Why Detroit's Bankruptcy Matters to Bonds

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As nearly everyone has heard, the city of Detroit filed for bankruptcy last week, and the bankruptcy and its resolution have the potential to rattle municipal bond markets. The $18 billion filing is the largest municipal bankruptcy in history.

First, here's what won't roil markets. The $18 billion of liabilities is only a tiny fraction of the municipal bond market, and about $9 billion is retiree health and pension benefits, not bonds. Even among high-yield muni bonds, exposure to Detroit is a small. The Market Vectors High-Yield Muni ETF (NYSEMKT: HYD  ) shows one City of Detroit issue in its list of holdings at 0.05% of assets. The SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEMKT: HYMB  ) has a Detroit water and sewer bond in its list of holdings at 0.42%. The two funds dropped 1.4% and 1.2%, respectively, on Friday -- much more than the holdings of Detroit paper. Losses may be serious for pensioners and anyone heavily invested in Detroit debt, but the liabilities alone simply aren't big enough to rattle the markets alone.

Here's what could roil the markets or change municipal finance.

The Detroit filing is classing general-obligation bonds as unsecured debt, putting them lower down the food chain than many had expected. If that holds as a precedent, investors and ratings agencies would re-evaluate risk and loss-given-default models. That would raise costs for municipal borrowers, particularly those with less-than-stellar credit ratings.

Municipal borrowers with underfunded pension plans may experience more scrutiny and doubt about their ability to meet their obligations. That may already be happening: The day before Detroit's filing, Moody's lowered Chicago's credit rating three steps to "Aa3" -- still investment grade, but three notches lower than it was. Pension liabilities were cited for the downgrade.

Public-sector unions may start to demand higher levels of pension-plan funding, thereby putting more strain on government budgets. It doesn't do much good to negotiate great pension benefits if there's no money to pay them.

If for no other reason than the size of the bankruptcy, the settlement will certainly establish a pecking order among creditors. To the extent that any new precedents change current perceptions, they'll change both risk and risk pricing in the markets, for better or worse.

The federal government could get involved in some way.

No one knows how everything will shake out, and maybe nothing will happen to drastically shake up municipal bankruptcy. However, I'd bet this case will set or change some assumptions along the way. I'm sure municipal bond managers will be watching closely.

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