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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