Detroit Municipal Bond Bankruptcy

I have commented for years on my personal concern about the future of the $3.7 Trillion U.S. Municipal Bond market on my financial blog www.mindofmoney.com.  With the recent filing of Detroit, the largest U.S. City ever to file for bankruptcy protection this week, I would like to recount the points which I have been discussing over the years:

1. Bonds have prices, just like stocks and other investments, and those prices are based on 2 primary factors 1) interest rates, and 2) perception of risk (‘risk premium’).
2. Interest rates have been at historical lows and really have nowhere to go but up.
3. The ‘Risk Premium’ on Municipals has also maintained its historical “safe” categorization thus far, and likewise has nowhere to go but down.
4. This combination means that investors in Municipal Bonds who have bonds with a longer duration (> 3-5 years) really are betting that interest rates will stay low and the risk premium will not rise for an extended period of time.
5. Historical analysis suggests that this is an extremely unlikely possibility.
6. Common sense agrees.
7. Combine that with a stagnant U.S. economy, an already  ‘taxed to the max’ local tax base, and the increasing willingness of people to simply move away from cities which are failing, and we have the perfect storm for a Municipal Bond crisis.

Am I predicting such a crisis?  The answer is no.  I am not that clairvoyant.  But what I do predict is that there will be increasing defaults in some municipalities.  That interest rates will eventually steadily rise, and that the result is that bond prices will ultimately have a “readjustment” to the realities of those events.

The Municipal Bond Market has the same “feeling” as Fannie may and Freddie Mac had prior to their crash.  The argument goes that Municipalities are somehow exempt because they can always raise the money by taxing.  And there is even an unjustified sense that it is a government backed market and somehow it will always be bailed out. Recent commentary after Detroit is already coming in which suggests that investors are waiting to see what a possible bailout might look like.

I believe that these assumptions are simply not true.  I believe that Meredith Whitney’s suggestion that we will see a significant shift in population and thus the tax base between cities, states and municipalities who are getting their fiscal house in order and those who are not is completely accurate.  And I have no doubt that the Municipal Bond market will directly reflect these changing realities over the next 3-5 years.

So what should you do if you are a Muni Bond investor?  My advice is to review your portfolio from top to bottom.  Look particularly at the duration of each bond and the underlying credit worthiness of each issuer. I would suggest that you make no assumptions and ask basic ‘stupid’ questions of your bond broker and not be satisfied with pat or trite answers.  Personally I would hold only those bonds which I was convinced had an unassailable repayment capacity, and even then I would only hold bonds with a duration to maturity of less than 3 years.

Do I think every Muni bond is doomed? Absolutely not.  But there is no doubt that if the bad ones start to fall, it will be inevitable that even the good ones take a beating on the way down.  I see no reason to make what I consider a contrarian bet on both the future of interest rates and the mood of the market with respect to the risk premium, especially in the face of just the latest in a rising tide of defaults, “The Motor City”- Detroit.