Municipal bonds: Swaps might decide Detroit bondholders’ fate
Muni market concern spreads to Chicago; Distressed buyers pile into Puerto Rico
Last month the city of Detroit reached a negotiated settlement with Bank of America Merrill Lynch and UBS over collateralized swaps hedging about $800 million of $1.4 billion of pension securities. The two banks have agreed to accept $85 million to wipe out a $288-million financial transaction brokered in 2005 by mayor Kwame Kilpatrick’s administration, which purchased the swaps to secure a 6% interest rate on a $1.4 billion pension debt agreement.
As Euromoney went to press the deal was due to go before US bankruptcy judge Steven Rhodes on April 3. Approval would give Detroit access to casino tax revenues, pledged as collateral on the swaps, and support efforts to win court sanction for its debt "plan of adjustment", filed by state-appointed emergency manager Kevyn Orron on February 21. However, Rhodes has rejected two earlier compromises on this issue as too generous to the banks. A third rejection is likely to lead to "costly and hotly contested" litigation, the banks warn.
Under Chapter 9 of the US federal bankruptcy code, a city that wins agreement from a single class of creditors whose interests are impaired by bankruptcy can seek to impose settlement terms on other classes of creditors. The April 3 proceedings are therefore being watched with interest by the city’s pensioners and municipal bondholders, who are locked in a battle for the proceeds from the plan of adjustment.
The city’s liabilities consist of $6 billion of obligations to the water department, $9.2 billion of pension liabilities and $2 billion of "general obligation" municipal bonds.
The key beneficiaries of the plan of adjustment are Detroit’s police and fire workers, who stand to eventually receive 90% of their claims, while other city workers will get a smaller proportion. Bondholders, on the other hand, stand to recover just 20 cents on the dollar.
The situation in Detroit has triggered a wider debate over the competing rights of pension funds and general obligation bondholders in municipal bankruptcies, the resolution of which will have an impact on some 55,000 municipal bond issues outstanding and millions of state civil servants across the US.
"There was an assumption in Detroit that the general obligation pledge was sacrosanct and the obligation to pay pensions under Michigan’s constitution was binding, and the question is whether one of these claims has supremacy over the other under bankruptcy law," says Alan Schankel, Philadelphia-based director of fixed-income research at Janney Montgomery Scott. "The court proceedings are yet to play out, but the implications for the municipal bond market, and the power of the general obligation pledge, are likely to be felt across the US."
Last year, $60 billion was withdrawn from municipal bond funds, according to Deutsche Bank estimates. At the same time, muni bond yields rose sharply. The asset class suffered losses of up to 6% in 2013, compared with positive returns of as high as 13% the previous year.
The legal uncertainties surrounding Detroit must be resolved before confidence can return to the market. The way in which the city’s pension liabilities have been funded since the Chapter 9 filing is adding to the complexity of the situation.
In January, a group of philanthropic foundations pledged $330 million to bolster Detroit’s municipal pension funds and help protect the Detroit Institute of Art’s collection from a sale to creditors.
"Here we have a situation where in court the bondholders may argue they are senior to the pension funds so that it makes no sense for the pensions to get a better cut, but the folks putting up the money in connection with the art have said they will not deal unless the proceeds go to the pensioners," says David Tawil, co-founder of New-York based Maglan Capital. "So that is very odd. I don’t think we have ever seen the bidder of assets in a bankrupt estate determining where the proceeds of those assets should go. However, in addition if bondholders do not accept this proposal there is a chance that the whole deal will fall apart, which means they are very much under the gun."
The perverse set of circumstances around Detroit nevertheless has resonance in the wider market. "There are lots of ways in which Detroit will have a wider impact, from the covenants that investors might wish to demand in future, to absolute levels of demand for municipal bonds and the fundamental question of how general obligation pledges are treated under Chapter 9," says Joseph Rosenblum, director of municipal credit research at AllianceBernstein in New York, which manages around $32 billion in muni bonds. "We have potential for precedents, despite the fact this is one court operating in a state framework."
Yawning pension black holes are emerging in other big US cities. In early March, for example, Moody’s Investors Service said Chicago’s massive unfunded public pension liability is a threat to the city’s fiscal solvency, and cut its general obligation and sales tax bond ratings one notch to Baa1 from A3. The downgrades, which affect $8.3 billion of debt, marked the second for the city by Moody’s in less than eight months.
"We are coming off a deep recession, the recovery is anaemic, budgets are pressured and there are changes in pension liabilities," says AllianceBernstein’s Rosenblum. "All of these are hot issues for the muni market as a whole."
Indeed, far from their traditional status as a source of stable returns, muni bonds are now attracting the attention of a very different type of buyer. Puerto Rico has some $70 billion of municipal debt outstanding, comprising around 2% of the entire market, and runs a debt-servicing burden of up to $3.8 billion a year, following an eight-year recession in which the economy shrank 14%.
In December, Puerto Rico bond yields hit 8.95%, the highest municipal yield on record, and in February the 70-island unincorporated US territory was downgraded to junk status.
However, on March 11 it sold an upsized $3.5 billion of tax-exempt general obligation bonds. The deal was the biggest junk offering ever by a state or locality, and was met by overwhelming demand, bankers said.
Along with traditional buyers, that demand came from hedge funds and distressed investors.
One recent buyer of Puerto Rico munis is Maglan Capital. "We saw last year that you could pick up Puerto Rican debt priced in the 60s, which brought it very much into our remit," says Maglan’s Tawil. "With the court cases and the sense that public pension schemes are something like pyramid schemes, this type of dysfunction could become increasingly common. I think the last time the distressed investing world was captivated by munis was in the 1970s, so our interest again now is very much a sign of the times."