Investors in Detroit municipal bonds are nervous

Detroit Free Press (Michigan)

 

The human toll of Detroit’s $10-billion debt load doesn’t stop at city employees, retirees and residents. Some investors who put money on the line in Detroit-related municipal bonds are worried, too.

Amid reports that the city is going broke and may need an emergency manager, Leon Pedell, a retired physician in Orchard Lake, said he has been in contact with his broker and bond management service about his Detroit water and sewer bonds. They are returning 5.5% tax-free at the state and federal level, but is there risk?

“You never used to worry about munis,” Pedell said. “There’s nothing like a risk-free bond any more.”

Pedell said he has been advised to hold steady now and that he may be able to keep the bonds until maturity without losing money.

Detroit is considered to be the largest U.S. city rated below investment grade. But some municipal bond experts say that investors should be able to ride it out — if they don’t need to sell those bonds early. Much depends on the type of bonds, with water and sewer considered as an essential service bond and less risky than Detroit’s general obligation bonds.

Would someone want to have all their money on the line in Detroit municipal bonds? Probably not.

But before making any moves, it’s also important to know an individual investor’s own strategy for managing risk.

Detroit workers, taxpayers at risk

When you’re looking for potential losers in the Detroit financial crisis, money managers say it’s not likely to be the holders of Detroit-related bonds.

“It is the taxpayer who is generally more exposed,” said Patrick Early, chief municipal analyst at Wells Fargo Advisors in St. Louis. “It’s the people of the city, especially government workers.”

Detroit residents and public sector employees are the first to feel squeezed as the city works out its serious financial troubles. Fewer services, more layoffs, potential changes in pension payouts and labor contracts are generally part of the solution. Some vendors for the city already are seeing delayed payments.

Even so, bondholders — whether they are mutual funds, insurance companies, banks, institutions or individuals — are closely watching as Detroit’s financial woes unfold.

There are risks. One municipal bond research group said a downside already is the assault on the state’s emergency manager law, which could preclude Gov. Rick Snyder from invoking it for Detroit.

A report by Municipal Market Advisors, an independent research firm in the tax-free municipal bond industry, said allocations of Detroit bonds should be considered speculative and kept relatively light as a share of total investments.

“The suspension of the existing EFM law would be a negative development for bondholders since it reduces the powers the manager has to implement expenditure reductions to improve the city’s fiscal position, notably the ability to amend/terminate collective-bargaining agreements,” the report said.

On the plus side, though, the report said if Detroit can achieve concessions, the EM process could stop.

The group also noted that Michigan’s governor “has indicated his unwillingness to permit any Michigan municipality to file for bankruptcy, making it an unlikely course of action at least in the near term.”

To be sure, some experts say they’ve stayed away from Detroit-related municipal bonds for some years. They saw too high of a risk and only added concerns now.

Going forward, investors will want progress toward a balanced city budget — and tough decisions made to cut costs.

Michael Schroeder, chief investment officer for Wasmer, Schroeder & Co. in Naples, Fla., said Detroit has experienced a gradual deterioration of its credit metrics for some time. He noted that Detroit’s general obligation bonds have recently traded at the deepest discount — some around 67 cents on the dollar.

So is it a good time to buy?

Not really, experts say.

“It would be an awfully speculative decision,” said David Joy, chief market strategist for Ameriprise Financial. “The situation is so fluid now; you don’t know how it’s going to turn out. I’d be very reluctant to take a position if I didn’t have one.”

Water and sewer bonds carry less risk than general obligation bonds. And experts say pension bonds carry more risk than general obligation bonds. But many bond groups have felt some impact of the city’s financial crunch.

A year ago, Moody’s Investors Service lowered its rating on $4.6 billion of bonds issued by the Detroit Water and Sewage Department, pointing to the risk from interest-rate swaps and “lean financial flexibility” that could crimp Detroit’s ability to service this debt.

The state began a 30-day review of the city’s finances on Dec. 6 to determine whether a financial emergency exists.

The following day, Moody’s Investors Service put the city on review for a possible credit downgrade, including the Detroit Water and Sewerage Department.

Moody’s noted that DWSD is city-owned and might not be immune to the risks associated with a possible bankruptcy.

Schroeder, whose firm manages about $4 billion in fixed-income investments for wealthy individuals and others, said that, in general, investors who plan to hold onto Detroit bonds need to keep a close eye on the city’s developing financial story. He said he does not plan to buy Detroit municipal bonds until key issues are resolved.

Oversight reassures

Experts say the city’s financial crisis will not follow the General Motors playbook, a quick-fix bankruptcy in which shareholders were stiffed and bondholders lost money.

“Bondholders are meant to be protected,” Early said. “There’s significant authority given to the emergency financial manager.”

A company undergoes a restructuring through Chapter 11 of the U.S. bankruptcy code. A municipality files under Chapter 9, which allows it to seek court protection and ensure that basic government functions continue. Creditors cannot force a municipality into bankruptcy.

Early and others say it’s key that the city’s investors do not lose principal if the bonds are held to maturity — and that interest continues to be paid. Detroit will need to go back to the bond market at some point to reissue debt.

“Once you alienate investors, it’s very hard to come back to market,” Early said.

Early said Michigan has strong oversight when cities run into financial trouble, which reassured bondholders.

 

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