How To Protect Your Muni Bonds During Detroit's Bankruptcy

| About: iShares National (MUB)

Detroit's bankruptcy filing has created confusion in several securities markets. It's time for investors to gain a broad understanding of what exactly is going on in Detroit, what the alternatives are, how various investments are being affected, and how best to protect your municipal bond portfolio. This is also one aspect of investing in which politics is also exerting extreme and undue influence, so it is critical to understand that angle in order to make informed investment decisions.

The Financial Status

The city has some $17 billion in liabilities. These include $1.1 billion in General Fund debt; $6 billion in enterprise fund debt; $1.8 billion in Pension Obligation Certificates (POCs); and other post-employment benefits (OPEBs) of $5.7 billion; and the city's pensions are about $600 million underfunded. The city routinely spends some $100 million more than it generates annually in revenue. The deficit is about $386 million, with expected negative cash flow of about $90 million. In late April, the city had $64 million of cash on hand and $226 million in current obligations.

An Unnecessary, Forced Bankruptcy

The reason the municipal bond market was thrown into a tizzy is because of a terrible choice by Gov. Rick Snyder to force the city into bankruptcy, without considering the many alternatives that could address the city's near-term cash flow issues. He did this in order to avoid having the state shoulder any cost burden to bail out Detroit, which would alienate his suburban voting base. But in doing so, he doesn't account for the fact that those same suburban residents travel to Detroit to take advantage of it, while never having to contribute to keep the city alive.

The better choice would be to ask these folks to help out: "You use Detroit. Pay for what you use, and help save it, or there won't be a Detroit." This approach would be palatable, it would fit in with the concept of shared sacrifice, and it would cost comparatively little. These citizens have already indicated a willingness to do exactly this. In 2012, citizens of three Michigan counties that surround Detroit voted to increase their own real estate taxes in order to guarantee the Detroit Institute of Arts $23 million annual operating budget.

Instead, his one-dimensional thinking puts investors, bondholders, and pension guarantors at significant risk, and the muni bond market has reacted negatively.

Solutions to Try Before Bankruptcy

None of this should even be an issue. Snyder and the city could at least address some of its fiscal problems, before even considering bankruptcy. Again, this is critical for muni bondholders, because if enough revenue can be generated to offset near-term deficits, then the muni markets will be given reason to stabilize.

The city's art collection is probably the cornerstone to this effort. Most people would never suspect that Detroit has a world-class storehouse of art. The museum itself was founded in 1885, is the second largest municipally-owned museum in the country, owns some 65,000 works, and is considered to have one of the top six collections in the U.S.. Fittingly for an American city, it houses masterpieces created by American artists, across all the artistic disciplines. The first Van Gogh to exhibit in any U.S. museum is here. Rivera's famous Detroit Industry fresco resides here. Even amateur art enthusiasts will recognize Rembrandt's "The Visitation," and Matisse's "The Window."

Detroit has retained Christie's to evaluate the collection's auction value, which most estimates put $1.1 billion. The obvious solution would be to sell the collection. It would be enough to handle both the deficit and unfunded pension obligations. In fact, it doesn't even need to be sold. There are plenty of financial institutions that will lend against the collection itself. Even a loan at 60% LTV would generate some $650 million, which is more than enough to solve the near-term issues.

The city owns multiple parking garages and parking meters. Leave it to Detroit to lose money operating the most hated revenue generation method to Americans - parking fees and tickets. Sell the land. Sell the garages. Sell the meters. Speaking of transportation, Ontario's mayor says he'd buy the tunnel that connects the two cities, so Detroit should sell that immediately.

Creative methods of reducing capital expenditures should at least be explored. The city's Emergency Manager estimated some $160 million was necessary for Detroit's utility company to improve lighting. How about exploring the possibility of reducing that expense by outsourcing these improvements to a private contractor, partially in exchange for cash and for a partial equity stake in the utility? The Emergency Manager said in his report that the city should exit the power supply business. So why not just sell it off?

