Detroit Suffers the Biggest Municipal Bankruptcy Ever — Are Your Muni Bonds Safe?

Detroit is broke.

That’s the stunning news that hit the wires late yesterday — and throttled investor sentiment. Unable to make good on more than $18 billion in debts, the city filed a Chapter 9 municipal bankruptcy in federal court.

The move follows years of overpromising on benefits to pensioners and city workers, under-delivering on services, and overborrowing to cover the gap caused by a shrinking population and tax base. The city’s population has dwindled to around 700,000 from 1.85 million at its peak. Manufacturing employment has plunged from 296,000 to just 27,000, and a whopping 15 percent of the city’s residential and commercial properties are blighted and decaying.

The move is clearly a tragedy for Detroit residents, workers and retirees. Many will see their health-care and pension benefits slashed. But, ultimately, Detroit felt it had no choice to get out from under its crushing burden.

Yesterday, Detroit became the largest American city to file for bankruptcy. But it’s far from an isolated case.

But what about the broader implications? What does this mean for the $3.7 trillion municipal-bond market?

Well, many market pundits will claim Detroit is an isolated case. Many bond-fund managers will try to downplay the significance of this.

Do not fall for it.

First, Detroit is far from alone. While it is certainly the largest municipality to go broke, the city is just the latest in a long line of troubled municipal borrowers to tumble into bankruptcy.

Jefferson County, Alabama, filed a $4.2 billion bankruptcy action in 2011. Stockton, Mammoth Lakes and San Bernardino in California all went broke last year. Harrisburg, Pennsylvania, tumbled into bankruptcy in 2011 after struggling with a $300 million debt burden.

Noted analyst Meredith Whitney took a tremendous amount of flack after forecasting in 2010 that as many as 100 governments could default on their muni debts, causing $100 billion or more in losses. The entire muni world downplayed the risk, and accused Whitney of provoking needless fear — not to mention requests from investors for their money back. But here we are a few years later, with bigger and bigger muni bankruptcies hitting the tape. Makes you think, doesn’t it?

Second, the same problems that plague Detroit affect many other towns, cities and even states. They have promised benefits and services to pensioners and current workers and residents that they simply can’t afford to cover over the long term.

They’ve been borrowing and borrowing to cover the gap, but that can’t go on forever. Eventually, you come to the end of your rope — and bankruptcy becomes unavoidable.

Third, and most importantly, Detroit’s bankruptcy plan envisions stiffing some general obligation municipal bond holders, paying them just pennies or dimes on the dollar. That’s an incredibly bold move with potentially huge implications.

Many investors hold G.O. munis because they assume that troubled municipal issuers will just raise taxes or take other steps to make good on their promised principal and interest payments. After all, those bonds are supposed to be backed by the “full faith and credit” of the government issuer.

But if Detroit is able to cram down muni holders via the bankruptcy process, it could very well set a precedent for all the other troubled issuers in this country.

Or as John Bonnell, a vice president at money manager USAA, put it in a Forbes article: “If bondholders take a big haircut, there may be other cities that try to play it the same way.”

SIFMA, the main trade group for the bond industry, is up in arms. It fired off a scathing letter to officials in Michigan saying the filing “could have potentially significant, negative municipal securities market implications.”

But do you really think city and state officials in hard-pressed locales will always and forever shaft pensioners, union officials, and hard-pressed workers in favor of big-money investment firms on Wall Street?

Is that something you want to bet on by continuing to shovel money into the munis your broker keeps peddling?

Look, I’ve hated long-term municipal bonds for a while because of interest-rate risk. I advocated dumping them — along with longer-term Treasuries, emerging-market bonds and junk bonds — several months ago, well before they all started crashing in value.

Now, in addition to interest-rate risk, investors will likely give more weight to credit risk on munis. That is likely to put even more pressure on muni-bond prices, and spur even more redemptions.

So my advice remains the same as it has been for months: Sell — if you still can.

Until next time,

Mike