How Detroit's Bankruptcy Affects Bond ETFs

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 |  Includes: MUB, MUNI, PVI, PZA, SUB
by: Matt Tucker, CFA

Following Detroit's record-breaking municipal bankruptcy filing, we've been fielding a lot of questions from investors. For the broader municipal bond market, we do not anticipate a widespread systemic effect and investors should expect little market impact as Motown's problems have long been known to bond traders. But what does this event mean for holders of muni bond ETFs?

In terms of exposure, none of our iShares ETFs hold Detroit general obligation bonds. While the iShares National AMT-Free Muni Bond ETF (NYSEARCA:MUB) does hold some Detroit-related paper, these bonds are not included in the bankruptcy and are currently highly rated by the credit agencies. Furthermore, these bonds only make up 0.12% of the ETF's $3.3 billion in assets. At the same time, this event does raise questions about how a fixed-income ETF could be impacted if one of its holdings defaulted or filed for bankruptcy. We have had more questions of this sort around our muni funds recently as there have been several bankruptcies since 2011, with Detroit following Stockton and Vallejo, two cities in northern California.

The first thing to know is that our muni bond ETFs track muni indices that use a fairly conservative approach when it comes to determining eligibility. The indices include only investment-grade bonds, and all it takes is one of the agencies (S&P, Moody's or Fitch) to downgrade an issuer to below investment-grade (lower than BBB-/Baa3) and the issuer's bonds will be removed from the index at the next monthly rebalance.

In the case of Detroit's general obligation bonds, they were removed from the index that MUB tracks all the way back in 2009. Most bond indexes are rebalanced on a monthly basis as are most bond ETFs. This means that within a month of the downgrades, these Detroit bonds would have been removed from the index; our MUB fund exited its positions around the same time as the index.

There is still much uncertainty at this point around Detroit. The city, which listed its liabilities at $18 billion, must prove its insolvency to a federal judge to qualify for Chapter 9 protection. It is expected to be a long and protracted battle. The bottom line for ETF investors is that investment-grade muni bonds rarely "jump to default" (i.e., default while they still carry investment-grade ratings).

If you hold an investment-grade muni ETF your risks are much lower than if you own, say, a high-yield ETF that holds below-investment-grade bonds that are more prone to default. Finally, ETF investors with questions about holdings can always take advantage of the transparency of ETFs; all fund holdings are published on a daily basis.

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