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In light of recent bankruptcies in California, supposed experts have commented that other municipalities will find it less of a taboo. Isn't the real problem behind a bankrupted municipality its inability to borrow? Why isn't more being made of this point?
- G.W., Michigan
Despite media reports to the contrary, we don't expect other municipalities to follow Stockton's lead. Although bankruptcy may seemingly provide some immediate relief, the long-term consequences are too onerous to be taken lightly.
After three years, Vallejo, California, emerged from bankruptcy in November 2011. It has a much smaller city government and a notable shortage of services, including major reductions in firefighters and police. There has also been a migration of residents because, as Mayor Osby Davis said, "nobody wants to be from a bankrupt city."
As in the case of Vallejo, you can be certain that Stockton has sacrificed its ability to access the municipal bond market. It is not lost on other city managers and local officials that no investors or bond insurers will accept a general obligation pledge from a city that sought bankruptcy protection.
As for your insightful question on why more isn’t being made of this point: Sensationalism sells, with the saga of Meredith Whitney's prognostications a case in point. Attention-grabbing headlines are difficult to elicit from reporting that shows things will be status quo.
Using the best rates that can be found, would you please explain if it is better to invest in zero coupon bonds or traditional bonds? Assume I would reinvest (likely in a savings account, until I have the minimum to reinvest in other bonds) the semi-annual money I receive from the traditional bonds.- J.P.,Pennsylvania
There is no simple answer to your question.
Assuming zero coupon bonds are held to maturity, they will accrete at the stated yield. Therefore, you can precisely calculate your return and proceeds at maturity.
On the other hand, by reinvesting the interest from coupon bonds, your total return will vary based on reinvestment rates over the term of the bonds.
Zero coupon bonds add balance to an equity-heavy portfolio and are an excellent vehicle for funding a future event such as a grandchild’s college education or any balloon payment. For more on zero coupon bonds, see: “A Prescription for Growth.”
What is your opinion regarding the safety of the city of Detroit's general obligation, water and sewer munis?- W.L Michigan
As you are aware, the city of Detroit has been in financial distress for quite a while. As a result of the city’s inability to overcome its chronic budget problems, the governor has appointed an Emergency Financial Manager who will have significant ability to make budget reductions, alter existing contracts and can even recommend to the governor that the city file for Chapter 9 bankruptcy. The law under which the manager was recently appointed took effect March 28, 2013; he has only recently taken office.
We believe that the manager would be reluctant to allow the city to default on its bonds because access to the financial markets for capital projects is the lifeblood of any municipality. However, the financial problems of Detroit are sufficiently severe that some sort of debt adjustment or restructuring cannot be ruled out. This would especially be the case should the city file for bankruptcy.
The enterprise debt of the city, i.e., water and sewer, would likely fare better than other city debt in such a case since those bonds are paid by a dedicated revenue stream. Typically, such debt has been allowed to continue to use system revenues to pay debt in other communities facing distress. In Detroit’s case, the water and sewer systems also serve other communities outside the city, and there would likely be a reluctance to take actions that would affect entities outside of the city.
Standard & Poor’s rates Detroit’s GOs “B” and Moody’s assigns the city a rating of “Caa1.” Both rating agencies cite the great uncertainty ahead as to whether the city’s debt repayments will continue unaffected by the appointment of the emergency manager and the potential of a bankruptcy filing. Of course, bonds that carry insurance are expected to be paid on time, as they have in the past. The city is entering uncharted waters and we will watch events carefully as events unfold.
This report is produced solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. This report is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.