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The Detroit decision with trillions on the line

Monday, 22 Jul 2013 | 2:05 PM ET
The battle over Detroit
Monday, 22 Jul 2013 | 8:30 AM ET
CNBC's Scott Cohn offers the latest news on Detroit's bankruptcy. Peter Hayes of BlackRock discusses the bankruptcy and how $1 trillion in muni bonds could be affected.

In the early days after Detroit's bankruptcy filing last week, concerns are mounting in the municipal bond market over how a certain type of the city's debt will be classified—a decision that could cause a nationwide ripple effect for millions of investors who thought their money was safely tucked away.

As part of Detroit's restructuring plan, Emergency Manager Kevyn Orr wants to treat general obligation (GO) bonds as unsecured debt. If that request is approved by the bankruptcy judge, the $3.7 trillion muni-bond market could be turned on its head, as would the long-held assumption that GO bonds represent a relatively risk-free investment.

(Read more: Detroit can't wait for federal cavalry, Orr says)

Treating GO bonds as unsecured would put them on an "equal footing with all other unsecured creditors," including pension and lease obligations, and retiree health-care benefits, warned Peter Hayes, managing director and head of the municipal bonds group at BlackRock.

"With GO bonds, you're talking about the full faith and credit," he said in a "Squawk Box" interview Monday. "Whether it's a city, a state or a federal government, it's basically 'sovereign-like debt,' where they pledge the ability to raise taxes or cut spending in order to pay back that debt service."

Hayes acknowledged that Detroit's steep population decline, high unemployment rate and sinking property values have limited its ability to raise taxes. It's also "very difficult to cut spending further," he added.

(Read more: Tear down chunks of Detroit: Billionaire landowner)

In an op-ed before the official bankruptcy filing, Hayes wrote in the Detroit Free Press that "breaking the promise to GO bondholders and treating all unsecured creditors equally could set a dangerous precedent with far-reaching implications—in Detroit, in Michigan and beyond."

Meanwhile, Moody's Investors Service said Thursday that the Detroit bankruptcy is a credit negative, because it creates uncertainty for bondholders; will likely interrupt payments on general obligation and limited tax bonds; and begins a process that may span years.

On Wednesday, the credit rating agency lowered Chicago's general obligation and sales tax ratings to A3 from AA3 because of the city's large and growing pension liabilities and the budget pressures related to them. The move affects $8.2 billion of Chicago's GO and sales tax debt, Moody's said in a statement.

Detroit's financial problems, and those of other cities and states, have already taken their toll on the muni-bond market this year.

In the week ended Thursday, investors had pulled a net $1.56 billion from U.S. municipal bond funds. It was the eighth straight week of net outflows and the largest in three weeks, said data-tracking firm Lipper, a unit of Thomson Reuters.

The S&P Municipal Bond Index has fallen more than 3 percent this year.

—By CNBC's Matthew J. Belvedere. Follow him on Twitter @Matt_SquawkCNBC. Reuters also contributed to this report.

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