Concerns about the Motor City bankruptcy have helped rattle muni markets, but how much direct exposure does the typical muni-bond fund hold?
When the city of Detroit filed for bankruptcy in mid-July, it made big headlines. That's for good reason: Detroit was once the fourth-most populated city in the nation, and it is the largest ever municipality to file under Chapter 9 of the United States Bankruptcy Code. (Chapter 9 is reserved for municipalities; corporations file under Chapter 7 or Chapter 11 of the code.) However, the filing didn't come as a huge surprise to market observers. Detroit has seen a decades-long decline as people and jobs have fled and the city's debts have ballooned, and its troubles were well-documented.
Stepping aside for a moment from the larger question of what impact the Detroit filing might have on the broader muni market, what's the potential impact of the Detroit bankruptcy on muni mutual fund portfolios?
Not All Detroit Exposure Is Created Equal
Detroit filed for bankruptcy with an estimated $19 billion in total liabilities, a staggering number by any measure. But not all of that amount is owed to bondholders. Indeed, the estimate includes roughly $10.0 billion in unfunded pension liabilities, unfunded other post-employment benefits--think health-care costs for retirees--and other associated liabilities. Morningstar's Beth Foos, municipal credit analyst, and Jeff Westergaard, director of municipal analytics, note that bondholders have not traditionally focused on pension liabilities, but that's changed with this bankruptcy. That's because bondholders and retirees are in direct competition for very limited resources under Detroit's proposed restructuring plan.
When we started looking at Detroit exposure in muni bond funds, we ran across a number of different bonds with "Detroit" in their name. We turned to our muni research team for help in sorting out those directly tied to the city's finances. Bonds issued by Detroit's school district, for example, have their own credit issues but were not affected by the bankruptcy. Even within the subset of bonds that we uncovered, however, there's a fair amount of variation in credit profiles.
Roughly $7.2 billion of Detroit's liabilities are backed by some kind of pledge of special revenues and are considered "secured debt" under the city's restructuring proposal. This basket includes more than $5.3 billion of bonds backed by water and sewer revenues. Detroit has continued to make interest payments on these bonds, and many observers expect that they will fare relatively well through the bankruptcy. It's also worth noting that a significant portion of the revenues backing the water and sewer bonds originate outside of Detroit proper through sales to suburban customers.
Debt considered "unsecured liabilities" per the restructuring plan includes unfunded pension liabilities, retiree health-care obligations, and approximately $530 million in general-obligation bonds. These bonds come in two flavors. Unlimited tax general-obligation bonds are voter approved and have historically been considered one of the strongest pledges in Michigan and for the muni market in general. Limited tax general-obligation bonds have priority over other budget line items but are subject to limitations on tax levies. Complicating the picture, specific general-obligation bond issues carry an additional pledge of certain state revenue-sharing payments (State Distributable Aid) that Detroit expects to receive; these are lumped in the secured bucket above. Investors will be watching carefully to see how the "unsecured" general-obligation bonds get treated in the bankruptcy proceedings. The city's bankruptcy plan placed these bonds together with unfunded pension and other post-employment benefit liabilities in the unsecured liability bucket, surprising many market observers and raising the risk that general-obligation bondholders could see worse-than-expected recoveries.
Bond insurance presents one final wrinkle in determining the risk of the underlying holdings. More than 80% of Detroit's obligations carry some kind of bond insurance. However, because the credit quality of the insurers also varies widely, it's not a foregone conclusion that investors will receive full payment.
Overall, while there's still a lot of uncertainty out there, investors in secured bonds backed by one of the stronger bond insurers could see decent recoveries. Holders of general-obligation debt that's not insured or insured by a weaker guarantor are much more vulnerable.