U.S. Bankruptcy Judge Christopher Klein has surprised the bond market by ruling that the California Public Employee’s Retirement System (CalPERS) doesn’t have any special rights as a bond holder in the City of Stockton’s bankruptcy proceeding, even though California law explicitly says that it does.

The implication for municipal bondholders – and for bond insurers such as Assured Guaranty Ltd. (NYSE:AGO), MBIA Inc. (NYSE:MBI) and Ambac Financial Group, Inc. (NASDAQ:AMBC) by extension – is the prospect of enhanced recoveries in future restructurings,” writes BTIG analyst Mark Palmer. “Bondholders would no longer have to settle for carving up the value that remained after state pension funds with exposure to distressed municipalities were paid in full, but would be placed in the same claims pool as the pensions.”

Bankruptcy Judge Rejects CaLPERs Seniority In Muni Bond Bankruptcies

California law invalid, says Judge Klein

During a municipal bankruptcy it has been taken for granted that state pensions will be the first to get reimbursed in full, leaving everyone else to fight over what’s left. From the state’s point of view this makes perfect sense, the California state government limits its own downside risk by giving CalPERS special rights, but Judge Klein is unimpressed.

“California public employee retirement law … is simply invalid in the face of the Supremacy Clause of the United States Constitution,” said Klein. Therefore, the federal bankruptcy code and contract law applies to pension funds just like everybody else.”

Stockton decision has major implications for the muni bond market

This has an immediate impact on Stockton muni bond holders who can now expect to recover more, but it also has broad implications for the muni bond market in general. If similar rulings in other cases follow Judge Klein’s lead, it would mean that the average recovery for everyone except state pension funds goes up and distressed muni bonds look a little bit better. Monoline insurers would also fare better in the short term since they would have to cover fewer losses (though it could even out in the long run if it puts pressure on their rates).

Pension funds, on the other hand, will have to reassess whether they can handle the risk that comes with those same bonds. As long as they had the first shot at recovery, pension funds were looking at a skewed risk/return compared to the rest of the market. This ruling has the potential to reshape the mix of muni bond investors, at least when bankruptcy is a serious concern, though we’ll have to wait and see how the changing position of investors impacts yields in the future.