To help answer questions about the recent Detroit bankruptcy filing, the Municipal Markets Team at American Century Investments (which has actively managed municipal bond portfolios since the early 1980s) provides several Detroit observations. The team also provides some broader municipal market background points to help put the Detroit situation into context.
First, the broader perspective/context for viewing this event:
- Municipal bankruptcies tend to be seasonal. Detroit might not be the only municipal bankruptcy we hear about in July 2013. While we expect these bankruptcies to be relatively isolated events, we are in “bankruptcy season,” as we noted at this time last year, when three California cities filed for bankruptcy protection within days of each other. Many municipalities have a June 30 fiscal year end, and make key fiscal decisions soon after the fiscal year closes. While we believe most municipalities we have examined are fiscally responsible and their finances have generally improved in the past year, we believe there will continue to be isolated local bankruptcy and default situations in the news.
- Every state and local jurisdiction can have multiple, separate bond issuers. Each state, county, and large city typically has numerous bond issuers. For example, a major city such as Detroit can have—in addition to its main city government—numerous districts, agencies, systems, authorities, and/or projects, each of which can issue its own bonds. These separate municipal entities aren’t necessarily tied legally or financially to the main city government itself. So, when you hear or read that a city has declared bankruptcy, that’s only one particular local government entity, not all of the municipal issuers in that city or region.
- Each municipal bond issuer is different. The credit story/situation for each issuer is different, separate, and individual. “One size fits all” credit quality viewpoints typically don’t fit municipal bonds any more than they do individual companies and their stocks. Each bond issuer, such as the City of Detroit, requires individual bottom-up, fundamental analysis to evaluate and understand it properly. This analysis, which is often beyond the resources or expertise of individual investors, is an important value component of professional municipal portfolio management.
With this broad background in mind, here are some specific Detroit observations:
Bankruptcy in Detroit came after years of fiscal problems—it was a long time in the making. On July 18, the City of Detroit filed for Chapter 9 bankruptcy protection, declaring itself financially insolvent after years of fiscal problems. This was big news, but not a big surprise. We have been monitoring this situation for years.
It’s a relatively isolated event (not systemic). As with other high-profile municipal bankruptcies, we believe this is an example of a relatively isolated municipal event (with particular extenuating circumstances) rather than an indicator of a systemic problem across the municipal market. Some of the “systemic problems” fears trace back to December 2010, when the broad municipal market suffered a sell-off after a feature on “60 Minutes” forecasted widespread municipal defaults within 12 months. That forecasted wave of defaults didn’t materialize, but the fear lingers.
Getting back to the specifics of Detroit’s situation, our analysis indicates that Detroit’s fiscal woes stem primarily from two factors:
- An extended period of fiscal mismanagement.
- Population loss (and therefore a severe reduction of the city’s tax revenue base) as a result of consolidation and production changes in the U.S. auto industry.
Not every bond labeled “Detroit” was directly affected. Direct obligations of the City of Detroit—such as Detroit general obligation (GO) bonds—are most affected by the bankruptcy filing. We believe the Detroit emergency manager’s “pursuit” of GO bonds is unprecedented and could have implications for other weaker GO credits.
However, it’s important to stress that not all “Detroit bonds” are direct obligations of the city. For example, the school district in Detroit is a legally separate entity from the city. Therefore, Detroit city school district GO bonds are not directly affected by the bankruptcy filing.
Structurally, some Detroit revenue bonds effectively have a form of bankruptcy protection. Essential service revenue bonds can potentially provide steady streams of debt service payments, even when a city has filed for bankruptcy. Take, for example, Detroit’s water and sewer system, a large, self-supporting enterprise (the net revenues exceed debt service, at last check).
This revenue bond issuer provides broad regional water service to roughly 40% of the population of Michigan, and sewer service to approximately 30% of the same population. Its revenue bonds are secured by a statutory lien under Michigan law. This means the lien of the bonds on the net revenues of the system should remain attached, we believe, after a Chapter 9 filing. So, we think debt payments should be maintained, assuming there are sufficient net revenues to cover debt service. Structural protections like these are features that professional portfolio managers seek in building municipal portfolios.
We believe the bottom line with Detroit is:
- It’s a relatively isolated event, created by its own individual circumstances.
- The bankruptcy doesn’t directly impact every municipal bond labeled “Detroit.” There are many different municipal issuers within the Detroit area. The impact can also be mitigated by how the bonds are structured.
- This situation helps point out the potential advantages and benefits of professional municipal portfolio management, and owning a diversified, well-selected municipal bond portfolio.
We plan to continue to provide updates on the municipal market as situations like this arise.
For more information on this Detroit event, read The Detroit Bankruptcy and Our Detroit-Related Holdings.
And, for more information about our Municipal Markets Team’s investment processes and procedures, please see its piece from earlier this year: Critical Focus for Munis: Credit Quality.
The opinions expressed are those of the Municipal Markets Team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is for educational purposes only and is not intended as investment advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.