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Detroit bankruptcy ruling may be good news for wary market

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December 3
6:53 PM 2013

A federal judge's ruling Tuesday that Detroit is eligible for bankruptcy protection offers municipal bond investors a dose of clarity that could be welcome news at the end of a rough year for the U.S. muni debt market.

If upheld by an appeals court, the ruling will allow the insolvent Michigan city to push ahead with creditor negotiations over how to restructure debt, which the U.S. federal judge said includes public pension liabilities. 

Retail investors might view the Detroit ruling as another frightful headline in a year when the value of their muni portfolios declined. After all, they have pulled a record $51.7 billion out of municipal bond funds so far this year, and the Bank of America/Merrill Lynch U.S. Municipal Securities Index has fallen 2.7 percent on a total return basis in the year to date after gaining 7.3 percent in 2012.

Nonetheless, some portfolio managers and analysts saw approval of the bankruptcy filing as a positive development that will eventually provide more certainty about a host of unresolved questions, in particular how various kinds of municipal debt and liabilities are treated in bankruptcy.

"If it had been dismissed I think there would have been a lot of chaos," said James Colby, chief municipal strategist at Van Eck Global."There is a structure in place," he said. "That's a better result than the alternative."

The ruling can also be seen as a signal to creditors - in particular public sector labor unions and pension funds - and Detroit's emergency manager Kevyn Orr that they need to go back to the negotiating table, according to Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management.

"The market can take some bit of positive out of this," he said.He also noted that while retail investors remain leery in the wake of negative headlines, they should take heed that Illinois finally appears to be nearing a deal to reform it's pension funds, which comprise the worst-funded state retirement system in the country.

On Tuesday, prices in the secondary tax-free bond market barely budged, according to Municipal Market Data's benchmark triple-A scale.The yield on 10-year muni bonds rose 1 basis point to 2.68 percent. The 30-year yield on top-rated tax-free paper remained flat at 4.14 percent, according to MMD, a unit of Thomson Reuters.

Some weaker credits, however, drifted to wider spreads because investors may be waiting to see how the Detroit ruling and Illinois pension reform affect primary deals later this week, according to MMD senior analyst Randy Smolik.

Some A2-rated bonds from New York's Metropolitan Transportation Authority with 5 percent coupons in the 10- to 12-year range traded at spreads of 87 basis points to a similarly-rated benchmark, when they usually trade at spreads inside 85 basis points, Smolik said.

"It's notable to see these trading outside that range today," he added.Still, others said that investors and advisers in the $3.7 trillion municipal bond market would need time to figure out the Detroit decision.

"Today was a ruling that was widely expected by the market, but it's going to take a while to digest exactly what it means," said Peter Hayes, head of the municipal bonds group within BlackRock Fundamental Fixed Income.

In particular, the ultimate treatment of general obligation debt in Detroit's bankruptcy case could affect pricing of similar bonds in the broader market down the road, said Richard Ciccarone, managing director of McDonnell Investment Management.

"If they make a determination that unlimited tax general obligations are unsecured, that is very likely to have an impact on pricing in the future when buying a long-term bond issue," he said. "It could spur states to take a look at their security provisions." 

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