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.
What's in Your Muni Fund?
Exposure to Detroit in the largest 10 national mutual funds is summarized below. Note the date of the most recently available portfolio; in some cases this exposure may have shifted materially since that date.
For investors concerned about Detroit bonds in their mutual fund portfolios--regardless of their flavor--there's mostly good news. Detroit exposure in the largest national municipal bond mutual funds is relatively muted, typically running at less than 1% in the most recently available portfolios. For example, muni giant
Vanguard Intermediate-Term Tax-Exempt VWITX held a relatively meager 0.32% stake in Detroit bonds as of March 2013, and the bulk of that was both secured and insured.
Even the handful of high-yield muni funds on the list didn't have a ton of exposure. Franklin High Yield Tax-Free Income FRHIX, for example, held combined exposure of just 1.15% as of June, mostly in water and sewer bonds. Meanwhile, its only exposure to general-obligation bonds was secured by a pledge of state revenues. The bulk of these holdings also carry some kind of insurance, although the general-obligation bonds do not.
Oppenheimer Rochester Limited Term Muni OPITX, held the largest position in the top-20 largest funds, a 3.7% stake in Detroit-related names as of June. Of that total, more than two thirds consisted of water and sewer revenue bonds, mostly with insurance. Approximately 1% of the fund's assets were in general-obligation debt additionally secured by the State Distributable Aid revenue pledge mentioned previously. The bonds held in the fund are a third lien on the state aid revenue stream, thus placing this particular issue third in line behind two previous city bond issues to receive the state funds. Despite the lien standing, Morningstar believes that the additional security offered by the state aid pledge significantly improves the credit strength of the holdings.
While large, national muni portfolios carry only modest exposure to Detroit, that's not true of dedicated Michigan muni bond funds. Indeed, of the 10 funds with the most exposure to Detroit (measured as a percentage of net assets), eight were Michigan muni funds, and for several the exposure ran into the double digits.
Within this list, a quick look at the underlying holdings shows a fair amount of variation. So, for example, eight funds on the list are invested entirely in debt secured by a pledge of special revenues, mostly water and sewer revenues, and are considered secured debt by city officials. Two funds on this list, First Investors Tax-Exempt Michigan FTMIX and AllianceBernstein Muni Income II Michigan AMIAX, held sizable stakes in general-obligation bonds (2.3% and 2.4%, respectively), but in both cases these were backed by State Distributable Aid receipts. Many also hold insurance on the underlying holdings, although, as noted above, the credit quality of the underlying insurers can vary significantly. So for example, Fidelity Michigan Municipal Income's FMHTX 9.5% stake in Detroit-related debt as of June 2013 was all secured by water and sewer revenues. Additionally, the majority of that--8.7 percentage points--was insured, mostly by higher-quality monoline insurers.
On the other hand, two funds had larger exposures to unsecured Detroit debt as of their most recently available portfolios. As of June, Oppenheimer Rochester Michigan Muni Fund ORMIX held a 3.6% stake in unsecured general-obligation bonds, and a total 14.7% position in Detroit-related debt. Offsetting this risk was the fact that most of this debt was insured, although by insurers of varying credit quality, including 1.6% of general-obligation debt backed by Ambac, a nonrated insurer. Franklin Michigan Tax-Free FTTMX had a smaller stake, roughly 1% of assets in unsecured, general-obligation bonds as of June 30. These, too carry insurance, but here by investment-grade-rated monolines.
With exposure to Detroit at relatively low levels outside of Michigan muni funds, and Michigan muni funds mostly concentrated in secured and/or insured paper, the bigger question for many investors may well be what effect the bankruptcy will have on the broader muni markets. Morningstar's municipal bond analysts argue here that the Detroit bankruptcy isn't a sign of widespread credit risk in the muni markets. However, its filing will, no doubt, have implications for muni investors. That may already be happening. While it's hard to isolate the impact of the Detroit filing, munis have been particularly hard-hit in the recent bond-market sell-off. The filing has also shone a spotlight on the troubles that underfunded pensions can wreak on municipal finances. Observers will be watching closely to see how Detroit's various creditors, and, in particular, pensioners and holders of its general-obligation debt, fare in federal bankruptcy court.