Big muniland haircuts
Are muniland bondholder haircuts a growing trend? Actually, recoveries (the principal and interest that the bondholders recover in a default) have varied a lot, according to a Moody’s municipal default report published in May:
Recovery rates are high but variable. Historical ultimate recovery rates on Moody’s rated defaulted US municipal bonds are generally higher than those for unsecured corporate bonds. On average, the ultimate recovery for municipal bonds was about 60 percent for the period 1970-2012, compared to 49 percent ultimate recovery rate for corporate senior unsecured bonds over 1987-2012. However, municipal recovery rates for the relatively small subset of defaulted bonds are highly dispersed across individual bonds, ranging from full recovery to two cents on the dollar.
When you drill into Moody’s default data, there is only one local government bond default where the recovery was less than 100 percent – the Belfield Limited Tax General Obligation default in 1987 – where bondholders ultimately recovered 55 percent of their principal (page 14). There were also recoveries of less than 100 percent on non-general obligation bonds. The low recoveries were almost always associated with housing or hospitals projects.
Jefferson County, Alabama is near an agreement with its bondholders to resolve the county’s bankruptcy. According to Moody’s, the agreement will require principal haircuts of about 40 percent – a recovery rate of about 60 percent. But those losses are not spread equally among bondholders. According to Al.com, the county’s bankruptcy attorney Kenneth Klee said that some creditors would take larger losses:
Klee said the agreement means creditors will receive about $1.835 billion instead of $3.078 billion. JPMorgan will give up about $842 million of the $1.2 billion in sewer debt it holds, according to Klee. In all, JPMorgan will give up about 88 percent of its total claims, he said.
We are definitely entering a new era for bond default losses.
In Detroit, the Emergency Manager Kevyn Orr is calling for bond haircuts, according to ClickonDetroit.com:
Orr wants to make deals and concessions with creditors and debt holders to forgive some of the money Detroit owes to them. Orr said he wants to avoid a bankruptcy filing, but he is determined to do whatever is needed to help the city recover.
“I have a powerful statute and I have an even more powerful Chapter 9. I don’t want to use it but I am going to accomplish this job,” Orr said.
Detroit has $8 billion in bonds outstanding. Fortunately, $5.4 billion are revenue bonds that should be insulated from a reorganization of Detroit’s debt. These revenue bonds were issued by the water and sewage systems and are secured by their revenues; payments don’t come from the city’s general operating revenue. Even if Detroit files for Chapter 9, we believe these bondholders should continue to be paid.
Unlike Jefferson County, the revenues of the Detroit sewer and water systems are sufficient to cover debt payments on the systems bonds. But other Detroit bonds could be treated differently, according to Rosenblum and Jenkins:
Most of the remaining categories of debt listed below will likely have wildly different recovery rates:
- General obligation bonds backed by an unlimited tax pledge ($369 million)
- General obligation bonds additionally backed by state aid ($479 million)
- General obligation bonds backed by a limited tax pledge ($161 million)
- Pension obligation certificates backed primarily by general fund payments ($1.5 billion)
General obligation bonds backed by an unlimited tax pledge are generally considered very safe municipal debt. In Detroit’s case, the revenues that service these bonds were approved by voters and are paid from a dedicated property tax levy. We believe the recovery rate will be high, but it may not be 100 percent.
The state-aid bonds are backed by separate revenues collected by the state and remitted directly to the trustee and are also likely to have a high recovery rate. The other two categories are essentially unsecured debt, and these bondholders may not receive close to their full interest payments and principal.
This is important commentary for muniland that mirrors conventional wisdom. What really caught my attention were the comments about bond insurers that wrap Detroit debt:
Although all creditors may share in the pain to varying degrees, the size of the loss to bond investors will also depend on the loss that bond insurers can absorb – because these bonds are in fact backed by municipal bond insurance. We believe that at least some of the bond insurers have sufficient reserves to meet the annual debt service on bonds pulled into a restructuring and are likely to do so.
Bond insurers have exposure in bankrupt Stockton, insolvent Harrisburg and tettering Puerto Rico, among other places. This is a new concern for muniland. Big bond haircuts among insolvent muniland issuers are sure to continue. A new research topic for investors will be legal protections and priorities for different categories of debt. We are far from sorting out all these issues.