Detroit's woes present opportunities

For most municipal bond investors, Detroit might seem like a place to avoid at all costs. But in a twist unique to the muni bond world, the perils that Michigan's largest city faces could be creating opportunities for investors seeking muni bonds issued elsewhere in the state. Last week when the Michigan Finance Authority for Ypsilanti Community Schools sold $18.6 million in bonds, investors enjoyed a yield of 4.29%, or about three-quarters of a percentage point above market rates. This is part of the new normal for muni bonds in Michigan. Issuers will either pay higher yields or hold out for a friendlier market.  Over the past few weeks, three major Michigan municipalities canceled scheduled debt issuance when it became clear that Detroit's July bankruptcy filing had made the muni bond market more cautious about virtually all debt issued across the state. Saginaw County, for example, became the third municipality to cancel a bond deal in a two-week period when it halted plans for a $60 million bond offering because it didn't like the interest rate that the muni market was demanding. Saginaw County, which is located about 90 miles north of Detroit, has an investment-grade AA2 debt rating from Moody's Investors Service. As is the case with the two other investment-grade-caliber Michigan jurisdictions that recently canceled bond sales, Genesee County and the city of Battle Creek, the credit ratings haven't been affected by Detroit's bankruptcy filing. In essence, if the credit quality is unchanged and the yields on the bonds being issued are higher, it should add up to a value, assuming that the municipalities are willing to embrace the higher debt costs. “I think it's a buying opportunity, as long as you're doing your credit research,” said Steve Czepiel, manager of the Delaware National High-Yield Muni Bond Fund (DVHCX). The guilt by association for Detroit, a city struggling to get out from under $18 billion worth of debt obligations, has something to do with the way that the city's emergency manager, Kevyn Orr, is proposing to treat certain secured bonds alongside all other debt, including the less secure debt such as pension and worker health care obligations. “The bondholders might have to work out some kind of deal in Detroit, but to throw those debt holders in the same group with the coffee vender doesn't make sense,” said Ronald Bernardi, a muni bond trader and president of Bernardi Securities Inc. “Until there is some clarity by a bankruptcy judge, money will migrate elsewhere or come at a very high price,” he said. “This dynamic is clearly unique to Michigan, and it is directly related to what is transpiring in Detroit where the emergency manager's position is that unlimited general-obligation bonds are to be treated as unsecured debt.” In the meantime, investors should be mindful of the evolving courtship between hundreds of cities and towns across Michigan, and the $4 trillion muni bond market. “The three deals that were postponed in the last couple of weeks were all issuers that had the flexibility to delay the deals, but they believe that if they come back in a month or so, things should normalize,” said Hetty Chang, vice president and senior credit officer at Moody's.

Lack of flexibility

“The real challenge will be for those municipalities that don't have the flexibility” and will have to accept the higher cost of borrowing, she said. The next real test of the muni bond market's appetite for Michigan debt will come next month when triple-A-rated Oakland County is slated to approach the market with a new debt issuance. Ms. Chang said it is too early to know if Oakland County will also get spooked by the higher cost of borrowing and cancel the bond issuance at the last minute. But investors should keep in mind that the suddenly higher cost of borrowing in Michigan “is not indicative of a sudden deterioration in fundamental credit quality,” she said. Moody's research shows that of the 12 double- and triple-A-rated muni debt offerings since Detroit's July 18 bankruptcy filing, eight have been set with yields above the muni market's double-A-rated muni bond average of just over 3%. Six of the 12 muni bond sales had yields above that of the single-A muni bond average of more than 3.5%. By comparison, of the 16 Michigan muni sales in the six weeks prior to Detroit's filing, three had yields set higher than the double-A-rated average, and just one had a yield higher than the single-A-rated average. The credit quality, as firms such as Moody's view it, hasn't changed for most Michigan municipalities. But thanks to Detroit, the muni market has become cautious, and that adds up to higher yields for the same quality bonds that investors were getting a few weeks ago.