Detroit recently declared bankruptcy, setting off the largest municipal Chapter 9 proceeding in history. There has been and will continue to be a lot of noise in the media, underscoring challenges but also presenting opportunity for experienced investors. In this interview, PIMCO senior vice president and municipal credit analyst Sean McCarthy and senior vice president and municipal bond portfolio manager David Hammer discuss the outlook for the muni market.
Q: What are your expectations for Detroit’s Chapter 9 process now that the city has filed for bankruptcy?
A: We expect that the bankruptcy process will be rife with headline controversy and legal challenges, and investors should prepare themselves for a long and contentious process with a lot of noise. Ultimately, there are several potentially precedent-setting issues that will be decided by the federal bankruptcy judge. It is worth noting that the Chapter 9 process may be unfamiliar to many traditional municipal bond investors as municipal bankruptcies are rare relative to corporate bankruptcies. Unlike the corporate Chapter 11 process, only the debtor (i.e., Detroit) can file a formal Plan of Adjustment under Chapter 9. There is also no liquidation test to protect bondholders in Chapter 9 since a municipality cannot be forced to liquidate its assets. These differences could ultimately set the bar low for overall recoveries. The emergency manager’s restructuring proposal for Detroit contemplates a recovery for unlimited tax general obligation (GO) bonds that is far lower than the historical average for municipal GOs.
The restructuring proposal contemplates a haircut on unfunded pension liabilities, which are protected from impairment in the State Constitution in Michigan, and gives all of the City of Detroit’s creditors equal priority across the capital structure, including holders of unlimited tax general obligation debt.
Any rulings contrary to the perceived priority of payments in the municipal market will be challenged by adversely affected creditors and may serve as precedent for future Chapter 9 filings, making the situation in Detroit relevant to all municipal market investors.
These facts all suggest a long and complex road to the ultimate reorganization of the city’s liabilities. The emergency manager is targeting a September 2014 exit from bankruptcy, but a conclusion may take several years. In addition, the importance of the rulings may ultimately lead Detroit’s case to the U.S. Supreme Court, which may need to decide on issues of state sovereignty, including whether federal law (Chapter 9) supersedes state law (Michigan constitution) with regard to reducing pension benefits.
Q: Is the Detroit bankruptcy an idiosyncratic event or a sign of systemic stress in the municipal bond market?
A: Detroit’s economic collapse was attributable to a variety of long-term secular trends specific to both the city and the U.S. automotive sector, which steadily lost global market share over three decades. These trends initiated a feedback loop that drove the destruction of the city’s tax base. The city’s fiscal condition eventually became untenable when revenues were overwhelmed by rising debt service, including expenses owed to retirees.
Investors in municipal bonds should consider carefully the promises governments have made to public sector employees and whether they are willing and capable of meeting those promises in the future. According to research compiled by the Center for Retirement Research at Boston College, which included data for plan assets for 90% of U.S. states and 30% of U.S. cities, the total unfunded pension liability was approximately $1 trillion for fiscal year 2012. At the same time, employers contributed only 80% of their annual required contributions (ARC) to plans during 2012. These figures exclude public unfunded healthcare obligations, which are generally funded on a pay-as-you-go basis. At PIMCO, our municipal credit research team carefully examines an issuer’s entire capital structure, including obligations from tax-supported debt and pension and healthcare plans, as a key component to our bottom-up credit process. Analysts regularly make adjustments to capture all these obligations in our debt metrics and consider an issuer’s historical contribution pattern to their retiree obligations as well as any reform measure when forecasting the growth of future liabilities over the cyclical horizon.
Q: What are the implications of the Detroit bankruptcy for investors in municipal bonds?
