Should Know About the Detroit Bankruptcy Filing

If you’ve been keeping up with the news, you know that on July 18, 2013, the city of Detroit filed for Chapter 9 protection in the largest bankruptcy filing in U.S. history. The city is seeking to restructure nearly $20 billion in unsecured debt to many groups of creditors, including bondholders, vendors, and city employees. Detroit’s bankruptcy was not unexpected. The city has had troubled finances for many years and a number of factors have brought Detroit to this point, including: a shrunken tax base, overwhelming city healthcare and pension costs, corruption, budget deficits, and repeated borrowing efforts. As part of its bankruptcy process, Detroit has defaulted on unsecured bonds, but continues to make principal and interest payments on secured bonds, such as its water and sewage bond issues, which are secured by revenues from those services.

It’s natural for investors and bondholders to have questions about how such a large municipal bankruptcy and debt default may affect their financial picture. We wanted to provide some information and guidance in putting this default in a larger context.

Should Investors Worry About Detroit’s Bankruptcy?

In short, probably not. We still are confident of the role municipal bonds can play in a well-diversified portfolio of stocks, bonds, and other investment types for some clients.

While we will continue to monitor the ongoing bankruptcy negotiations, we are not unduly worried about the effect a single bankruptcy will have on investors for the following reasons:

    • Municipal bond defaults are rare. According to default statistics kept by Moody’s rating agency, the default rate of A-rated bonds after three years is just 0.01%, or only 1 in 10,000 bond issues. In contrast, AAA-rated corporate bonds have a default risk of 0.50% after 10 years, meaning approximately 50 bond issues in every 10,000 default.
    • Detroit bond obligations represent an extremely small fraction of the overall muni bond market. According to a Vanguard report, Detroit bond debt represents just 0.05% of the municipal bond market, meaning that most bondholders will not be affected by the default.
    • Some Detroit bonds are insured, and insured bondholders will suffer no loss of principal or interest payments should the city fail to honor its obligations. Historically, municipal defaults have led to periods of increased demand for bond insurance and investors may see an uptick in the number of insured bond offerings in the near future.

What This Means for Investors

How Do I Know if My Bonds are Affected by a Bankruptcy or Default?
Bondholders will be notified directly, or through their financial representative if their issuer files for bankruptcy or goes into default.
Ask us if you have any questions about your bonds.

In the short term, interest rates may rise for new municipal bonds since investors perceive their risk to be greater in the wake of high profile bankruptcies. If interest rates rise, investors may also experience some price volatility in municipal bonds, but that will only affect investors who choose to buy or sell their bonds on the open market. Holders of existing municipal bonds who keep their bonds until maturity will not be affected by changes in bond prices.
The municipal bond market will be paying attention to the Detroit bankruptcy process as courts determine whether or not holders of general obligation bonds stand higher in precedence to other creditors such as city workers. Traditionally, general obligation bondholders have been given precedence over other creditors in bankruptcy processes and a change in this arrangement may have ripple effects in the overall bond market.
While no one can foresee exactly what will happen, we believe that while the number of municipal bankruptcies and bond defaults may rise from historically low levels, they should remain very infrequent and unlikely to affect the overall municipal bond market over the long term. The vast majority of municipal bonds should continue to make payments to bondholders in a timely fashion and we urge our clients not to put too much stock in the headlines surrounding a few defaults.
We hope you’ve found this letter educational and reassuring. If you have any questions about municipal defaults and how they may affect your personal financial situation, please reach out and let us know; we would be happy to discuss your concerns. As always, it is our sincere pleasure to be of service.