Municipal Market Update from RNC Genter

7.2.13_RNC_Muni_UpdateCity of Detroit Halts Payments on Outstanding Debt

The city of Detroit has been in a deteriorating situation for decades and unfortunately only received a limited benefit from the resurgence of the auto industry since the financial crisis. Although the initial home of the auto industry, it experienced its heyday back in the 1960’s.

Therefore, this course of action, which may or may not eventually lead to filing for protection under Chapter 9 of the bankruptcy act, has been expected by many market participants for well over two years. As a result, we have avoided the city’s outstanding bond issues. We do own a $1.14 million block of pre-refunded bonds that are defeased and secured by U.S. Treasury Securities (SLGS) that are held in escrow. Those bonds will mature on July 1, 2013 and are not affected by the action of the city.

The problem that bears close scrutiny with this situation concerns its present negotiations with bondholders, wherein they have proposed placing $369 million of full faith & credit “general obligation” bondholders on equal setting with $161 million of “limited general obligations”, $1.4 billion in “pension obligation bonds,” and the unfunded pension liability of $3.5 billion and OPEB (other post-employment benefits).

7.2.13_RNC_Muni_Update_2Depending upon the ultimate outcome from the negotiations, it is possible that concerns will be raised that not all GO bonds are created equal. So, just like the approach that Stockton, CA applied to their weak-linked lease type COP’s (certificates of participation) debt, this action is unprecedented. Essentially, Detroit is attempting to dissolve its capital structure.

It is too soon to determine an outcome from the action. However, we are hopeful that logical reasoning prevails. If not, this could potentially have a negative impact on the municipal bond market. Presently high-grade muni yields are ranging from 106% to 127% of taxable US Treasury benchmark securities.

In our view, there is a 50-50 chance that Detroit may use the bankruptcy option. However, we do not think that is the best plan of action. Based on other muni entities that have tried that approach, the only thing that is certain is that legal costs will escalate and must be paid. Vallejo, CA, the poster child for Chapter 9 Bankruptcy, certainly regrets their decision to go that route, while bemoaning the $12 million in legal costs that have accrued so far.

Overall, the situation reaffirms that some municipal entities continue to be under stress and that clients should be very cautious in stretching for yield. We will continue to be diligent and maintain our focus to add value through utilizing stronger credits with broad taxing and revenue sources. Please do not hesitate to contact us should you have any specific questions about this issue or other general questions about the municipal bond market.

The content above was provided with the consent of RNC Genter Capital Management. Information contained herein has been derived from sources that we believe to be reliable but has not been independently verified by us. This report does not purport to be a complete statement of all data relevant to any security mentioned, and additional information is available on request. The information contained herein shall not constitute an offer to sell or the solicitation of an offer to purchase any security.

Municipal Market Update by Dan Genter, RNC Genter Capital Management

The city of Stockton, CA has decided that it will file for bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code. This announcement is likely to be a national news item that may catch the eye of many investors.

This call to bankruptcy was anticipated considering that Stockton had already defaulted on its debt and, for the last 90 days, had been in a mandatory mediation period in an attempt to negotiate concessions in labor costs and benefits, which are currently almost 70% of the city’s general fund. We do not believe this headline will be considered unexpected or that it will have a negative impact on the municipal bond market.

We also do not consider that this is the start of an epidemic among municipal entities to use default or bankruptcy strategies. Though there may be more smaller entities that will use this option going forward, we view this as more of a politically expedient approach versus a viable solution, which will generally be adopted by municipalities under financial stress.

Frankly, it is hard to understand after the Vallejo, CA experience that a municipal entity nearby would even consider the bankruptcy route. Vallejo spent many months initially having the bankruptcy proceeding approved (it is not as automatic as with corporations), spent three years in bankruptcy proceedings, spent $10 million in legal fees, and almost a year, after emerging from bankruptcy, is still struggling to meet the mandates that were dictated by the bankruptcy court. Considering that their tainted reputation has now effectively barred them from the capital markets, and that the ultimate concessions that they received in bankruptcy mirrored what likely would have been accomplished through diligent negotiations, they clearly have not established an attractive road map for others to follow.

It does reaffirm, however, that smaller municipal entities continue to be under stress and that clients should be very cautious in stretching for yield.