Detroit is the largest and (still) most populous city in the state of Michigan. It is also the largest U.S. city on the U.S./Canadian border. Detroit is also poised to significantly haircut G.O. bondholders.
Last Friday, Detroit filed a proposal to reduce its $18 billion debt load and exit court supervision. The proposal offers municipal pension plans 50 cents on the dollar while G.O. bondholders could receive as little 20 cents on the dollar. This may come as a shock to G.O. holders as many believed that having a general obligation gave creditors more security. As most of our experience has been in the corporate credit markets, we viewed general obligations somewhat differently than municipal bond investors.
In Muni-land, general obligation bonds are usually backed by the full faith and taxing power of the issuing municipality. Many municipal bond investors were of the opinion (an opinion reinforced by municipal bond market salespeople) that a municipality would simply tax its way out of trouble. However, as Detroit is proving, you can’t tax people and businesses which aren’t there. Detroit has experienced a significant decline in both individual and business taxpayers. The city is now faced with trying to get blood from the proverbial stone. Unlike Puerto Rico, Detroit cannot (or cannot easily) claw back revenues to which revenue bonds appear to be legally entitled. If we were to draw a parallel between municipal bonds and corporate bonds, a senior general obligation municipal bond would be most similar to a senior unsecured corporate bond.
Both municipal G.O.s and senior unsecured corporate bonds are backed by the full faith of their issuers. However, both bonds can be less secure than bonds which are backed by specific revenues. In our opinion, a G.O. is simply an unsecured bond (meaning that it is not backed by specific revenues). It is for this reason that we have focused on municipal revenue bonds. The exception is general obligations of U.S. states. U.S. states cannot file for bankruptcy protection and are eligible for Federal assistance.
Will Detroit senior G.O. holders actually receive only 20 cents on the dollar? It is possible. This is not good news for municipal bond insurers as they would have to make up the difference. We believe that the insurance should be there, but we expect continued push-back from the insurers in court. The deal proposed by the City of Detroit is not a fait accompli, but we expect bondholder recovery to be fairly low in the case of uninsured Detroit G.O.s.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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