The municipal bond market has always been bifurcated. No, I don’t mean insured vs. uninsured bonds, although that is certainly true as well. There has always been (and still is) a consensus that a general obligation (G.O.) bond is king and anything else is at least a step or two below. The reason for that is simple: a G.O. bond is backed by the full faith and credit of the state or town that issued it. That definition means (or, I guess in the real world, implies might be a better word) the municipality will use all of its taxing power to pay off those bonds. Yes, even if they have to tax your house at 100% of its value, the city will do it to pay off these bonds. Of course, to get back to the real world alluded to above, that 100% tax would never happen, but still, the city (or state) has enormous power to enforce the payments on a G.O. bond. Other types of bonds are often at the whim of a particular taxing mechanism. For example, if the state builds a parking garage for a basketball arena, the bonds payments are taken from the revenue it generates. If the fans come out in lower numbers than assumed then the bond payments may be in jeopardy. In a G.O bond if taxes come in below expectations, well tough luck. Payments must still be made even if it has to be done by raising taxes.
Now in the latest mess out of the once great city of Detroit, a showdown is occurring which just might leave G.O. bond holders across the country shaking in their boots. The city’s unions are fighting for every penny they can get their hands on so as to shore up its pension that is, well, shaky at best. As you might imagine, their respect for the “full faith and credit” section of G.O. bonds, is not at a high level. In fact, they couldn’t care less, and have every intention of putting themselves above those G.O. bond holders, who took a “certain amount of risk”.
“Planning for retirement and working for employers was not an investment into the market,” he added. “These are people who are on a fixed income at this point in their life. They can’t go back to work and start all over again.” He said it was unthinkable to cut retirees’ pensions outside of bankruptcy.
As is often the case in politics, that statement appeals more to emotion than, you know, the actual laws, but it can nevertheless be effective. And that is why many municipal bond holders are watching Detroit very closely. If G.O. bonds are subordinated to, well, anything it could roil the market nationwide:
Public finance experts have warned that broad societal problems could follow a loss of faith in municipalities’ commitments to honor their pledges. In a major report on the state of the muni market last year, the Securities and Exchange Commission warned that communities would find it increasingly costly to raise money, throwing into question the time-honored practices of building and financing public works at the local level.
That might be putting it a little too gently. Yes, that statement is true, but it only really hints at the paradigm shift that would occur if G.O bonds’ status at the top of the food (tax?) chain was ever threatened. With plenty of municipalities in financial holes, any excuse to shave off some of their debts would be lunged at. In addition, if the courts put the public workers pensions on an equal footing as the G.O. bond holders, some serious recalculation will ripple through the muni markets and fast. As I am sure you all know, public pensions are at or near the top of most cities’ problems. Not only that, but future obligations, in most cases, are gigantic. As a matter of fact, their future obligations may be so high as to be mathematically impossible. If they get to jump up to the head of the line, then how much money will the G.O. bond holders really get in the end?
As usual, it is always a good time to review your portfolio. This ongoing event may encourage you to take a look right now. Your broker may have told you that G.O bonds are the safest ones out there, but that could be in danger of not being true any longer. How much pension debt does that state or town have that you invested in? It may already be more than they could possibly pay. Will you be left out in the cold? Well, no one knows of course, but it may pay to look into it before any rulings are made. Be prepared, as they say, and take a good look at your portfolio. You may have more municipal bonds than you are comfortable with, especially if you factor in the new added risk factor coming out of Detroit.