Detroit Files for Bankruptcy

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

On July 18, the City of Detroit filed for bankruptcy, becoming the largest American city to seek bankruptcy in court.  This course of action was anticipated by many market participants as Detroit’s fiscal situation has been deteriorating for some time. The city has accumulated more than $18 billion in debt, including $12 billion in unsecured obligations to lenders and retirees, over $6 billion in bonds secured by revenues, and has run operating deficits for a number of years. Detroit has suffered from a confluence of demographic and economic factors, including a significant loss of population and declining tax revenues, as described in the bankruptcy court declaration filed by Kevyn Orr, Detroit’s emergency financial manager (via Zero Hedge).

7.19.13_Magnotta_DetroitThis situation will be contentious as there are a number of parties involved, including bondholders, retirees, and other creditors that will seek recovery through the bankruptcy process.  Revenue bonds, which represent $6 billion of Detroit’s outstanding debt, have historically had high recovery values in bankruptcies.  The case will be watched very closely as the outcome could determine whether this type of restructuring becomes a model for other municipalities under significant fiscal pressure.

We do not view the actions of Detroit to signify broader credit weakness for U.S. municipalities.  Overall, municipal credit has been improving as revenues have rebounded.  The recent sell off in municipal bonds can be more attributed to the concern surrounding the Fed’s tapering of asset purchases and some technical pressures, not to underlying fundamentals.

At Brinker Capital, we favor active municipal bond strategies that draw on the resources of strong credit research teams and emphasize high quality issues and structures.  We have not felt it prudent to reach for yield in the current environment and will maintain our high quality bias.  With yields moving slightly higher, some value can be found in municipal bonds at the long end of the curve with yields at close to 5%.  Our municipal bond separate account strategies have no exposure to Detroit paper.  The mutual funds used within our discretionary products have very limited exposure to Detroit, the vast majority in bonds backed by revenues of the Detroit Water and Sewer Department.

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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.

The Name is Bond, Muncipal Bond

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

As interest rates have moved higher over the last six weeks, municipal bonds have sold off along with other fixed income sectors, but to a slightly greater degree. From May 1 through June 17, the Barclays Municipal Bond Index declined -2.25%, compared to -1.98% for the Barclays Aggregate Index and -1.72% for the Barclays Treasury Index. While municipals are still in negative territory year to date, they are slightly ahead of taxable bonds.

6.19.13_Magnotta_InterestRatesBoth the technicals and the fundamentals in the municipal bond market remain on solid footing. From a technical perspective, supply and demand dynamics are favorable. New issuance isn’t keeping up with maturing debt, resulting in a reduction in total outstanding supply. With 10-year municipal bonds now yielding 2.4% and 30-year maturities yielding above 4%, we will likely see buyers step back into the market. The muni/Treasury ratio is north of 100%. In addition, June and July are typically large months for reinvestments, potentially creating more demand for municipals.

On the fundamental side, state and local government finances have improved. State revenues are back to pre-2008 levels across the board and are expected to increase. Local governments, which source their revenues primarily from property tax receipts, have received a boost from stabilizing home prices. Most states have taken steps to address their longer-term entitlement program and pension issues in some form. While credit is improving generally, there are still areas of concern. Headlines surrounding Detroit, MI, Stockton, CA and Puerto Rico could negatively impact the municipal bond market, but we do not see a concern regarding widespread municipal defaults.

The backup in interest rates has resulted in significant outflows from both taxable and municipal bond mutual funds over the last two weeks. ICI reports that municipal bond funds experienced $2.2 billion in outflows the week ending June 5 and $3.2 billion in outflows the week ending June 12. The recent sell-off could provide an opportunity for municipal bond investors, especially those focused on higher quality intermediate and longer-term bonds where valuations are attractive.