Will Detroit’s Bankruptcy Affect Your Portfolio?

One month ago, unable to pay its debts with an ever-dwindling supply of cash flow, the city of Detroit filed for bankruptcy, becoming the largest American city ever to do so. The filing left holders of $369 million in G.O. (general obligation) bonds issued by Detroit facing the probability of an 80% haircut on their investment. It also began to drive up borrowing costs for some nearby municipalities, though the effect has not been nearly as widespread as many feared.

Still, many investors do have heightened concerns about investing in municipal bonds now. After all, bankruptcy has never before been used to force a cut in principal on G.O. bonds. So today, I wanted to share two good analyses of the current state of the municipal bond market. If you’re worried about your muni holdings—or if you’re an opportunist wondering if this is the “blood in the streets” moment to be buying muni bonds—read on for some interesting insights.

The first perspective comes from Mark Salzinger, Editor of The No-Load Fund Investor. Here’s what he wrote earlier this month:

“The Detroit bankruptcy has caused investors in municipal bonds to worry that their holdings will lose value, or that issuers will follow in the Motor City’s footsteps and even go belly up. In fact, for three months now, municipal bonds have been among the worst performing sectors of the U.S. fixed income market. Case in point: the iShares National AMT-Free Municipal Bond ETF (MUB) produced a loss of 6.4% over the past three months, vs. a loss of 3.2% for Vanguard Total Bond Market ETF (BND).

“We would urge you not to overreact to the recent volatility in the municipal bond market. After the recent losses, municipals are more attractive than they have been in quite some time. We see no problem with their constituting significant portions of your fixed-income exposure, especially if you are in a high tax bracket.

“Despite the fiscal problems in Detroit and some other cities, we believe that interest rate risk, not credit risk, is the biggest risk municipal bonds face now. In fact, with some notable exceptions, the fiscal situations among states and localities have improved markedly over the past several years.

“First, revenue has been increasing. For example, the U.S. Department of the Census reports that state tax revenue in the first quarter of 2013 increased by nearly 10% year over year, with individual income-tax receipts leading the way with a gain of almost 20%. For the 12-month period ended March 2013, total state tax revenue reached $821 billion, up from $789 billion in the previous 12-month period. Adding in local tax revenue, the sum for the year ended March 2013 comes to $1.42 trillion, vs. $1.35 trillion for the year prior.

“Second, spending has been restrained in many jurisdictions. Combined with the greater revenue, this is resulting in the expectation of budget surpluses for 2013 in many large states, including Texas, Ohio and even California.

“The damage to municipal bond prices has been so severe over the past several months that yields within the sector exceed those of Treasury bonds with similar maturities, even though municipals offer tax advantages to individual investors. Take a look at the following chart of Vanguard funds.

“Especially for investors in high tax brackets, municipal bonds offer significant after-tax advantages in yield.

“Municipal bonds are funded either by general tax revenue or by fees associated with certain municipal projects and facilities, such as schools, hospitals and toll roads. The former are called General Obligation (G.O.) bonds, while the latter are generally called revenue bonds. In the old days, G.O.s were considered safer, because they were backed by the full taxing authority of the issuer. Now, revenue bonds are more in vogue. After all, there might even be specific projects in Detroit that are solvent, with associated solvency for the bonds that funded them.

“In a rising-rate environment, it makes sense to limit your exposure to any type of long-term bond. So, if you want to decrease your risk while harvesting some yield, it would make sense to own intermediate-term municipal bond funds whose managers favor revenue bonds within a broadly diversified framework, including exposure across states and issuers.

“Despite the newsworthiness and human cost of Detroit’s fiscal catastrophe, Michigan is not one of the largest states within the municipal bond market. In fact, bonds from all of Michigan account for less than 2.6% or so of the national total. (The largest issuing states are California and New York.)

“While G.O.s account for a little less than half the municipal market, several municipal bond funds with boldface status in our performance comparison tables devote much lower percentages to such bonds. For example, T. Rowe Price Summit Municipal Intermediate (PRSMX) recently devoted about 16% to G.O.s, while American Century Intermediate-Term Tax Free (TWTIX) devotes about 30%, just a little more than Vanguard Intermediate-Term Tax-Exempt (VWITX). Though Fidelity Intermediate Municipal Income (FLTMX) devotes more to G.O.s (about 46%), its performance so far this year has been as good or better than that of most other intermediate-term municipal bond funds.”—Mark Salzinger, The No-Load Fund Investor, August 2013

I found a second good argument for muni bonds in the latest Fidelity Monitor & Insight. Co-Editor John Bonnanzio also pointed out that investors have to keep in mind the special tax status of muni bonds before making up their minds about the market. Here’s his argument:

“It hasn’t escaped our notice that muni bond funds have bled red this year. Saddled by the same fears that have hobbled taxable bond funds, they have the added burden that some state and local governments are yet to get their fiscal houses in order. (Illinois, California and especially Detroit are prime examples.)

“On the other hand, because muni bond fund yields have already backed up so much (remember, their yields move in the opposite direction of their price — see chart), their tax-equivalent yields have become somewhat inviting. This is especially true for higher-income individuals (who can handle both the credit and interest-rate risks of a muni fund) who stand to benefit the most from their elevated tax-equivalent yields.

“Fidelity Muni Income Fund (FHIGX) now yields 3.09% (see table). But investors in the 25% to 39.6% federal tax brackets enjoy tax-equivalent yields of 4.12% to 5.12%—and even a bit more from state funds. To get a similar yield from a taxable, you’d have to buy a riskier ‘junk’ fund such as High Income (5.12%). … In practical terms, more highly taxed and risk-tolerant investors who follow one of our more income-oriented models could exchange Corporate Bond for a muni fund.”—John Bonnanzio, Fidelity Monitor & Insight, August 2013

Wishing you success in your investing and beyond,

Chloe Lutts Jensen

Editor of Investment of the Week

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