Power in researchThe bankruptcy filing by the City of Detroit underscores the value of fundamental credit analysis.
July 25, 2013
On Thursday, July 18, the City of Detroit, Michigan filed a voluntary petition for relief under Chapter 9 of the U.S. Bankruptcy Code. The filing is the largest Chapter 9 bankruptcy case of a local government in United States history, with Detroit having estimated obligations (secured and unsecured) totalling nearly $19 billion.
In the comments that follow, I’ll discuss the background and specifics of Detroit’s bankruptcy filing and provide a broad outlook on the municipal credit landscape, as well as some notes about our philosophy and approach toward municipal credit research in general.
Notably, Delaware Investments municipal fixed income portfolios have not had any exposure to Detroit, nor to other notable municipalities that filed bankruptcy claims in recent months, including Jefferson County, Alabama and the cities of Vallejo, Stockton, and San Bernardino in California.
In our national portfolios, we are underweight compared to our benchmark indices in local general obligation bonds, due to the exact type of pressures a city with limited resources may face.
Detroit’s long, well-publicized financial difficulties
Over the past five decades, Detroit has experienced: significant declines in population; high levels of unemployment; erosion of its tax base; declines in personal income; cutbacks in state aid, and continued budget deficits. Combined, these conditions have led to significant fiscal stress and reliance on outside credit support for continued access to the capital markets. The decision to seek bankruptcy protection was anticipated as inevitable by many municipal market participants. Detroit’s lack of market access and declining cash position were contributing factors in its decision to seek bankruptcy protection at this time.
On July 14, the City’s Emergency Manager released a Proposal for Creditors, and conducted several meetings with bondholders and representatives of the City’s other creditors, including the City’s major pension plans, and city unions concerning healthcare benefits for existing workers and retirees. The 128-page report presented a detailed discussion of the severe fiscal situation that Detroit faces and provided documentation to support a case for insolvency by the City. The City’s economic and demographic trends have deteriorated since the 1970s, but accelerated during the severe economic recession. Since 1950, the City’s population had declined 63% from 1.85 million to 685,000 in 2012.
The unemployment rate remains very high, at 18.3% in June 2012. Property tax revenues have dropped 20% over the past five years, driven by a $1.6 billion decline in assessed valuation and low property tax collection rates of only 68%. State revenue sharing has declined by 48% over the past ten years due to the declining population base and reductions in statutory revenue sharing by the State. At the end of fiscal year 2012, the City’s accumulated General Fund deficit was $326 million, which would have been much higher except for recent bond issues that funded the City’s operating deficits over the last several years. The report details years of inadequate investment in infrastructure and public facilities and equipment.
Municipal credit research requires independent proprietary analysis that does not solely rely on the credit rating agencies. It requires the review of financial and operating data, legal covenants, management, capital structure and covenant analysis.
The Proposal calls for a radical restructuring of the City’s debt obligations, pension obligations, and post-retirement health care obligations (OPEB liabilities), with significant principal haircuts for unsecured creditors and an unspecified plan to negotiate for concessions with secured creditors, such as the City’s water and sewer bonds and swap counterparties. The Proposal divides the City’s obligations into “unsecured” obligations and “secured” obligations secured by special revenues. The unsecured obligations, which total $11.55 billion, include general obligation bonds and notes ($650 million), certificates of participation ($1.4 billion), unfunded pension liabilities ($3.5 billion) unfunded OPEB liabilities ($5.7 billion) and other liabilities of $300 million. The estimate of unfunded pension liabilities is well above the reported actuarial pension liabilities of $646 million. Secured obligations (secured by special revenues) total $7.44 billion and include water and sewer revenue bonds ($6 billion) secured GO bonds backed by state aid payments ($450 million), swap payments backed by gambling taxes ($890 million), and other secured obligations of $100 million.
Unconventional equal treatment of unlimited GO bonds with limited-tax and other general fund obligations
Defying long-standing market convention on security pledges, the Emergency Manager’s Proposal elects to make no distinction between general obligation bonds backed by an unlimited tax (ULT) pledge, bonds backed by a limited general obligation pledge, and unsecured general fund obligations. The Proposal places all ULT GO bonds (other than the GO bonds backed by a state aid pledge) on parity with all general fund obligations, including public pension liabilities and post-employment health care benefits. Under the Proposal, about $11.5 billion in unsecured obligations (GO debt, pensions, and OPEB liabilities) are proposed to be exchanged for a $2 billion contingent note, which would have a limited claim on City revenues over a 20-year period at a 1.5% coupon rate.
Based on a discount rate of 7%, the recovery value to unsecured creditors would be worth 11% of claims, not the estimated 17%. This recovery rate is far below the estimated average recovery rate for municipal bonds of 62% (cited in a Moody’s municipal default study covering the period of 1970-2012). In light of the significant haircuts, the Emergency Manager was not successful in garnering concessions from the various unsecured creditors in the weeks following the release of the Proposal. The Emergency Manager’s decision to treat all voter approved unlimited tax general obligation that has a specific tax pledge on the same level as unsecured general fund obligations is likely to be highly contested in court, as will be the significant increase in valuation of the unfunded pension liabilities.
