About two years ago, Jefferson County/Alabama filed for bankruptcy; it was at that time the largest such case, with debt of around USD 4 billon. In July, the city of Detroit filed for bankruptcy, and in our view, this will have further negative implications for the municipal bond market. Jefferson County was a relatively small problem. Detroit is a whole different case, since the size of open dept is close to USD 20bln (!!). Detroit was once the fourth largest city in the U.S. with almost two million people living there. Today, only about 700,000 are left. That was in the 50s and 60s when the car industry was booming.
What makes the Detroit bankruptcy special is not the fact that this is a very large bankruptcy, but the fact that the holders of GO Bonds (General Obligation bonds) might lose up to 60 or 80% of their investments. This category has so far been regarded as relatively safe, and many investors are holding such positions with the idea that this is a very low risk investment with good after tax returns. One rule of capital markets is that there is no free lunch, not even in the muni market, and increasing problems in this market could mean that this is really going to shake capital markets, especially in the U.S.
The U.S. muni market is very large, with almost USD 4000bln of debt outstanding, of which so-called GO bonds make up about a quarter. So it is potentially a very large problem that touches a large number of individual investors, and the fever curve is going up. The yield of the GO20 Muni Bond Index has gone up significantly in the past few weeks, touching almost the 5 percent level. Last year at the same time, the yield was about 1.2% lower. Compared to the levels seen at the end of last year, there has even been a jump of 1.6%. With the yield levels that many muni bonds have reached, the illusions that many investors had are gone.
This is a market that is in structural change, and the finances of many cities and communities in the U.S. are deteriorating despite the fact that some are experiencing slightly higher revenues (mainly because of higher taxes). What has brought Detroit down is going to bring down more cities in the coming years. Many of them have accumulated unsustainable amounts of debt. There are a number of reasons causing the financial problems, but many cities have simply overspent in the past. Almost all of them have huge unfunded pension liabilities. For example, in the case of Illinois, the future annual liabilities for pension payments is eventually going to be twice as much as the tax revenues. Chicago is already feeling the heat; just recently the city had to fire more than 2000 teachers because of rapidly rising costs.
The municipal bond market is one of the most decentralized segments of the capital markets and one where risks have not really been priced correctly. Holders of GO bonds, so far considered to be a very safe place, might be at risk. The fact that also holders of such bonds might lose money is something really new, something that might change the landscape of this market. Claims of pensions might have priority over GO bonds, not only in the Detroit case, but maybe for future city bankruptcies as well. That is the reason why investors need to critically review the credit quality of such bonds, specifically looking at problems such as unfunded pension liabilities.
It looks like the next large bankruptcy in this area is just a matter of time. Detroit has been the biggest so far, but more might follow. This will cause investors in such bonds to reconsider the risk of such investments in comparison with other financial investments. The recent increase in risk spreads confirms that this process has already started and will make it harder for certain muni issuers to raise money. A situation that can be compared to Europe, where the different countries also trade at different yield and yield spread levels.