Detroit Spawns Risk Of Muni-ETF Purgatory

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July 19, 2013
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The biggest municipal bankruptcy in U.S. history has created more questions than answers, but don’t shun all bond ETFs.

 

Detroit’s historic bankruptcy declaration has created a fair amount of “headline risk” and probably given investors second thoughts about gravitating toward municipal bonds, but many of the muni bond ETFs available—even those with high-yield Detroit credits—are diversified enough to protect investors from the “Motor City’s” travails.

It’s not like muni bond prices world have fallen off the edge of a cliff in the wake of the biggest U.S. municipal bankruptcy in history, though prices are clearly under pressure, particularly funds that have high-yield credits. For example, the $900 million Market Vectors High-Yield Municipal ETF (NYSEArca: HYD), which has a 0.08 percent holding in Detroit debt high-yield debt in the form of one C-rated junk bond issue, fell 1.5 percent Friday.

Other cities are clearly watching to see how Detroit works through its $18 billion bankruptcy, with potentially far-reaching changes hanging in the balance. Notably, Detroit officials have suggested that revenue bond obligations could be pooled with general obligation credits as the city presents its financial picture, bridging a historically sacrosanct gap between the two classes of muni debt.

The risk is that, as the Detroit story plays out, muni bond ETF prices are in something of a holding pattern—a significant near-term impediment to a market many advisors have been saying was looking attractive at a time when other parts of the bond market have turned dicey in the wake of Fed signals that the era of ultra-low yields may soon start to end.

“It’s far too early in the process to understand what the next step is going to be to know whether this is going to be an opportunity,” said Jim Colby, a Van Eck Global executive in charge of the company’s Market Vectors lineup of five muni bond ETFs. “I sense that it could be, but there are just too many moving parts.”

The good news is that Detroit’s bankruptcy is largely Detroit-specific—decades in the making as the U.S. auto industry has lost ground to foreign competition from Japan, Europe and now South Korea. That means other financially troubled cities aren’t likely to follow in its footsteps for the same reason, save perhaps for Flint, Mich., another town hard-hit by the U.S. auto industry’s fortunes.

Additionally, the muni market’s overall size of $3.7 trillion in issuance helps keep the significance of Detroit’s $18 billion-plus challenges in perspective. Bankruptcies such as the $2 billion workout in Stockton, Calif., last year seem even less significant.

But to the extent that Detroit may work through its challenges by altering how general obligation and revenue bonds have been segregated in past municipal bankruptcy work-outs creates uncertainty about how relatively large cities such as San Jose, Calif., which is buckling under pension obligations, will end up dealing with potential bankruptcy proceedings it may choose to enter.

General obligation (GO) bonds, which make up about 70 percent of the U.S. muni market, have traditionally been considered safer. But with Detroit possibly trying to include revenue bonds issued by entities such as the Detroit Water and Sewerage Department in a financial analysis pertinent to the GO bond market, it seems the tables could be turned, which might change municipal finance and thus even ETF issuance.

“This is a situation that bears close watching, but it’s too early to say what the long-term effects will be,” IndexUniverse ETF analyst Gene Koyfman said, referring to unanswered questions, including whether Detroit will even be able to raise more tax revenue without chasing more of its population out. The city is now home to about 700,000—down from a high of around 1.5 million in the 1950s.

Koyfman added that the headline risk investors are likely to react to, in the end, will be much more about specific muni credits rather than about pooled muni investments such as ETFs.

 

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