Detroit and You

Contrary to popular opinion, things do actually happen in the municipal bond market.  Sometimes we wait years, even decades, before taking action, but actions do happen, eventually.  Municipal bankruptcies have occurred, will occur, and are getting bigger.

Years ago we predicted both more and bigger bankruptcies.  While some may argue that wasn’t much of a reach compared to the few and small bankruptcies of the 1990s and early 2000s, the belief that municipal bankruptcies affect one’s eventual recovery on their municipal bond investment is changing.  Bondholders have taken haircuts in municipal bankruptcies and in the future this will probably include having your head handed to you.  Detroit may be the turning point.

Detroit filing for bankruptcy should have been as newsworthy as dog bites man.  Of course they filed for bankruptcy!  This was seen as a foregone conclusion, one would think, except for the bondholders of their billions in debt.  I guess these holders were comfortable in the fact that losing money on a municipal bond investment is a very low odds proposition.  Perhaps the holders have tremendous faith in what is left of the municipal bond insurance industry, including Warren Buffet’s BHAC insurance that insures about $400 million in Detroit debt.  That faith ignores the holders of Detroit’s uninsured debt; they must have been truly delusional.  Evidently the faith in Detroit’s bonds must be due to the seemingly high prices and “normal” yields where it once traded.  The days of Detroit kicking the can down the road are thankfully over and hopefully the idea that municipal bonds always result in a full recovery are over as well.

The latest chapter in the finances of Detroit began with the May 12th release of Emergency Manager Kevyn Orr’s report on the status of the city’s finances.  Mr. Orr wasn’t proclaiming new revelations in the report but for those who faithfully believe that municipal debt always gets paid, the report was yet another reason to hide your head in the sand.  Later Mr. Orr revealed an accounting error that led to an additional $3.5 billion hole for the city.  What?  How come bad seems to continue to become worse?

The $3.5 billion pension hole is the result of differences in actuarial accounting, according to a New York Times published piece.  One day all is fine (with respect to pensions), the next day there is a $3.5 billion hole.  This is possible because most bond investors rely on balance sheets as an indicator of health.  Unfortunately the balance sheet is also governed by mood.

In good times , prices are high, problems low and optimism allows for accounting rules that are, shall we say, optimistic.  Receivables on the balance sheet will be received and shortfalls in pension funding will be closed down the road.  The longer the period of good times and prosperity behind us, the more lax the accounting seems to be.

Reality, and the reality that mood has changed, greatly affects balance sheet figures.  Receivables may not be received after all.  Pension fund gaps are indeed pension fund gaps, except now they reflect the current reality of more out and less in.  Even Cash on the balance sheet is suspect as it may just be the result of a municipality’s latest borrowing.  This is the power of a shifting mood, especially one that allows the largest municipal bankruptcy in history to happen.

With billions of dollars in debt outstanding, evidently others were willing to own Detroit paper thinking much will never change in the municipal bond market.  Others must believe bailouts will always occur and cans will continue to be kicked down the road indefinitely.  Let these investors continue to own what I call rubbish under the guise of diversification.  Impaired bonds are still impaired bonds and no longer do we have to wait for actual haircuts to know municipal bondholders will not always come out whole.  Haircuts are first; having your head handed to you will probably come later.

This is my fundamental problem with municipal portfolio management as practiced by the mutual funds.  Diversification doesn’t keep you from owning rubbish; it simply spreads the rubbish around.  The industry also counts on a swelling of assets under management to dilute the rubbish they own.  When assets pour out of the funds as they are currently, such dilution does not occur; instead the rubbish intensifies.

Who, in their right (investment manager) mind would own Jefferson County and Detroit debt?  One could easily see the debt of these two entities could not be repaid in full yet investment managers continue to own it.

This is where changes in mood become so important.  In the everything was great days of 2004-2006 we advised our clients to sell their long-term municipal bonds.  Defaults were nonexistent and all the worthwhile municipal bonds tended to carry insurance anyway, so what could possibly go wrong?  This is why we sold.  One sells when prices, along with optimism, are high and municipal bond prices were indeed high.

After arguably the most volatile periods in municipal market history, 2007-2009, long-term municipals did recover from their plunge in price to achieve, by some measures, new all-time highs in price.  For a while in 2012 it appeared interest rates would remain low (seemingly forever) and that bankruptcies and financial distress were once again a thing of the past.  Again, we saw this as a time to sell at what we called the bubble high of Thanksgiving 2012.

Since the 2012 high we have seen several things occur.  Some owners of Jefferson County bonds will not be paid back in full and now we learn a similar fate should befell holders of some Detroit bonds.  More importantly we now have performance issues.  Long-term municipal bond prices have fallen 10-15% since Thanksgiving, an amount equal to several years of interest income.  Evidently there has been a shift in mood.

I have said several times since the financial crisis began in August 2007 that I do not trust municipalities any further than I can throw them.  This has been my compass, guiding me in finding worthwhile municipal bonds while avoiding those not worthy of our time and especially our money.

Full faith and credit of municipalities back about one fourth of all municipal debt in the $3.7 trillion municipal bond market.  We have witnessed how even these general obligation bonds can plunge violently in price from 2007 to 2009.  We have seen how municipal accounting (or the lack thereof) can hide (reveal) massive liabilities.  So why would I want to pay full price, let alone a premium, to own these general obligation bonds?  I would not.  Not even with diversification!

This is what makes the municipal bond market so worthwhile for us: we have a choice and we can make it when it comes to what bond is worthy of our time and money and which bonds are not.  With tens of thousands of issuers and even more different credit terms available, we find bonds, almost daily, that make sense even in a world of changing moods, changing accounting and more bankruptcies.

I continue to not trust municipalities any further than I can throw them, and as long as bond prices remain high, this will continue to be my guide.  I do not expect municipal bond prices to remain high (forever), I never did, and this is why I called the Thanksgiving 2012 the top of the municipal bond market bubble.  At only down 10-15% we have a long way to go before my faith in a diversified portfolio of long-term municipal bonds is restored.  Until then we will continue our well-worn path of following The Select Approach^TM.