Will Detroit's Bankruptcy Kill This Key Market?

Just over a week ago, the city of Detroit became the largest municipality ever to file a Chapter 9 bankruptcy proceeding. Yet even though markets haven't collapsed in response, investors are increasingly wondering whether Detroit's bankruptcy will end up curtailing or even destroying the ability of every city and state in America to get financing in the municipal-bond market to pay for essential projects.

A delayed reaction?
Despite big news headlines and considerable debate about the potential impact on city residents as well as current and former municipal employees, the impact on the markets was relatively muted. The Dow Jones Industrials have traded in a very tight range ever since the announcement, with several days featuring moves of less than 10 points showing the tug-of-war between bulls and bears.

Even in the municipal bond market, where you'd expect to find the most chaos, prices remained calm. The iShares S&P National AMT-Free Muni Bond ETF dropped by half a percent the day following Detroit's filing, but it was down only slightly this week, paralleling movement in the Treasury-bond market tied more to general interest rate levels than to specific risk related to municipal creditworthiness.

But now that markets have had time to react, a number of different opinions are surfacing about how important Detroit's bankruptcy is:

• Investment manager BlackRock said early this week that its analysts "anticipate the impact of the event will be much smaller than its size might indicate," calling Detroit "an idiosyncratic situation" and saying that therefore its analysts "do not anticipate a widespread systemic effect."

• UBS noted that "precedents that do exist would appear to favor holders of [general-obligation municipal] bonds backed by an unlimited property tax" in its argument that the bankruptcy shouldn't create big problems, also noting that muni-bond insurance companies cover almost 90% of Detroit's debt.

• Citigroup notes that "the magnitude of Detroit's economic and financial problems dwarfs those of any other large local government in the U.S. by a wide amount" in arguing that muni-bond yields aren't likely to rise too far.

• Taking the other side of the argument, muni-bond specialist Nuveen Asset Management believes that "municipal investors should now view all Michigan general-obligation bonds as having no greater standing than any other form of municipal obligations," reversing the general understanding that general-obligation bonds backed by broad powers to tax are inherently more secure than bonds with more limited sources of revenue backing them. Indeed, Michigan-specific muni-bond funds took much more serious hits over the week than the broad muni-bond market, with BlackRock MuniYield Michigan falling almost 5% since last Thursday and Nuveen Michigan Quality Income posting about a 4% loss.

• Analyst Meredith Whitney went a step further, predicting a wave of municipal bankruptcies resulting from Detroit's action. Yet after having cried wolf in late 2010 and having proven to be wrong in her expected 12-month timeline for massive defaults, Whitney has had her credibility questioned by many experts in the muni-bond arena.

Amid all this uncertainty, investors have been remarkably calm. Money flowed out of muni-bond funds this week, but only at a modest pace of $1.23 billion -- a slower pace than it has seen in recent weeks as part of the broader bond-market fallout from the Federal Reserve's discussions of QE tapering.

Is a slow-motion crash coming?
But even if the muni-bond market hasn't crashed and burned quickly, it has taken some damage. Moody's noted that only one out of every six of its muni-bond rating changes in the second quarter were upgrades, with major downgrades including general-obligation and sales tax bonds for the state of Illinois and Detroit's general obligation and water-and-sewer bonds. Moreover, depending on what happens to Detroit bondholders, long-held beliefs about credit quality and default risk of muni bonds might well end up turned on their heads.

In the long run, though, Detroit's bankruptcy might actually have a beneficial impact on the broader muni-bond market. By highlighting issues that will become increasingly common among state and local governments, including outsized pension and health-care benefits, government entities might have the incentive to tackle problems before they reach bankruptcy-level proportion. That would be good news not only for bondholders but for millions of city residents across the country.

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The article Will Detroit's Bankruptcy Kill This Key Market? originally appeared on Fool.com.

Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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