The Independent Market Observer

7/25/13 – Is the Detroit Bankruptcy the Beginning of the End?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 25, 2013 9:55:57 AM

and tagged Debt Crisis

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Short answer: no. Detroit is an exceptional situation, which was telegraphed well in advance, and investors and portfolio managers had lots of time to relocate their money if they were paying attention. Retirees, of course, may not be so lucky.

Longer answer: Detroit is a cautionary tale, but not the future. The city’s problems exceed those of almost any comparable municipality in the country, and the results certainly aren’t typical. At the same time, other states and cities face similar issues, if not of the same magnitude, and investors should be aware of them. We will see more situations like Detroit, but not enough to pose a systemic problem.

None of this is to minimize the effects of Detroit’s situation on local residents and pensioners. For them, the results could be catastrophic. For the market as a whole, though, the impact will be minor. According to Capital Economics, the total amount of debt at stake—about $18 billion—is less than 1 percent of all municipal bonds. The corporate bond market is twice the size of the muni market, and the Treasury market is three times the size. For the domestic bond market as a whole, Detroit represents about one-sixth of 1 percent. Not material.

So what does this mean? There are three groups in particular that should be paying attention.

First, investors in municipal securities. Once seen as “buy and forget,” munis now require more active management. Here at Commonwealth, we have an in-house bond research team that follows the market and analyzes individual bond issues to help keep clients out of situations like Detroit. Investors who manage their own money should do the same thing with their holdings. Typically, situations like Detroit’s are well telegraphed, so a reasonable level of monitoring should avert most of the risk

Second, taxpayers. While the fiscal situations of state and local governments have improved markedly over the past couple of years, the nature of pension liabilities is that they are long term. If the state or city you live in has an underfunded pension plan, chances are you’ll be paying for it at some point. As we are seeing with Detroit, pension obligations can only be shed under dire circumstances, which means that, in most cases, taxpayers will be on the hook for promises made decades earlier.

Third—and most directly—retirees, both current and prospective. If you’re looking at any pension at all, you need to consider the funding level of the plan and the financial strength of the sponsor. Think of your pension like a bank account—if you didn’t have deposit insurance. One study of funding levels among state plans can be found here. The problem may be even worse than presented there, as many public pensions use unrealistic return assumptions that overstate their funding levels. Anyone looking at these systems should be prepared to dig deeper.

What can people do if they are in a troubled system? For investors, sell and get out. Risky bonds may have a place in a diversified portfolio, but be sure you understand the risk and are getting paid for it. For taxpayers, potentially plan on moving. For retirees, note that if all of the taxpayers do move, you’re in trouble—so increase your other savings and investments accordingly.

Again, this is not a systemic problem, and it seems that any direct effects will be small, although potentially not on the Detroit retirees. At the same time, it does serve as a reminder that risks do remain in what is considered a relatively safe market. As always, paying attention will serve you better than not.

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