A: The Detroit bankruptcy is challenging the perceived priority of payments within the municipal capital structure. It has long been assumed by many investors that unlimited tax GO bonds and pension benefits were at the top of the municipal capital structure, followed by limited tax GOs, then pension obligation certificates (POBs) and all other general fund claims, and, finally, retiree healthcare obligations. The emergency manager’s plan, however, puts all of these obligations on equal footing. And while we expect that legal challenges and negotiating may restore some hierarchical separation to these classes, lower recovery assumptions for GO bonds are still likely to be the most significant result. The outcome will help define the options for Detroit to reorganize, and also clarify the balance of power between unfunded pension claims and bondholders. If there’s a positive, it is that the Detroit reorganization ultimately may clarify the parameters for negotiations between pensions, bondholders and politicians, and lead to a call to arms for greater pre-emptive pension reform in other stressed states and cities.
Q: Do we expect there will be federal intervention?
A: PIMCO ascribes a low probability for a direct federal bailout simply because the federal government is more likely to let the process play out through the Chapter 9 proceeding, particularly as there is the potential for precedent-setting outcomes. Intervention could also create a disincentive for pensions to negotiate outside of the Chapter 9 process by introducing moral hazard.
The White House recently sent a delegation to Detroit which pledged on behalf of the administration a modest $320 million in federal and private-sector funding for rehabilitative purposes (e.g., transit repairs and blight demolition) instead of debt relief. The federal share of this funding includes largely a redirection of already approved grants and not newly appropriated funds. If the bankruptcy is drawn out over an extended period of time without a foreseeable exit, Detroit may need additional financing, but in our view a major federal bailout is unlikely.
Q: What about Detroit’s water, sewer and other essential services bonds?
A: PIMCO has long favored special revenue essential service bonds over GO bonds. Detroit Water and Sewer bonds are payable by a pledge of and statutory lien on net revenues of the water or sewer system, and as such benefit from provisions in the federal bankruptcy code ensuring that the pledge is not affected by the petition. However, that does not mean that there will not be some kind of haircut on these bonds. First, many of the bonds were issued with higher coupons and were trading at a premium prior to the announcement of the restructuring plan. The current plan calls for redeeming these bonds at par to issue new notes at prevailing market rates that, while still preserving capital, would create financial losses for existing holders. The proposal also calls for a “transaction payment” to be paid senior to debt service on the exchanged notes, which would be an additional cost to existing bondholders. Most recently, the emergency manager revealed in a deposition that the city may attempt to access $1.2 billion maintained in the water and sewer system’s capital fund, which would adversely impact the quality of the system’s services. These costs are dramatically different from the loss severity proposed for GO bonds, and any attempts to modify the terms of the notes or subject bondholders to exorbitant charges would be a source of contention and likely lead to legal challenges, as they have in the past.
Q: Should investors alter their approach to municipal bonds in light of Chapter 9 bankruptcies?
A: PIMCO continues to have an underweight bias on local GO credit. The vast majority of our municipal exposure is in bonds backed by dedicated revenue streams.
It is still important, however, for investors to understand the credit strength of the underlying service area and the related municipality or territory for revenue-backed bonds. Although revenue pledges can offer a secured interest, essential service revenue credits can still be adversely affected if the local service area is weak or if the related municipality is under financial stress. In some instances, the municipality or territory may transfer cash from enterprise funds or municipal utilities to bridge operating deficits or, conversely, support the utility’s obligations with government loans. Rating agencies are also likely to downgrade affiliated revenue bonds as the underlying area becomes more stressed. These weaknesses could result in spread widening, diminished liquidity and an increase in mark-to-market volatility.
Post financial crisis, the municipal bond market has transitioned from a duration-based market to one driven by credit, combining investment grade, high yield and distressed issues. The municipal credit research team looks at the management of municipalities the same way we look at the management of a company, examining its fundamental health and the potential aggregate demand for services in the underlying area. Our municipal credit research analysts build forward-looking models for revenue bonds, which are based on both the future cash flow and the financial strength of the underlying service and incorporate PIMCO’s cyclical forecasts. These projections help us focus on avoiding spread-widening events before they occur. This type of bottom-up analysis is geared to help avoid blowups and can also identify opportunities created by the type of indiscriminate or forced selling we have seen in the wake of the Detroit filing. At the moment, for example, we’re seeing some high quality revenue-backed bonds offered at distressed prices. This repricing is temporary, but it has made many bonds inexpensive relative to their value.