Detroit bankruptcy case could bring unwanted change for muni market

Justin Solomon | CNBC

Detroit city grate is missing a cover. With cut backs to city services, Detroit's infrastructure has fallen into disrepair.

Detroit's bankruptcy is sending shivers through the more than $3.7 trillion municipal bond market, as investors worry the case will change the way certain bondholders are dealt with.

The municipal bond market is concerned on several fronts, but one of the thorniest problems is how the city's general obligation bonds will be viewed. Detroit Emergency Manager Kevyn Orr said that the city is treating its limited and unlimited-tax General Obligation bonds as unsecured debt, except for those backed by liens on state aid.

The market has been selling off, with other credit, since early May on talk from the Fed that it will likely pare down the size of its bond purchases before the end of the year. The 10-year Treasury yield has gone from a low of 1.61 percent in early May to 2.57 percent Thursday. In the same time frame, the 10-year 10 year AAA muni yield, as defined by the MMD scale, went from 1.66 percent to 2.75 percent.

The selloff triggered fund redemptions, and the selling has cascaded. Detroit is a relatively new concern in the selloff. Investors have been exiting municipal bond funds, with $2.5 billion of outflows in the last week alone and about $16 billion in the past five weeks, according to ICI data.

"The GO portion of Detroit's debt package is not so high relatively," said Patrick Early, chief municipal analyst at Wells Fargo Advisors. "The reason people are so concerned is there has been an expectation that GO is about as good as it can get, and even in a bankruptcy it ought to take priority over some other liabilities, and what Kevyn Orr is trying to do is treat all the unsecured debt with parity."

One type of bond Orr is targeting is the unlimited-tax GO bond, viewed as the highest order of muni security, as it is voter-approved, properly authorized and has unlimited taxing power, according to Blake Anderson of Mesirow Financial.

"It is the Cadillac of general obligation securities," he said.

(Read more: Detroit not a one-off, aftershocks will be staggering: Whitney)

GO bonds represent a relatively small portion—about $1.1 billion—of Detroit's total $18 billion in debt, Mesirow strategists said. The premium, unlimited-tax GO bonds total just under $500 million. Mesirow makes a market in some Detroit issues and other Michigan bonds. Other GO bonds do not have an unlimited taxing ability.

While the portion of its GO debt is small, Detroit could be making a big statement if its emergency manager gets his way.

"It would cause some havoc and some significant repricing in the market if that were found to be the case," Anderson said.

Because these types of bonds previously have been dealt with as sacrosanct, the market is assessing other GO bonds—particularly those on Michigan municipalities—for similar risk. If upheld, Orr's plan would be precedent-setting and could throw into question the pricing of hundreds of billions of dollars of debt.

As in the case of Detroit, there are municipal GO bonds that have state protection, and those additional security features may get a premium to other GO debt if Orr's plan goes ahead.

(Read more: How your city might pay for Detroit's money mess)

"If in fact it is upheld that they're allowed to dissolve the full faith and credit of general obligation bonds, then that will be priced into the market," said John Donovan, senior vice president at Drexel Hamilton. "I don't ultimately believe that will happen, so I don't think it's affecting the market. If it was affecting the market right now, you would see massive credit-spread widening, and we're not seeing that."

"People are paying attention. They are aware and they are concerned. I don't think it's radiating too far yet," Early at Wells Fargo said of the Detroit issues. "The ripples are there, but they're not killing the market so to speak. … Right now, it's probably more localized to Michigan and with municipal bankruptcy, there are so few settled municipal bankruptcies and the settlement that was adjudicated doesn't necessarily translate to the next municipal bankruptcy. I think the market does understand what's going on in Michigan could stay in Michigan, and right now there is concern about Michigan municipal GO."

About 40 percent of municipal bond market is GO bonds, and a municipality's debt service on such bonds typically is less than 10 percent of its budget, Early said. While it seems a Detroit issue would be contained to Michigan, the market is also concerned about contagion if Orr succeeds, he added.

Anderson said, "If the legal theories that are being asserted by the emergency manager and [law firm] Jones Day are upheld, it would not be a great thing for general obligation bonds, and the rating agencies would have concerns."

The state of Michigan "has extended itself pretty aggressively to their great credit in all these other emergencies," he said. "They have really built this great reputation of intervening as needed, up until now, and I think that's one of the reasons the market talk has been so negative. It's absence of support."

There is also concern about Detroit's water revenue bonds, Anderson said. Orr proposes restructuring the water and sewer department into a separate new agency and to substitute new bonds. Those bonds are backed by the water department's revenue stream and are not counted as Detroit bonds. Yields on the water bonds have gone from about 3.8 percent in early May to nearly 6 percent.

It was positive that a federal judge allowed the bankruptcy to go forward, as there will now be a process with a court overseeing it, Anderson said. "This is an opening bid from a very aggressive law firm and a manager here. … There's a lot of process between here and there."

(Read more: Detroit bottom could mean boom for entrepreneurs)

I's unclear how Orr would be able to modify the water bonds, Early said.

"They are statutorily protected revenue streams. … We have a hard time seeing how he actually forces an exchange," he said.

—By CNBC's Patti Domm