July 19, 2013
David R. Kotok
Long awaited and now finally arrived, Detroit’s bankruptcy was expected and priced into markets. Some Detroit debt had been trading down to 30 cents on a dollar prior to the announcement.
Let’s dig into this news. Detroit will now be a poster child. It will reveal the tragic decline in the economics of many cities and other jurisdictions that did not correctly manage their fiscal affairs.
The news is filled with photographs of empty buildings and reports of population declines. The statistics show the remaining residents’ income deterioration. The high taxation rates implemented to correct imbalances completely destroyed the fiscal viability of the city.
In the days of the Wild West we had ghost towns when the ore ran out. In the modern world we have large unfunded liabilities, a population drain (Detroit lost two-thirds of its peak 2 million) and then a financial wreck.
We will have a bankruptcy fight to watch. Conflicting interests will battle over payments. This afternoon, a judge ordered a reversal of the bankruptcy action. So the courts are now in a fight with the State’s Governor as legal combat attempts to preserve pension benefits which are unfunded and not economically viable.
Who will get paid, who will lose money, and how much? The battle will rage. Labor contracts will be rewritten, and pension benefits will be reexamined. Unsecured creditors, derivative counterparties, and vendors will compete for a limited pot of money. Secured creditors may take haircuts. This fight will be over many innings and will not be quickly resolved.
While we watch this denouement unfold in Detroit, much as we have watched it unfold in other cities, Cumberland takes a more disciplined approach with municipal bonds. Stay away when credit is questionable. Do not get sucked into a higher yield on a weaker credit. It is all about credit.
At Cumberland, we look at everything the rating agencies do and say. We also analyze and score credit internally. We combine research to synthesize a judgment about whether to buy, sell, or hold a specific bond.
Remember all municipal bonds are idiosyncratic securities: they are not all exactly alike. Their structures, priorities of payments, intricacies of clauses in bond indentures, and pricing of various options within the bond indenture all reflect the individual characteristics of each bond. Homogeneity does not exist in the specifics of municipal bonds.
In the old days bond buyers used to say, “Well it’s insured and rated AAA – that’s all I need to know. Just give me the coupon, call date, and maturity date.” Those days are gone and will not be back for a long time.
There are over 90,000 municipal entities in the US. There are approximately 40,000 separate bond issues that trade in sufficient depth for information to be tracked in databases. Bond investors need to understand that this specific type of municipal bond credit research and resulting assessments are more important than ever.
We would like to suggest a metaphor. There are approximately 6,000 stocks trading in the U.S. They are widely followed by advisory companies and are collectively assembled in over 1,000 ETFs (exchange-traded funds). They get a lot of attention.
There are almost seven times as many separately trading bond issues as there are stocks. These are collectively assembled in a few mutual funds and a few ETFs and are mostly held in passive structures or by passive investors. Think about it: seven times as many instruments, perhaps, get one-seventh of the scrutiny of stocks in terms of detail. Many analysts estimate the earnings for IBM. Few analysts dissect the trust accounting of a major city.
Detailed research and data tracking are critical in this $3.7 trillion asset class of municipal bonds. When it comes to the data, governmental units are usually more transparent than corporations are. Public bodies and reporting systems make relevant information available, although the structure of the information portrayal is complex. Despite its complexity, municipal bond data is available; all you have to do is examine it. In 99% of the cases, it is forthright and can be relied upon.
Any bondholder that holds Detroit debt today asked to be put at risk for this event. Detroit’s financial disaster was visible and predictable. If the bondholder suffers a loss, so be it. At Cumberland, we hold only one small Detroit piece and it is insured by Berkshire and is rated AA.
Credit is the key component in Muni-land. The rules by which this $3.7 trillion asset class should be addressed are straightforward: (1) perform credit analysis, (2) make sure you get paid, and (3) walk away from trouble fast.
We will watch the events in Detroit transpire and learn from them. Detroit joins a growing list of troubled municipalities in the U.S. Its predecessors like Harrisburg, PA, and Vallejo, CA, are part of that list.
The best advice for investors is to stay away from tomorrow’s bankruptcy. There is plenty of evidence to afford early warning signs.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors