Bankruptcy's Bright Side

With pundits predicting a "wave of bankruptcies" in the municipal market this year, experts say one thing should be kept in mind: the majority of distressed issuers undergoing the Chapter 9 process don't end up stiffing bondholders.

Dreadful images conjured up by all the talk of bankruptcy stem from what often happens in the corporate world when a company goes bankrupt. Corporate bondholders routinely take huge losses and it's not uncommon for companies to liquidate their holdings at fire-sale prices, distributing the losses far and wide.

But history suggests that municipal market dynamics compel issuers to continue paying bondholders.

Take Orange County, Calif., which infamously declared bankruptcy in 1994 after some leveraged bets on derivatives turned sour. The bankruptcy debacle — it was the nation's fourth-largest county by population — has since served as a warning that even a municipality not experiencing stagnant growth and a demographic exodus can end up in Chapter 9. But it's worth remembering how much bondholders lost during the 18-month case: not a dime.

With one exception, Orange County bondholders continued to receive full payments throughout and after the Chapter 9 proceeding. The outlier was $2 billion of short-term obligations, where principal repayment was extended by a year and topped with a higher interest rate as compensation.

Chapman & Cutler lawyer James Spiotto says that, technically, general obligation debt without any pledge of revenue or special constitutional priority can be treated like any other unsecured claim, meaning that interest rates can be trimmed and maturities extended.

Restructuring bonds in a bankruptcy scenario has been a rare occurrence because it's a virtual necessity for municipalities to continue making payments in order to retain market access.

Spiotto, who is widely acknowledged to be the foremost authority on Chapter 9, calls capital market access the "lifeblood" of municipalities. Without access to new debt, he said the municipality will have little chance to fund the next bridge, sewer system, or other capital improvement.


The precedent for prioritizing bondholders was set in 1968, when Medley, Fla., opted to pay interest on its GO debt in full and on time, while stretching out payments to other unsecured creditors over a 10-year period.

The San Jose School District provided further precedent in 1983. When it filed for Chapter 9 to renegotiate teacher salaries, it was clear from the start that outstanding debt would in no way be impaired, despite a general prohibition for paying interest during a proceeding where a debtor is insolvent.

An agreement reached one year later cut promised future income raises to teachers by 60%, but full payments to bondholders were never delayed.

A more recent example is the Sierra Kings Health Care District in Fresno County, Calif. — where the unemployment rate has sat north of 15% for most of the last two years.

The district filed for bankruptcy in October 2009 after discovering that hospital management had spent $1.7 million of bond funds on operating expenses.

Two months into the filing, Moody's Investors Service referred to the district as "severely stressed," noting the hospital had a scant five days of operating cash on hand and that the long-term viability of its operations was questionable.

Still, the chance that the district would default on its Ba2-rated GO debt was considered improbable. Moody's called it a "somewhat remote possibility" that the district would stop levying and collecting taxes for the bonds, given the nature of the GO security.

Like most municipalities, Sierra Kings recognized that skinning bondholders would do it little good. The district paid all of its $257,000 in interest payments last year, prompting Moody's to remove the district's negative outlook.

Those payments were less than 2% of its total operating revenue of $13.2 million, the bulk of which — more than $10 million — were for salary, benefits, and contract labor.

The district remains under Chapter 9 protection and may soon enter into an agreement for Adventist Health to lease its facilities. That would raise revenue and further support efforts to pay bondholders, said Riley Walter, the district's bankruptcy attorney.

"In essence, Adventist would take over operation of the hospital, but the district would continue on in existence and continue to receive the tax revenues that would then be paid over to the bondholders," he said. "The hope of the district is to preserve its ability to borrow in the future."


Market data indicates that sophisticated buyers are well aware that distressed issuers tend to continue to make their bond payments.

Duane McAllister, investment manager from M&I Investment Management, notes that when a municipality enters Chapter 9, the value of its bonds declines much less compared to when a corporate issuer enters Chapter 11. "Obviously you will see a reaction in the market, but institutional investors appreciate the difference between the corporate and muni worlds, so the decline is less significant," he said.

McAllister remembers that Orange County GO bonds fell to 85 cents on the dollar in the immediate aftermath of the unexpected filing, but then quickly rebounded as savvy investors looked at the transaction and observed the strength of the GO.

Orange County Transportation Authority bonds fell further, to about 70 cents on the dollar. When enough buyers in the market understood the debt benefited from a separate pledge with no direct link to the county itself, values climbed as well.

By contrast, it's not unusual to see corporate bonds trade down to 50 cents on the dollar or lower when Chapter 11 is announced, and then stay there, McAllister said.

Moody's data compiled over the past four decades shows the median trading price of a defaulted municipal bond, 30 days after the default date, is 59.9 cents on the dollar, whereas for a corporate senior-unsecured bond the rate is 37.5 cents.

The more stable prices indicate an understanding that the Chapter 9 process has not been an assault on bondholders. It doesn't hurt that recovery rates in Muni Land are much higher than in the corporate world, just as payment defaults are much lower.

But bondholders can still lose out. Unaware of how they tend to be treated during a bankruptcy proceeding, retail investors have an instinct to sell at a loss now and ask questions later.

"All people hear is 'Chapter 9 bankruptcy' and they fear the worst," said Belle Haven Investments chief executive Matt Dalton, who called that instinct a misperception.

McAllister said there is a need to get the word out on the subject, but the current fearful atmosphere makes it difficult to explain the differences between a technical default, like filing for Chapter 9 protection, and a monetary default resulting in tangible losses.

Far from being aware that municipalities often continue paying bondholders during a bankruptcy proceeding, retail investors are often unaware that continued payments are even possible. And they might not know that defaults can occur without a bankruptcy filing.

"There is little awareness as to the nuances, which really dictate how and when bondholders are going to be paid," said Lourdes German, a vice president at Fidelity Capital Markets.

"That's one point that needs to be understood," she added. "It's a critically important issue."


On Tuesday: A look at the Vallejo, Calif., bankruptcy and why Chapter 9 gives issuers an incentive to prioritize bondholders.

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