By Joseph Rosenblum and Neene Jenkins
It could be several weeks or a few months. But before long, the city of Detroit is likely to default on some of its outstanding bonds and possibly file for Chapter 9 bankruptcy protection. It would be a historic bankruptcy and is sure to create uncertainty in the municipal bond market. Some types of debt will fare better than others in the final restructuring.
Detroit’s emergency manager, Kevyn Orr, reports the city has at least $15 billion in long-term liabilities and unmanageable cash-flow shortages. The real shock is that it took so long to get to this point. Detroit has been in a steep decline for decades, with its population (and tax base) dwindling from 1.8 million in 1950 to just over 700,000 today. The percentage of families living below the poverty level is roughly three times higher than it is in the rest of the country.
The Headlines Will Be Alarming
Under state law, an emergency manager can seek bankruptcy protection with the governor’s approval. If Orr takes that path, we’ll likely see volatility in the price of Detroit bonds, temporary and/or permanent bond payment disruptions, and a huge media focus on the city and its problems. This focus will likely expand beyond Detroit to include other cities with fiscal issues. Some analysts will predict an onslaught of municipal defaults.
But while many other local governments face financial challenges, Detroit’s were 40 years in the making and in our opinion do not signal an uptick in overall municipal bond defaults.
The Pain Will Be Uneven
Detroit has $8 billion in bonds outstanding. Fortunately, $5.4 billion are revenue bonds that should be insulated from a reorganization of Detroit’s debt. These revenue bonds were issued by the water and sewage systems and are secured by their revenues; payments don’t come from the city’s general operating revenue. Even if Detroit files for Chapter 9, we believe these bondholders should continue to be paid.
Most of the remaining categories of debt listed below will likely have wildly different recovery rates:
- General obligation bonds backed by an unlimited tax pledge ($369 million)
- General obligation bonds additionally backed by state aid ($479 million)
- General obligation bonds backed by a limited tax pledge ($161 million)
- Pension obligation certificates backed primarily by general fund payments ($1.5 billion)
General obligation bonds backed by an unlimited tax pledge are generally considered very safe municipal debt. In Detroit’s case, the revenues that service these bonds were approved by voters and are paid from a dedicated property tax levy. We believe the recovery rate will be high, but it may not be 100%.
The state-aid bonds are backed by separate revenues collected by the state and remitted directly to the trustee and are also likely to have a high recovery rate. The other two categories are essentially unsecured debt, and these bondholders may not receive close to their full interest payments and principal.
Bond Investors’ Recovery Rests on Fate of Bond Insurers
Although all creditors may share in the pain to varying degrees, the size of the loss to bond investors will also depend on the loss that bond insurers can absorb—because these bonds are in fact backed by municipal bond insurance. We believe that at least some of the bond insurers have sufficient reserves to meet the annual debt service on bonds pulled into a restructuring and are likely to do so.
At the end of the day, the debt that Detroit restructures will be smaller than the headlines suggest because the majority of the debt is water and sewer system revenue bonds. Ultimately, the magnitude of loss from the debt directly supported by city tax collections will depend on the ability of municipal bond insurers to meet their claims. Whatever the ultimate recovery, expect a volatile ride, accompanied by shouting from all sides.
Joseph Rosenblum is Director of Municipal Credit Research and Neene Jenkins is a Municipal Credit Research Analyst, both at AllianceBernstein.
Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.