The city owns a whopping 60,000 vacant parcels and some 78,000 vacant structures. Private enterprise could purchase this distressed real estate and renovate it, and depending on the relative proximity of the property, create a revitalization zone. Federal tax incentives are available for just such a purpose. For areas where such a concept doesn't work, and the city wishes to forestall blight, then make the same cash-equity deal with private contractors to clean up those areas. Give those contractors a piece of ownership in the land they clean up.

Look at city services. Residential garbage is collected once a week. What if instead it were collected every 8 or 9 days? By pushing out collection even one day, it results in a 17% annual savings. The city is moving ahead with a bond issue to spend $440 million on a new arena. This makes no sense. It is already spending more than it takes in. This plan should be cancelled.

These are just a few ideas. However, they could have a short-term and lasting impact on municipal bonds, muni bond ETFs, and bond insurers for some time to come.

What's At Stake for Investors

Municipal bonds are a cornerstone of many retirement and high net-worth investment portfolios because of their tax-free status. If an investor is in the highest federal tax bracket, a 3% muni bond is paying the equivalent of about 5%. However, the risk associated with municipal bonds has historically been considered much less than equities paying the same rate, since municipal bonds are often secured by any number of revenue sources. What happens to Detroit will be critical for the muni bond market, because it may signal what muni holders can expect from other cities that may suffer the same fate.

Then there are bond insurers. Investors should keep a very careful eye on them. During the financial crisis, it was discovered that many bond insurers didn't have nearly the liquidity or assets necessary to cover even tiny defaults on bonds collateralized by mortgages. Nobody wants to see the same thing happen here.

What's Actionable?

Let's look at the status of investments that are directly or indirectly related to what's going on in Detroit, so investors can determine what, if any, moves they may wish to make.

Municipal Bond ETFs are the first place to look. The broadest securities include iShares S&P National AMT-Free Muni (NYSEARCA:MUB). It closed at $104.46 on July 19, the day the city declared it was filing for bankruptcy. Since then, it has fallen to $101.36 as of this writing and is off almost 13% since peaking in late November. That has to be of concern for a security only paying 2.93% in yield, tax-free or otherwise.

SPDR Nuveen Barclays Capital Muni Bond (NYSEARCA:TFI). It peaked at $25 last November, and has fallen to $22.05. Since July 19, it has fallen from its price of $22.54, a bit less on a percentage basis than MUB. This is a bit odd, considering it holds some 500 securities in its fund vs. 2000 for MUB. You don't get much additional in the way of yield for this concentration, as the yield is 2.83%.

Market Vectors Long Municipal Index (NYSEARCA:MLN) peaked at $20.91 last November, as well. On July 19, it was at $17.75 and now rests at $17, a decline of 4.5%. The yield here is 4.36%, as it focuses more on the long-term end of the bond spectrum, and is also ATM-free. There's obviously more risk associated with the longer-term position, but the firm is well-diversified.

Due to the broadly diversified nature of these two ETFs, I would suggest that investors hedge their position a bit, either by selling out 15-20% of their position or shorting the same percentage against the box. Once the situation resolves, the hedge can be removed.

Market Vectors High-Yield Muni ETF (NYSEARCA:HYD) may present an interesting opportunity. This high-yielding security (5.48%) is off its July 19 price of $29.60, and now sits at $27.63 - an almost 7% drop for an ETF that only holds 0.1% of its portfolio in Detroit bonds. It's also some 16% off its high of last year. I think the perceived risk with this ETF is greater than actual risk, in that it holds 300 securities, an enormous number of which would have to go bad to justify the price hit it's taken. I think it's a buy.

If you want to stick with other less risky securities, consider SPDR Nuveen Barclays Capital S/T Muni Bond (NYSEARCA:SHM). The risk is less here because of the short-term nature of the bonds it holds. Of course, you only pick up a 1.09% yield as a result. The fund is down less than 1% since July.

As for bond insurers, there are basically six big names in the space. The big issue surrounding these companies is whether those bond insurers will be on the hook for Detroit. If it turns out that way, you can expect a downdraft in these stocks, as their risk will have suddenly increased across the board. Who knows what city or state will be next? That's why I would take money off the table on these companies for the time being. They include Assured Guaranty Ltd. (NYSE:AGO).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.