— Although a municipality filing for bankruptcy protection is rare, you still ought to be paying attention to what happens to bondholders in the case of Detroit.
The city's Chapter 9 filing will likely set some precedents including how investors and/or their investment advisers view municipal bonds, also known as munis.
"I think that the potential risks to the municipal bond market are serious," said David D. Tawil, co-founder and portfolio manager for Maglan Capital, a New York investment firm that specializes in distressed assets. "At the very least, municipal bonds will no longer be considered a risk-free asset."
Detroit's filing comes at a time when the Securities and Exchange Commission is increasing its investigations of municipalities that aren't being upfront about their finances in disclosures about their bonds.
Earlier this month, the SEC charged the city of Miami and its former budget director with securities fraud related to several municipal bond offerings. The SEC alleges that misleading financial information was given to investors.
Municipal bonds have significantly lower rates of default than corporate or foreign government bonds. "Nevertheless, municipal bonds can and do default, and these defaults can negatively impact investors in ways other than non-payment, including delayed payments and pricing disruptions," the SEC said in a report last year.
As Detroit's bankruptcy progresses and other municipalities face greater scrutiny over their lack of disclosure, it could affect the reputation and cost of municipal bonds, some experts believe. But even if that doesn't happen, watch and learn more about an investment you might have in your portfolio but may not really understand.
When states, cities, counties and other governmental entities need to raise money to build highways, hospitals, schools, libraries, sewer systems or other public projects, they may issue bonds or debt obligations. Investors lend the municipalities money to pay for the projects in exchange for a promise that they will get back their principal at a specified maturity date plus interest paid at a specified time. The appeal of many munis is the state and federal tax exemption on the interest.