Detroit bankruptcy rattles muni bond investors

• Muni bond investors are fearful of the effect of Detroit%27s bankruptcy
• Detroit bonds had been trading down ahead of the news
• High-yield muni bonds are not reacting strongly to the news%2C yet

Detroit's bankruptcy protection filing is introducing the word fear to the vocabulary of investors who have sought shelter in the municipal bond market.

Already, municipal bond owners and the cities themselves are wondering if the long reputation that municipal bonds were a safe place to be is a faulty assumption now that Motor City has filed.

Hardest hit so far have been Detroit's pension fund taxable securities, which are trading for between 30 cents and 40 cents on the dollar, says Matt Fabian of Municipal Market Advisors. But the real test for the municipal bond market will come next week as individual investors assess their positions and decide if adjustments are needed, he says. "Detroit's paper is taking it on the chin," Fabian says. "But the question is if retail (investors) sell off (municipal bonds beyond Detroit) next week or the week after .... it takes them longer to react."

What investors decide about the fallout from Detroit stands to have a huge effect on the municipal bond market, says Bill Larkin of Cabot Money Management. Municipal bonds have long carried yields that are about 85% of those of Treasuries, offering a huge cost benefit to cities, he says.

If the bankruptcy of Detroit causes investors to demand more protection, they might bid muni bond yields closer to that of Treasuries, forcing cities to pay more interest costs.

"Depending on the outcome of this, if the (Detroit) bondholders take a haircut, people will look at the (muni bond) market much differently, and want protection," Larkin says.

Even before the news of the bankruptcy filing broke, investors in Detroit debt were already looking for added compensation. Detroit unlimited general obligation bonds, generally considered to be among the safest, with maturities in April 2028, traded with an average yield of 5.73%, says Bloomberg News. That is 2.5 percentage points more than comparable debt from other issuers, Bloomberg News says.

Investors have seen Detroit's problems coming, Larkin says. Detroit's struggles "have been in the pipeline for such a long time. It sounds alarming, but almost everyone on the Street holding this debt knew," he says.

While the Detroit problem could send shock waves through the system, right now, investors are taking it calmly. The SPDR Nuveen S&P High Yield Municipal Bond exchange traded fund, which tracks the bonds of cities with low credit ratings, was essentially unchanged Friday, down 0.2% to $52.45.

It's difficult to gauge the true impact of the Detroit news since muni bonds were already falling ahead of the bankruptcy announcement as investors shift more into stocks, Fabian says. Muni bonds "were already under pressure," he says. "Detroit comes at a bad time. It makes things worse and hard to tell the impact."

Chapter 9 municipal bankruptcies remain very unusual. Including Detroit, there have been five filings this year so far, says Tom Kozlik of Janney Montgomery Scott. All of last year, there were 12 Chapter 9 municipal bankruptcies.

Investors suspect that some outside government source might step up and fund the losses in Detroit, Cabot says. "We bailed out GM. We bailed out the banks. Do we not bail out our own country?" Cabot says. "At this point, this is something critically important to watch."