Detroit’s Bankruptcy and Municipal Bonds

July 19th, 2013

by Don Gould

The City of Detroit, burdened by huge financial obligations it cannot meet, declared bankruptcy yesterday. This was no surprise—the city’s industrial base and population have been shrinking for decades. Still, for investors, it’s a reminder that lending money to municipalities, for example through purchase of tax-exempt “muni” bonds, does carry risk. It will be a while before we know the extent of the haircut that bondholders will take, but it could be significant.

In the immediate aftermath, there has been a lot of chatter about the implications for muni bonds generally, much of it in alarming tones.  While not discounting concerns specific to Detroit and perhaps Michigan, too, we would point out the following:

1. Municipal bonds remain a very safe and resilient segment of the overall bond market.  Municipalites can’t print money when under financial stress, and that imparts a degree of fiscal discipline sorely lacking at the federal level. The 2007-2009 crisis was a major stress test for muni bond issuers—one they passed quite well, despite the pain involved in adjusting budgets to a new, more frugal reality.

2. When building a portfolio of bonds, diversification is critical. Detroit’s bonds once carried a high rating, and it’s near impossible to spot the next Detroit from a distance of 10-20 years.  The only real protection is to limit exposure to any single issuer. We diversify clients by type of bond (e.g., government, corporate, municipal, international), and, within the municipal segment, by region and by issuer.  Well managed, low cost bond funds greatly facilitate the process.

 

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