The restructuring proposal also discussed the need to restructure the City’s water and sewer bonds under a new regional authority, when in accordance with past practices in prior Chapter 9 cases, such revenue bonds should be treated as special revenue bonds not subject to the automatic stay on payments under federal bankruptcy. The Emergency Manager’s plan for an exchange of this secured debt would weaken the security treatment of water and sewer bonds that are not currently callable. This proposal is likely to be strongly opposed by the bond insurers that insure most of the City’s water and sewer bonds.
The road ahead for municipal markets
We do not believe that Detroit’s decision to seek federal bankruptcy protection will have a systemic effect on the municipal bond market at this time. We believe that the city’s long-standing and unique structural fiscal stresses make it an outlier that should not trigger a systemic market reaction. However, we know that we will have to monitor distressed communities that might consider using the bankruptcy option to sharply compromise and reduce their pension and healthcare retirement obligations, and materially alter debt-security provisions.
Detroit’s filing could lead to wider credit spreads for distressed local governments that exhibit similar patterns of population loss, property valuation declines, limited financial flexibility, and high legacy costs for pensions and OPEB liabilities. Bond investors can be expected to focus on the risk of elevated contingent government liabilities as a trigger point for fiscal distress.
When interest rates are declining, many investors tend to favor the higher yields available on mutual funds over the yields on individual bonds. Conversely, when yields are rising, the reverse tends to be true. As we discussed in our second quarter municipal market commentary in early July, the tax-exempt market experienced a harsh response by retail investors in the form of outflows from mutual funds, due to the interest rate sell-off caused by market expectations for tighter monetary policy.
Before Detroit filed for bankruptcy, it was this phenomenon that caused weakness in the municipal market even as the U.S. Treasury and other fixed income markets rebounded. The negative news generated by the Detroit filing may once again exacerbate these outflows.
We would argue that the exact opposite should occur. It is situations like Detroit that demonstrate the value of fundamental credit analysis and a well-diversified portfolio. At Delaware Investments, we employ a bottom-up (bond-by-bond) security selection process that relies on fundamental credit research. We have a dedicated municipal bond research team with six analysts that average 21 years’ experience within the municipal markets.
Municipal credit research requires independent proprietary analysis that does not solely rely on the credit rating agencies. It requires the review of financial and operating data, legal covenants, management, capital structure and covenant analysis. Securities should be reviewed before initial purchase and an active credit surveillance schedule should be maintained going forward. After all, an investor who correctly predicts interest rate movements over many years can see gains reduced severely by a single credit default.
Step back for the big picture
It is important to keep in mind that, aside from Detroit’s very-public bankruptcy, municipal bankruptcies have been relatively rare events in the $3.7 trillion municipal bond market, and we expect they’ll remain so.
- Since 1937, just 650 municipalities have filed for bankruptcy since the adoption of the Chapter 9 statute, and just 332 cases filed since 1954.
- There have been five Chapter 9 filings so far in 2013, including Detroit, with 12 cases filed in 2012, and 13 cases in 2011. By comparison there has been an average of 12,190 corporate bankruptcy filings per year under Chapter 11 over the past five years.
- Most Chapter 9 cases have been small municipalities, special tax districts, or utilities. Only a few of the filings have been major municipalities, such as Orange County, CA in 1994, Vallejo, CA in 2008, Jefferson County in 2011, and Stockton, and San Bernardino County in 2012, and now Detroit.
- Most municipal bankruptcies are long and difficult, with the expense of litigation often serving as a severe deterrent, causing municipal borrowers to consider other alternatives, such as a negotiated restructuring of debt and labor contract terms.
Emergency Manager for the City of Detroit, http://www.detroitmi.gov/EmergencyManager.aspx
Janney Capital Markets. Municipal Bond Market Note. Janney Fixed Income Strategy. July 19, 2013. Author: Tom Kozlik.
Moody's Investors Service, Special Comment: U.S. Municipal Bond Defaults and Recoveries, 1970 – 2012. Report Number 151936. May 7, 2013. New York, NY. Authors: Merxe Tudela, Alfred Medioli, Anne Van Praagh, Katherine Shinkareva.
U.S. Federal Bankruptcy Court, http://www.uscourts.gov/Statistics/BankruptcyStatistics/12-month-period-ending-december.aspx
U.S. House of Representatives, House Judiciary Committee's Subcommittee on Courts, Commercial and Administrative Law, Hearing on the Role of Public Employee Pensions in Contributing to State's Insolvency and the Possibility of a State Bankruptcy Chapter, February 2011, Testimony of James E. Spiotto, Partner, Chapman and Cutler, LLP.
Reuters, Factbox: Recent U.S. Municipal Bankruptcies, July 18, 2013,
The views expressed represent the Manager's assessment of the market environment as of July 24, 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Diversification may not protect against market risk.