Detroit is bankrupt, and investors and officials alike have been questioning the future of general obligation bonds. Source: Bill Pugliano/Getty Images
Last week, Detroit’s city manager announced plans for filing bankruptcy. From Detroit’s predicament, we can deduce two main lessons: First, like any security, municipal bonds aren’t risk free. Second, that doesn’t mean Detroit will be a harbinger of muni debt doom. More likely, Detroit’s municipal bondholders face issues specifically tied to Detroit’s financial instability—not munis as a broad category.
But that doesn’t stop some from fretting a potential muni meltdown. Munis are popular, especially with retirees, because they can provide tax-free income and are often backed by a taxing authority. But their (typical) backing by local governments’ “full faith and credit” often leads investors to misunderstand them as effectively safe havens—which they are not. Nor are they necessarily wildly risky investments. Rather, municipal bonds carry some risk associated with the backing municipality’s financial situation. And not all municipalities are created equally.
For example, when Detroit filed Chapter 9, the big question was: How will this impact its investors? Specifically, what about those holding general obligation (GO) bonds—which are backed by the broke municipality’s “credit and taxing power,” not projects’ or utilities’ revenues? Detroit’s city manager, Kevyn Orr, plans to treat GO bonds as unsecured investments during Chapter 9—meaning investors would receive as little as 20 cents on each dollar invested. The plan isn’t very popular, so it likely will be challenged in bankruptcy court.
Notably, this is the first time a municipality has attempted to treat GO bonds as unsecured debt. As municipal Chapter 9s happen very infrequently (just 648 municipalities filed for it since 1937), much about the process seems open to interpretation. Hence, Orr’s plan isn’t guaranteed to be the one the city follows—which likely relieves Detroit’s investors some.
Whatever the path, Detroit’s situation doesn’t reflect much on GO bonds—or muni bonds in general—as investments. Muni bonds are only as good as an issuer is financially stable (or the project backing it is stable, in the case of revenue bonds). Detroit’s muni debt was primarily risky because, in large part, Detroit’s been in a bad way since the ‘70s when much car manufacturing—which initially brought economic vibrancy to the city—began leaving for cheaper, easier production elsewhere. Politicians often chose to fight Detroit’s dwindling tax base by increasing taxes. As we often see, increased taxes don’t guarantee higher future receipts, and in Detroit’s case, they likely contributed to more of the tax base leaving for friendlier tax climes. Before the city’s bankruptcy filing, Detroit’s GO bonds were trading with a +5% yield and a C rating from S&P—both signals of riskier bonds (hence the higher return).
However, Detroit’s problems are Detroit’s problems: Muni bonds in other cities don’t appear riskier simply because Detroit failed. (Unless they have identical problems to Detroit—but Detroit is pretty darn far out the bell curve). Across the rest of the country, tax bases have grown, as have tax receipts on national and overall local levels. Detroit’s sunk, but that’s not the trend.