Detroit’s bankruptcy has the potential to reshape municipal bondholders’ assumptions as Emergency Manager Kevyn Orr pushes further than most investors expected, but the upheaval has also created some interesting investment opportunities.

Investors were disappointed when Orr released his plan to restructure Detroit’s debt last month because it treated limited unlimited tax general obligation (GO) bonds the same, offering a 20% recovery to each. The plan also proposed a system that would let the investors for different classes of secured Detroit Water and Sewer bonds (DWSB) to vote whether their bonds would be replaced with Great Lakes Water Authority (GLWA) bonds or re-couponed. These terms aren’t final, US Bankruptcy Judge Steven Rhodes still has to rule and monoline insurance companies are pushing hard against them, but it seems likely that even unlimited tax GOs will end up taking a haircut (even if it isn’t 80%).

Spread widening could force states to pass new laws

“Spreads of local GOs did not widen in response to the introduction of Detroit’s plan, helped by strong and improving muni technicals early in 2014, as well as to the belief that Detroit may be a unique case,” write Citi analysts Mikhail Foux, Vikram Rai, and George Friedlander. “Spread widening, if it occurs, would most likely show up on lower investment grade credits —triple-B and below, since stronger credits would be far less likely to transition into the condition of deep financial insolvency experienced in Detroit.”

Spread widening becomes more likely if Judge Rhodes approves the plan, but that could actually be to the long-term benefit of muni investors. Since municipalities have a clear interest in keeping their financing rates low, they might pass new laws clarifying and strengthening the rights of bondholders in case of bankruptcy, something that Rhode Island has already done.

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Detroit muni bonds: Two DWSB plays

While Orr’s plan has a lot of negatives for current bondholders, it does create a few opportunities for investors who are willing to get involved in Detroit muni bonds despite all the bad press. One option that Foux, Rai, and Friedlander propose is to buy floaters and zero coupon DWSBs. If the deal doesn’t go through they will actually become couponed bonds, and since they are already trading in the high 70s, there isn’t that much downside even if the deal does go through.

“A somewhat riskier trade is to buy DWSB bonds wrapped by Assured with 6.25%, 7% and 7.5% coupons,” they write. “There is a strong case to be made by investors for Assured to continue paying the original coupons at least until the original call date on these bonds (2018-2019), even if these bonds are called.”