Home ListingAugust 20, 2014

Detroit’s Bankruptcy and its Impact on Your Bond Portfolio

Columbia Management’s Ty Schoback gives a verdict on the effects of Detroit’s Chapter 9 bankruptcy on bond investors.

Reported by Featured Author

Investors in municipal bonds need to factor in political risks that may trump even legal agreements, according to Columbia Management.

Twelve months on from the bankruptcy filing by the city of Detroit, Michigan, the US-based manager warned that the write-down of bonds issued by the city showed “political pressures continue to influence the bankruptcy process”. This had resulted in “politically-connected stakeholders [being] more equal than others”.

“A city’s desire to pay employees to continue providing essential services to residents and taxpayers will come before bondholders, regardless of legal language.”—Ty Schoback, senior municipal analyst at ColumbiaThis may come as a shock to Detroit’s pensioners, who last month agreed to a cut in benefits in order to reduce the city’s huge pension bill—a move which directly contradicts the wording of Michigan’s state constitution.

Ty Schoback, senior municipal analyst at Columbia, said: “While the direct implications of Detroit may be largely limited to other fiscally distressed Michigan local governments, the bankruptcy has yielded significant insights for municipal market participants.”

He pointed to Detroit’s limited-tax general obligation bonds (LTGO bonds). When issued, the city pledged to service this debt first when collecting taxes. However, following the Chapter 9 bankruptcy filing in July last year, holders of these bonds were eventually paid just 34% of par. Holders of unlimited-tax general obligation bonds settled for 74%, despite the city’s pledge to raise taxes specifically to pay off this debt if necessary. The remaining 26% is to go to pension funds, Schoback said.

“This is a clear demonstration that, despite what legal protections bondholders are afforded per their indentures, a city’s desire to pay employees to continue providing essential services to residents and taxpayers will come before bondholders, regardless of legal language,” Schoback said.

He added that the situation in Detroit “demonstrated how the intensity of political influence multiplies in a situation of fiscal distress and is likely to result in more beneficial terms to politically-favored classes of creditors at the expense of the less well-connected”.

Earlier this year the California Public Employees’ Retirement System (CalPERS) voiced opposition to the plans to cut benefits, arguing that the decision threatened the security of the entire US pension system.