Is Detroit to Blame for the Muni Market's Woes?

How Motor City’s bankruptcy petition has affected the municipal bond market.

Detroit may have particularly large fiscal problems to face, but it is not alone.
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The Motor City blues have helped push municipal bonds into the red.

For municipal bond investors, many of whom had been concerned for months about interest rates, Detroit's decision to declare bankruptcy provided yet another piece of bad news. After all, little is more disconcerting for investors who own the debt of state and local governments than a major city declaring bankruptcy.

[Read: Can Detroit Come Back Again?]

Muni funds have been experiencing bruising outflows since March, well before Detroit took the plunge, according to data compiled by the Investment Company Institute. In June alone, their asset levels declined by roughly $10 billion. Meanwhile, the average fund in every municipal bond category tracked by Morningstar has lost money so far this year.

Jeff Tjornehoj, Lipper's head of Americas research, says most of the recent outflows stem from the same issue that is also plaguing taxable bond funds: the potential for rising interest rates. "That [has] caused a lot of heartburn in the muni market," says Tjornehoj. That's because when interest rates go up, bond prices fall.

Still, it's undeniable that Detroit's troubles have contributed to the plight of muni investors. James Colby, the senior municipal strategist for Market Vectors ETFs, describes the phenomenon as "headline risk," which is the idea that the attention Detroit's bankruptcy petition has been getting has cast municipal debt in a negative light. That, in turn, can affect how investors behave.

Part of the reason Detroit's situation has not had more of an effect on the muni market is that investors saw it coming far in advance. "For municipal investors, the sad state of Detroit was known for a long time," says Tjornehoj.

[Read: What to Expect from Bond Mutual Funds in 2013.]

Although the shockwaves from Detroit have been relatively contained so far, they may not stay bottled up for long. Kevyn Orr, Detroit's emergency manager, has proposed doing away with the priority that owners of general obligation bonds, a popular form of municipal debt, have long anticipated they would enjoy in cases of bankruptcy. In other words, Orr wants to treat those who own such bonds as unsecured creditors.

"Most unsecured debt in bankruptcy gets a haircut," Orr told Reuters. "That's just what happens." In bankruptcy, a so-called "haircut" happens when creditors get less than what they are owed. The remaining amount is shaved off the top because there is not enough money to go around.

Whether Orr will be successful remains to be seen, but his proposal has captured the attention of municipal bond investors throughout the country. The concern is that if owners of general obligation bonds are not given some type of priority in Detroit's bankruptcy, investors will be less likely to invest in municipal bonds in other parts of the country because they will lose faith in the security of the products.

Colby, for instance, says that if Orr's plan goes through, it could have a "ripple effect" throughout the rest of the municipal bond market. Richard Ciccarone, managing director of the Illinois-based firm McDonnell Investment Management, suggests that Orr's proposal challenges "long-standing expectations about the sanctity, the sacrosanct status" of general obligation bonds, which are backed by strong guarantees from issuers.

Ultimately, though, little is known with any certainty about how Detroit's various creditors will fare. "I think it's going to be a long fight," Tjornehoj says. "There are a lot of politics to be played, and I think it's still far too soon to tell what Detroit's creditors will receive."

[See: 7 Mutual Funds for Gamblers.]

In the meantime, Tjornehoj suggests that muni investors should not be overly concerned with Detroit's woes. "We've had disruptions in the muni market in the past," he says. "The problems out there are generally known well ahead of time, and the market does price those risks [appropriately]."

Tjornehoj also notes that investors can minimize risk by investing in a diversified portfolio of municipal bonds. "Your conservative investor is probably just fine using national [muni funds] with a lot of geographic diversification," he says.