Detroit Reorganizes. The Muni Market Takes Notes. by Joseph Rosenblum, AllianceBernstein
Stockton. San Bernardino, California. Jefferson County, Alabama. Over the past few years, municipal bankruptcies (Chapter 9) have captured headlines. Detroit’s case, the largest municipal bankruptcy in history, was recently settled. What have we learned?
Here are four key take-aways for muni market investors.
1) Economics Trumps Legal Requirements
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Every case of municipal distress is unique, but one lesson is constant: a borrower’s ability to pay matters more than its legal requirement to pay. Detroit is a good example. The city endured decades of economic decline and population loss, and its revenue suffered accordingly. The city cut staff and borrowed to meet operating deficits.
Throughout this time, management promises, and legal provisions that appeared to guarantee payments, assured the safety of Detroit’s bonds to investors. But in the end, the city’s economic base couldn’t generate enough revenue to support the debt the city built up (bond payments as well as pension and retiree health commitments) and provide basic services. The lesson: legal promises to repay don’t mean much in the face of deteriorating economic factors.
2) Bias Against Bondholders
Chapter 9 law says that debt adjustments have to be tested so they’re reasonable and fair. But the Detroit case shows that these provisions are subject to interpretation by the municipality—and the judge. We’ve seen several instances of bondholders labeled as “Wall Street” and pitted against “Main Street.” In Detroit and the various California cases (including some municipalities still in Chapter 9 protection), retired municipal employees have generally seen better results than unsecured creditors. The lesson: bondholders aren’t necessarily treated as equal to municipal employees in cases of bankruptcy.
3) Pensions Can Be Impaired—but Most Likely Won’t Be
Judges in the Stockton and Detroit cases have articulated the legal view that pensions can be impaired—which means pension terms can be altered. But evidence so far still seems to support pensioners over bondholders.
Restoring a municipality’s capacity to deliver basic services is central to a Chapter 9 restructuring. That’s because unlike corporations, cities don’t go out of business. So, a judge almost has to defer to the municipality and its plans over those of creditors. The takeaway is that pensions can be impaired, but not so much that it prevents the city from attracting or keeping needed employees.
4) Special Revenue Bonds Have Taken a Reputation Hit
In the first six proposed plans of adjustment released by Detroit (these are plans covering emergence from bankruptcy), the city tried to impair the rights of investors in its water and sewer revenue bonds. For years, the market had assumed that 1980s amendments to the bankruptcy code had made special revenue bonds safe from impairment.
Ultimately, the city and bondholders reached an agreement and the bonds weren’t impaired, but the bonds’ reputation has been tarnished. The bottom line is that special revenue bonds no longer offer the absolute certitude the market previously believed.
Recent defaults and bankruptcies remind us that the muni market isn’t risk free. But it remains a very safe market. From 2008 through November 2014, despite all the headlines, the total value of defaulted bonds was less than 2% of the market. The average annual default rate was a very small 0.3% during that almost seven-year period (the average for the period since 1991 was 0.1%). From 2008 through 2013, there were an average of nine Chapter 9 filings per year; for the 25 years before that period, the annual average was eight.
These defaults are all minuscule numbers in the context of some 90,000 units of state and local governments. But careful research and analysis of exactly what you’re buying is key for investors.
The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams. Past performance of the asset classes discussed in this article does not guarantee future results.
Joe Rosenblum is Director of Municipal Credit Research at AllianceBernstein.