CHICAGO -- Detroit’s controversial debt restructuring proposal, lumping the city’s general obligation bonds together with its least-secured debt, illustrates the need for clarity in a shifting municipal market, the director of municipal research at Breckinridge Capital Advisors said Wednesday.
“We don’t expect there to be some radical uptick in bond defaults, but we do think it’s worth watching how [legal bond] covenants play out in a restructuring or Chapter 9,” said Adam Stern, director of municipal research for the firm, said Wednesday in a conference call on Detroit.
“Investors need to be cognizant that while covenants, including general obligation and special revenue covenants, are still enormously relevant to most issuers, when things get really, really bad, recoveries and issuer behavior is becoming more unpredictable in the current environment,” he said. “Next time we see something like this, there may be new norms that affect recoveries.”
Breckinridge held the call Wednesday as muni market participants continue to digest Detroit emergency manager Keyvn Orr’s debt restructuring proposal, released Friday. The plan defines more than half of the city’s GO debt as unsecured and on par with the city’s sizable pension and retiree health care liabilities.
Orr has proposed issuing $2 billion of notes to repay holders of $11.4 billion of unsecured debt on a pro rata basis. The city has halted all payments on its unsecured debt. It will continue to make payments on its secured bonds, but hopes to renegotiate the debt with investors.
The idea that the secured debt, backed by a specific revenue lien, is open to negotiation, is “big news,” Stern said. “Backing bonds with liens carved out of revenue is a time-tested way for investors to invest in distressed governments,” he said. “Frankly it’s unclear anything should be negotiated if you’re a holder of one of these bonds.”
Unlimited-tax GO bonds, meanwhile, even those not backed by a specific revenue, have represented a gold standard in the muni bond market for 200 years, he said.
“It doesn’t make a lot of sense if your gold standard pledge is somehow subordinated to the point where you’re getting 10 cents on the dollar,” Stern said. “The municipal market is in a period of adjustment about its general obligation bonds, and Detroit is a good example of it.”
Stern said Breckinridge considers Detroit an outlier and isn’t changing its own investment strategies based on the city’s default or restructuring plan. But along with uncertain recoveries and a new willingness to walk away from GO pledges, Detroit’s plan shows that the old model of troubled governments refinancing their debt, by pushing off near-term debt service or maturities to generate relief, may be fading.
“Investors just need clarity,” said Stern. “States can do a lot to telegraph that ... Making more clear which bonds will be honored and when would be very helpful to the municipal market.”
Rhode Island, for example -- despite its most recent controversy over a $75 million video game studio project backed by the state’s moral obligation -- was a leader in providing some of that badly needed clarity in 2011. Its lawmakers enacted a law that gave bondholders priority in a bankruptcy ahead of a Chapter 9 filing by Central Falls. The law helped clarify the status of bond debt and helped the city emerge from bankruptcy after only 13 months.
“That was a good strategic policy decision,” Stern said. “Giving the market clarity has definitely kept the credit markets opens to Rhode Island’s 39 municipalities that without that [law] would have had a tougher time accessing capital.”