Morningstar Advisor - August/September 2013 - (Page 40)
Spotlight
Motor City Meltdown
By Jeffrey Westergaard and Elizabeth Foos
The municipal-bond industry’s reputation as a safe haven could
get a drastic makeover now that Detroit has filed for bankruptcy
protection. Here’s what investors need to know.
Detroit, once a gleaming example of U.S.
manufacturing muscle for most of the
last century, is in the midst of a spectacular fall
from grace. The cradle of the country’s
automobile industry filed July 18 for protection
under Chapter 9 of the U.S. Bankruptcy Code.
The decision to file makes Detroit the
largest city to file for bankruptcy in U.S. history.
Earlier, in what he claimed was an effort
to avoid such a filing, Detroit’s state-appointed
emergency manager, Kevyn Orr, unveiled
a massive and controversial proposal
to substantively restructure the entirety of the
city’s $19 billion liability profile, offering
pennies on the dollar to many of the city’s
major creditors.
Detroit has suffered for decades from a
deteriorating economy characterized by rapid
population loss, high unemployment rates, and
an eroding tax base. Resulting revenue
losses coupled with significant mismanagement led to poor delivery of basic city services,
huge budget deficits, and a liquidity crisis,
which officials say has now rendered the city
insolvent. Absent structural changes, city
and state officials estimate that Detroit’s
accumulated unrestricted general fund deficit
could grow to more than four times its current
level of $326.6 million (negative 26.5% of
general fund spending) to $1.4 billion by fiscal
2017. The city currently isn’t paying its
obligations as they become due; it deferred
40 Morningstar Advisor August/September 2013
more than $100 million of pension contributions,
and it missed a $39.7 million scheduled
payment on its pension-related certificates
of participation on June 14.
The city’s demise and Orr’s plan to fix it have
sent shock waves through the municipal
market. The plan treats much of the city’s
general obligation unlimited tax debt, often
considered one of the most secure pledges of
repayment, on par with pension obligation
certificates, unfunded pension liabilities, and
accrued retiree health-care benefits. This
treatment is in sharp contrast to the traditional
risk assumptions associated with certain
legal security pledges, and if upheld, it could
have major repercussions for municipalities
and bondholders alike. The market will
be watching closely, as the results of these
bankruptcy proceedings could have farreaching implications for bondholders, issuers,
and municipal retirees. This case could
set a precedent for the treatment of certain
general obligation debt, the consequences
of which would reverberate throughout the
municipal market.
Calm Before the Storm
It’s worth exploring just how the municipalbond market got to this point. Events such as
the one playing out in Detroit are a rarity
in an industry where one of the truly remarkable attributes is the low number of bond
defaults. While there have been notable
exceptions, such as the Washington
Public Power Supply in the 1980s, muni bonds
have proven to be a very successful investment
vehicle. In turn, investors have taken as an
article of faith that the muni market represents
inherent safety. A further extension of this
has been the abiding belief in the supremacy of
the full faith of governmental issuers.
Before the 2007–2008 downturn, that
feeling of safety was pervasive. At that time,
more than half of the muni bonds issued
annually were coming to market with an
insurance-policy wrapper. While it’s reasonable
to question the need of a backup guaranty
on an asset class that historically did not have
a need for insurance, there was clearly
market demand for it. Having protection from
credit risk made the investment process simpler
and safer in the minds of individual investors.
The housing boom also boosted the economic
strength of muni issuers. The primary revenue
sources for state and local governments—
property, sales, and income taxes—were
booming. Interest rates were low, at least
relative to the previous 25 years. Returns on
pension investments were high. Things
looked like they were almost too good to be
true, yet many politicians and government
officials assumed that the good times would
continue, and they planned accordingly,
Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2013
Morningstar Advisor - August/September 2013
Contents
Contributors
Letter From the Editor
Under Pressure
Has Your View of Bonds Recently Changed?
The Simple Life Cuts a Path to Prosperity
How Extended Is Your Bond Fund?
A Bond Contrarian Scours the Globe for Value
Investments á la Carte
Investment Briefs
Bond Market Behemoths
Shopping in the Digital Age
Shopping in the Digital Age
Diverse Crowd
Motor City Meltdown
Bond Convergence
Corporates Are Fairly Valued, but Opportunities Will Arise
A Legend Still Pines for the Good Fight
Greener Pastures
Forecasting Market Bubbles and Crashes
Forecasting Market Bubbles and Crashes
Home-Court Advantage
Overcoming Technophobia
These Funds Are Counting on Undervalued Sectors
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
What Price Advice?
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