Champagne, Corks, and Muni Bond Consequences

Any time a negative headline hits a particular asset class, investors can often throw away the champagne with the cork – meaning, they sometimes treat the good and the bad in the same manner…regardless of the underlying fundamentals. With Detroit’s bankruptcy, municipal bond investors are at risk of throwing a lot of champagne away because of just a few corks. In my last blog post, I looked at what the fallout might be for Detroit in particular. This time, I’d like to examine what Detroit’s implications are for the wider muni market, and how to separate the champagne from the corks.

There’s some differentiation that can be seen in impacts for municipal issuers. For larger, higher-rated issuers who are disciplined market participants, there should be relatively minimal market impact. Remember, Detroit is an outlier and doesn’t represent the situation of the largest possible majority of creditworthy issuers. It’s just that most municipalities stay out of the newspapers because they’re able to keep their fiscal houses in order.

For smaller issuers and/or lower-rated issuers – those that have less operational or financial flexibility –  there are a few possible implications. The first would be negative rating actions – credit rating agencies could get their red pencils sharpened and start examining these municipalities to assess if they are at risk for decline. In order to maintain their current credit quality ratings, many issuers at this level might have to pursue additional cost reductions.  Higher borrowing costs could also be an outcome for these issuers; though, this would translate into wider spreads for investors. There’s also the possibility that these issuers could just issue less debt, essentially limiting supply for investors.

Regardless of the fundamental issues a municipal issuer faces, there are some implications for all levels of issuers. First, the Detroit bankruptcy has focused a lot of attention on the pension and post-retirement health care benefits that the city’s retiree’s stand to lose – expect there to be a greater differentiation made between these in the future. Expect more pension reform too. Corporations have dropped the defined benefit pension plan in droves, in favor of defined contribution plans, which carry no hefty future obligation; municipalities are starting to follow this path as well. Lastly, anticipate greater credit scrutiny of governance and policy decisions, cost management, and debt structure.

So, recognize that negative headlines can cause other investors to have a knee-jerk reaction to a particular asset class. They’ll be throwing out a lot of champagne with the corks. The opportunity for experienced investors comes in catching the champagne while not getting hit by the corks.

 

 

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