In recent weeks, Detroit's bankruptcy trial and its implications for the $3.7 trillion municipal bond market have been lost amid the news coverage surrounding the mid-term elections. Lawyers for the Motor City have delivered their closing arguments before Judge Rhodes, who is now expected to issue a decision on Friday. As we await his ruling, munis face a truly momentous time.
First, it is worth taking stock of recent developments in California. After warning the City of Stockton that its pension obligations did not enjoy a privileged position in federal bankruptcy court, U.S. Bankruptcy Judge Christopher Klein proceeded to confirm the city's plan of adjustment. Judge Klein's decision to overlook the disparate treatment accorded pensioners and capital-market creditors disappointed municipal-bond investors, who had hoped for better treatment in the wake of his Oct. 1 decision that pensions deserved no more protection than other contractual obligations.
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Meanwhile, in Detroit, the city initially classified its general obligation bonds as unsecured debt before settling with creditors for less than 100 cents on the dollar. The State of Michigan actively promoted a plan to protect Detroit's vast art collection, recently valued above $2.75 billion, even as the city was seeking concessions from its capital market creditors. Judge Rhodes is now obliged to review a plan of adjustment where the losses imposed on capital-market creditors are far more punitive than the haircuts given to pensioners.
We believe the treatment of bond investors by Detroit and Stockton represents the bleeding edge of a trend that accords a higher priority to some public expenditures over others. And as we survey the wreckage left in the wake of Detroit's decision to file for protection from its creditors, we believe that the municipal-bond market is on the cusp of profound change. Distressed governments have always been obliged to protect the health and safety of their citizens and to make difficult decisions regarding the allocation of scarce resources when budgets are tight. The difference today is that some governments appear more willing to forego a negotiated solution with their bondholders in favor of a more confrontational approach.
The notion that municipal-bond investors are exposed to greater systemic credit risk from rising pension liabilities has been a recurring refrain for some time now. We have been reluctant to add our voices too loudly to that chorus out of concern that the message might be too easily misinterpreted. After all, the absolute number of municipal bankruptcies recorded each year has not increased in the wake of insolvency declarations from Stockton, San Bernardino, Jefferson County, and Detroit.
State and local governments are reporting higher revenue as the economic recovery gains traction. And the U.S. equity market's strong performance has bolstered the financial position of most state pension funds, at least temporarily. Most municipalities will manage their expenditures, gradually amend their collective bargaining agreements, and endure the adverse impact of the next recession without resorting to debt renegotiations.
However, while very few municipal governments are headed for financial distress, we expect that local governments so situated will adopt a more adversarial posture towards capital markets creditors in the wake of Detroit and Stockton. In the framework created by these two cities, a municipal government's general fund obligations appear to be structurally subordinate to its pension liabilities. Investors should position their portfolios accordingly. In an era when the pension liabilities of local governments remain a concern, investors may want to consider the debt offered by established public enterprises – airports and utilities, for example – as an attractive alternative to lease revenue and pension obligation bonds.
Commentary by Thomas McLoughlin, head of municipal fixed income at UBS Wealth Management Americas. Follow UBS on Twitter @UBSamericas.