My colleague, Jonathan Chirunga, is a municipal bond credit analyst and portfolio manager at Pioneer who offered these thoughts on Detroit and the impact of its potential bankruptcy on the municipal bond market.
Pundits have been calling for Municipal Armageddon since the Great Financial Crisis (GFC) of 2008. A combination of runaway debt issuance, plummeting tax receipts, massively underfunded pensions, and, in some cases, outright corruption, were all elements of the plotline. In 2010, a now notorious “Chicken Little” alarm sent the Municipal market into a tailspin, auguring default for hundreds of billions in municipal securities as cities and municipalities collapsed in domino-like fashion. Just recently, the municipal market took another hit – this time as a result of a violent back up in treasuries as investors (ironically) now see a greater risk in faster-than-expected economic recovery. But during this period of time the poster child of the Domino crowd—Detroit sought bankruptcy protection. Thus, the question remains: is this the beginning of a larger default wave? In which case, could municipal securities get slammed from both a simultaneous rise in interest rate risk and credit risk?
Detroit’s Situation no Surprise
While the recent bankruptcy of the City of Detroit was not a surprise to the bond market (bonds were rated Caa by Moody’s and CC by Standard & Poor’s, signifying tremendous credit stress), concerns over who might be next have surfaced. A careful analysis suggests that Detroit is, indeed, a special case. Detroit’s sickly credit profile stems from a decades-long decline of the city’s population from over 1.8 million residents in the 1950s to 714,000 residents in 2012. In the past five years, Detroit’s tax base has deteriorated sharply, dropping from a high of $14.1 billion in 2009 to $9.4 billion in 2013, a 33.0% decline. The end result: extraordinarily high debt levels and an 18%+ unemployment rate, greater than two times the national average. In the chart below, we compare Detroit to other large U.S. cities on the basis of a couple of typical debt measurements:
Finances of Other American Cities
Thus, we find it unreasonable to closely compare Detroit to other large cities.
Other City Managers Will Watch Detroit’s Example on Pension Obligations
The more nuanced concern over Detroit’s situation is that a key reason to file was to renegotiate the city’s pension obligations. Unfunded pension liabilities are estimated to be at least $5.7 billion, or 50% of unsecured liabilities. A Chapter 9 proceeding is being viewed by City managers as a way to reduce or even eliminate this “unfunded” liability that would continue to strain city finances. The risk is that (if successful) the elimination or offloading of pension obligations could provide an attractive option for other strapped obligors. While that’s a possibility, we have a different take.
The silver lining of the Detroit situation may be that it will cast more light on the need for employee funds and municipalities to negotiate what are, in many cases, untenable benefit programs. It is very likely that municipalities will transition to deferred contribution pension programs (such as 401K plans). Thus, a successful abrogation of unfunded liabilities could break the deadlock that so many cities, municipalities and States find themselves facing in with their current and future retirees.
While there are clearly risks in the Municipal bond market, we don’t think a cascade of defaults occurring is something investors should lose sleep over.