Is Motown Bringing Down Your Muni Bond Portfolio?

Includes: HYD, MUB
by: Eric Parnell, CFA

Detroit has been buckling under the weight of its deteriorating finances for sometime now. And with places like Harrisburg in Pennsylvania, Stockton and San Bernardino in California and Jefferson County in Alabama having filed for bankruptcy over the last few years, it is reasonable to wonder whether the major city of Detroit may ultimately be next. With the takeover of the city by the state of Michigan now imminent, it is also reasonable to contemplate the direct exposure to Detroit in your municipal bond portfolio and the potential implications of its ongoing problems on your muni investments.

In order to explore the question about direct exposure to Detroit, we will examine the iShares S&P National Municipal Bond Fund (NYSEARCA:MUB), which is by far the largest national municipal bond ETF with $3.6 billion in assets. Overall, this product has a total of 2,332 holdings as of Tuesday. Of these securities, only eight are issuance from the city of Detroit, constituting just 0.35% of the assets in the entire ETF product. It is also worth mentioning that five of these securities are utility bonds, two are school district bonds and one is a tax revenue bond. It is also important to note is that none of these bonds are showing any signs of distress, as one of the utility bonds appears set to mature at par come July 2013 while the other seven bonds with maturities ranging from 2 to 17 years are trading at a near +10% premium to par on average. Thus, the exposure to Detroit in municipal bond portfolios like MUB is likely to be generally low, and any small exposures appear to be holding up fine despite the challenges facing the city as a whole.

It is also worth looking at the high yield municipal bond space in this regard, particularly given the rapid growth of assets directed at this area of the market in recent years as investors reach for yield. To explore this point, we will review the Market Vectors High Yield Municipal Index ETF (NYSEARCA:HYD). This product has 323 holdings, and only 11 are from the entire state of Michigan. And of these 11, only 1 is from Detroit. This is a tax-revenue bond with a CCC rating that makes up only 0.08% of the assets in the ETF. And although its credit quality rating is lower than most of its peers in the ETF that have a credit rating, the bond is pricing at a -10% discount to par, which is competitive with the large majority of bonds in the product. As a result, there is generally little reason for concern directly related to Detroit as it relates to the high yield muni space as well.

With all of this being said, specific allocations across individual investment products or investment managers can vary widely. As a result, it is worthwhile to examine your own municipal bond allocation to determine your specific holdings, as specific holdings and percentage exposures may be widely different from what is presented here.

Looking ahead, the fact that Detroit stands to have an emergency manager appointed has the potential to bring progress in helping the beleaguered city to overcome its financial troubles. In this role, the emergency manager is expected to have the authority and flexibility to enact measures that might otherwise prove elusive in carrying out through the current city government framework. Of course, none of this necessarily means that Detroit will avoid bankruptcy in the end. This will be a point worth watching in the coming months. But it is suggested that the change may provide the city with a better chance at getting on the right financial track.

Instead, the issues that should perhaps garner more attention for your municipal bond portfolios are the following. The first is some of the larger and potentially more problematic exposures. These include California, which has been struggling under the weight of significant fiscal problems and collectively makes up over 22% of the entire MUB allocation and over 9% of the HYD. Illinois, which makes up over 4% of the MUB and roughly 5% of the HYD, is another that warrants attention given its major budget shortfalls and massively underfunded pensions. This does not at all imply that the problems in these states are any immediate cause for concern, particularly since the bonds from these states and others are spread widely across a variety of municipalities and bond sectors. But they are exposures that should be noted to watch for future developments if nothing else.

Perhaps the more pressing issue for the space beyond the challenges facing any particular municipality is the potential for any tax law changes associated with the ongoing budget negotiations in Washington DC. Talk continues to linger about potentially modifying or even eliminating the tax-exempt status for municipal bonds. This is arguably the most important issue for municipal bond investors to monitor in the coming months, for any changes in legislation not only has the potential to have a considerable impact on the asset class in general but also stands to influence the financial planning decisions of many individual investors across the country. I will be monitoring any potential developments on this front as it unfolds in the coming months.

In the meantime, while the financial problems in the Motor City are certainly unfortunate, investment exposures in municipal bond portfolios are not only minimal but appear largely unaffected to this point.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long MUB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.