Detroit Will Save Municipal Bonds!

“So how could that be good news for municipal bonds, especially since editorialists have had a field day expatiating on the contagion effect of the decision on other municipalities? It is good news because it is bad news, and the bad news has already beaten down the value of bonds.” Sanford Rose

Dolors & Sense

By Sanford Rose

KISSIMMEE Florida—(Weekly Hubris)—8/12/2013—Detroit Will Save Municipal Bonds? That has to be a typo, knowledgeable readers will insist.

Detroit is bankrupt, and its emergency manager has said that its bondholders will have to queue up with the rest of its numerous creditors. No special rights for the so-called general obligation bondholders, even though many were promised that unlimited taxes would be levied to pay them off.

So how could that be good news for municipal bonds, especially since editorialists have had a field day expatiating on the contagion effect of the decision on other municipalities?

It is good news because it is bad news, and the bad news has already beaten down the value of bonds.

But bear in mind that the Detroit debacle is not the only negative influence on values. Muni prices have been tumbling since June because general interest rates have been rising (prices and rates behave inversely), and the tax advantages of munis are threatened by an Administration budget proposal.

A couple of months ago, a high-quality municipality could have raised long-term funds at an interest cost of about 4 percent. Today, that same city would have to pay 5 percent.

A 25 percent increase in borrowing costs can put many a job-creating highway or bridge-building project on hold.

And if the threat to tax exemption embodied in the budget proposal materializes, costs will increase still more, with obviously even greater negative impacts on infrastructure spending.

This argues that the Administration may stay its hand on the budget proposal, lest it be accused of “piling on” the tottering market and undermining its own professed job-creating endeavors.

(The budget proposal, by the way, is not new. It is based on the idea that tax exemption is an inefficient way to subsidize cities. Critics of the proposal contend that it is supported by bad data that overstate the yield required to clear the market and therefore understate the marginal tax rate of the marginal muni buyer.)

Since the budget proposal is probably the biggest threat overhanging the municipal market, it is conceivable that a smaller, but more headline-generating, negative influence, such as Detroit’s default, can, by forestalling the larger danger, lead to a substantial recovery in values.

Bad news can at times be good news.