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Detroit bankruptcy will answer tough questions

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The city of Detroit has capitulated, and will take its place in history as the largest U.S. municipal bankruptcy. This is unfortunate but widely expected. The Motor City and home of Motown has been in terrible shape for years. And the hardball tactics that Kevyn Orr, the corporate bankruptcy lawyer turned Detroit emergency manager, took with creditors and unions signalled that an out-of-court compromise was unlikely. After years of worrying that poor fiscal management would end in tears for the $4-trillion U.S. municipal bond market, investors will now be thinking about two very simple questions. The first is whether Detroit is a sign of things to come or due to unique circumstances. Second, will the city's blockbuster bankruptcy spook investors out of their other municipal bond holdings?

The answers, at least for now, are more nuanced. Any impact on other cities will remain unclear until the Detroit bankruptcy plays out. If it is perceived by other municipal leaders as a successful way to get out of crippling pension obligations, other troubled cities could well follow. How many? No one knows. Then again, Detroit's dire situation may mean it is an aberration. After all, U.S. housing and the economy are picking up.

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Regarding the fallout for muni bond prices, they face a bigger near-term threat from rising interest rates and the stock market. Wealthy U.S. individuals – the biggest buyers – typically move their money into stocks when interest rates are rising and rallying equities beckon. Just recently, for example, muni bond funds have seen eight consecutive weeks of net outflows totalling about $20-billion, according to Lipper.

An important detail of the Detroit bankruptcy is the value of the so-called general obligation pledge on certain muni bonds. These bonds are backed by the "full faith and credit" of cities and states. That often means that interest owed is the first budget expense that gets paid. General obligation bonds are perceived as some of the market's safest securities. Detroit wants its GO debt holders to take significant losses, lumping them in with unsecured creditors. The corporate bond market has a clear idea of the pecking order of creditors, perhaps because these rules have been frequently tested in bankruptcy. But muni bankruptcies are rare. One positive result of Detroit's long slide into bankruptcy could be clarity about the muni market's underlying risks.

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