Headlines about Detroit's bankruptcy have been hard to ignore. Many of our clients have at least some sort of exposure to Detroit, often in the form of a municipal bond. So it seems appropriate to address what the Detroit situation means for all of us.
To start, it's important to recognize that not all municipal bonds are created equal, and that certainly applies to those with "Detroit" in the name. Some are direct obligations of the city, while others were issued by separate enterprises or agencies. Some bonds are secured by liens and dedicated revenues, while others do not have that same backing.
There are two primary categories of municipals - general obligation bonds (GOs) and revenue bonds, based on how the debt will be repaid. GOs are backed by the "full faith and credit" of the issuer, while revenue bonds are generally backed by a particular project being financed.
GOs have historically been considered the safer of the two categories, with the assumption that municipalities will do everything possible (i.e. raise taxes as high as necessary) to pay their general obligations. Defaulting would certainly make future borrowing extremely expensive, if not impossible, making it something to avoid at all costs.
Detroit, however, is a rather unique situation. The appointed emergency manager has outlined a plan described as "unconventional and precedent-setting" in its treatment of bondholders. Specifically, G.O. bondholders would be lumped together with other unsecured creditors, meaning they could end up getting pennies on the dollar for their bonds. Historically GOs have been given priority over other unsecured debt, and prior to this no municipality has ever used bankruptcy to force a cut in principal on general obligations. This will likely be battled out in court.
Fortunately, our clients have no general obligation bonds from Detroit. Our exposure is in "secured" debt that is backed by special dedicated revenues (taxes or fees). The majority is in "essential service" water and sewer bonds, with a few issues tied to the Downtown Development Authority (i.e. revenue bonds). The city's plan, as currently proposed, excludes these bonds from the bankruptcy case, since they are secured by revenues that are not part of the city's general operations. The Detroit Water and Sewerage Department is actually one of the city's healthiest assets, serving a large swath of the state. It is self-sufficient, with adequate revenue to make debt payments. People place a high priority on toilets that flush.
Nearly all of our Detroit bond positions are also insured, meaning an outside insurance company would make principal and interest payments in the event of a default. This adds an important level of protection to bondholders.
Above and beyond these attributes and credit protections, the primary method of reducing the impact of negative events is by keeping positions small (i.e. diversification). The typical exposure to Detroit is well below 2% of total assets for our clients, a target we try to maintain for any entity (i.e. company or municipality). Keeping positions small reduces risk.
Detroit has been a prominent story, but we need to put it in context. The municipal market includes over a million individual bonds representing $3.7 trillion in principal. Yet defaults are extremely infrequent, averaging fewer than five per year over the past five years. That number is elevated with the recent recession, and the longer-term average has been less than two defaults per year. Fact is, the vast majority of bonds are repaid in a timely fashion, and bondholders enjoy the consistent cash flows those bonds provide. It's not as interesting as the stories about Detroit, but it is much better news for investors.
