Bondholders stand to be among the biggest losers in the latest wave of municipal bankruptcies if current trends continue, but the trend surprisingly may not sour future investors.
The creditor group could recover as little as 50 cents on the dollar in bankruptcy trials in Detroit; Jefferson County, Ala.; Stockton, Calif. and Harrisburg, Penn., according to research by Moody’s Investor Services. The recovery is far below the average of nearly 80 cents on the dollar for defaulted municipal bonds since 1970.
But restructuring plans for Detroit, Jefferson County and Harrisburg all depend on the municipalities' ability to continue to borrow as they call for new financings to partially repay existing bondholders. It’s a trend that Moody’s analyst Dan Seymour says is relatively new among restructuring strategies.
The strategy carries risks – most notably that interest rates will rise and the plan won’t work as proposed. That’s what’s happening in Jefferson County, which declared bankruptcy in 2011, and is proposing to issue new bonds and redeem defaulted ones at a loss to bondholders. But in the months since the plan to partially refund $3.2 billion in bonds was first proposed, interest rates have increased, meaning it's more expensive now for the county to borrow. So, county commissioners are asking bondholders to take a deeper cut – an additional $350 million in concessions to make the bankruptcy exit plan viable. That moves the group from taking a loss of about 40 cents on the dollar to losing half their investment value.
The proposed recoveries for Detroit and Harrisburg also would involve the issuance of new debt (to a lesser degree). Bondholders can vote against the plan but municipalities have the option to “cram-down” their plan of adjustment as long as another creditor group approves it.
It’s a stark contrast to just a few years ago in Central Falls, R.I., where officials sought to keep the city’s borrowing ability intact and made bondholders whole by cutting retiree pensions. (The former mill town was also helped by a new state law that secured the city’s general obligation bonds in the event of bankruptcy, having the effect of putting bondholders first in line for recovering their money.)
But what about the effect of Jefferson County’s strategy on its already high-risk (Caa3) credit rating?
“They can’t get much lower,” says Moody’s analyst Greg Lipitz.
Bondholders in Detroit face a potentially worse recovery as Emergency Manager Kevyn Orr in June proposed paying back just 10 percent of the city’s debt. The plan was immediately rejected and the city filed for bankruptcy a month later. Orr is now attempting to shift more of the cost burden onto employees and retirees by cutting pensions but that will be a hard-fought battle as the legality of cutting pensions, protected by the state constitution, is an unknown in federal bankruptcy court. Orr’s planned cuts to retiree healthcare (benefits that are not protected) has already prompted a lawsuit filed this week by groups representing workers.
In Stockton, bond insurer Assured Guaranty argued that pensioners (via the California Public Employees' Retirement System) should take their place in line with other creditors rather than be made whole. But the Northern California city is instead proposing no cuts to pensions and recovery rates varying between 1 and 100 percent for bondholders. As the largest creditor, Assured Guaranty is slated to receive about 50 percent of what it is owed.
Harrisburg’s recovery plan could be the most generous for bondholders; its exit proposal would refund roughly 60 to 70 percent on total defaulted principal and accrued interest for General Obligation-guaranteed resource recovery bonds. (Harrisburg also does not seek to cut pensions.) Ultimate recoveries may prove to be higher over the longer term, Moody’s notes, given that the plan outlines the potential for additional future revenues for creditors. Still, “an inability to execute the plan could lead to lower recoveries,” the ratings agency says.
Bondholders are losing because of the nature of these types of municipal bankruptcies, Seymour says. Issuers are faced with long-term, fundamental credit deterioration instead of short-term cash flow problems as in municipal bankruptcies of the past. These challenges include mounting pension costs and other post-employment benefits, a weak overall economic recovery, and declining revenue sources, such as state aid and property taxes. In extreme cases these persistent credit problems may lead to default on bonded debt.
“In these, the cause of default is long-term insolvency,” Seymour says. “Issuers are not able to provide basic services and pay their debt at the same time.”
The varying fates of bondholders has led to uncertainty about the group’s status in Chapter 9, especially in light of the fact that most cities are avoiding any cuts to pension obligations. But a recent Moody’s report on the situation observed that there is still an appetite for investment, even in shaky municipalities, from “hedge funds and other nontraditional buyers who are more accustomed to the high yield market.”
That prospect may also mean that scenarios like Central Falls’ protection of creditors are a thing of the past: “To the extent that issuers retain market access at a tolerable cost,” the report says, “then the disincentives to bankruptcy and/or default would be greatly diminished.”