Municipal bonds 'hemorrhage' $1.2 billion on Detroit fears

Adam Jeffery | CNBC

Municipal bond funds saw outflows of $1.2 billion in the week ending July 24, on concern that Detroit's filing for bankruptcy - the largest in U.S. history - will set an important precedent and more cities could follow suit. It was the ninth consecutive week of outflows from the fund type.

The move out of municipal bonds or munis began after the U.S Federal Reserve said it could scale back asset purchases later in the year, causing Treasury yields to jump.

"Caught up in the exodus from [Treasurys] and govies and the drama surrounding the nation's largest city filing for bankruptcy (Detroit), municipal debt funds (ex-ETFs) experienced net outflows for the ninth week in a row," Lipper said on Thursday.

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

Detroit bankruptcy followed years of a declining population and its once famous auto manufacturing industry.

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.

Detroit's decision helped to drive yields on 30-year AAA muni bonds higher to 4.14 percent on July 19, the highest since August 2, 2011.

(Read more: Judge halts lawsuits seeking to block Detroit bankruptcy)

Yields on 10-year AAA-rated bonds were steady at 2.76 percent on Wednesday and yields on top-rated 30-year bonds were at 4.31 percent, according to the latest data from MMD, a unit of Thomson Reuters.

Detroit's leaders have set an important precedent in siding with residents rather than unions and bondholders in their decision, Meredith Whitney wrote in the Financial Times on Wednesday, adding that it would not be a one-off and there are many more municipalities across the country in similar positions.

Whitney also painted a dire picture in a CNBC interview on Wednesday of cities slashing services and communities battling for mere survival.

(Read More: 'Neighbor vs. neighbor' in US cities, Whitney says)

"I think you're going to see a real issue of neighbor against neighbor on these very issues," she said. "That has been glossed over for years. What's at stake are social services we count on."

By's Matt Clinch. Follow him on Twitter @mattclinch81