Barnet Sherman, Portfolio Manager, TIAA-CREF Tax-Exempt Bond Fund
Joel Levy, Senior Municipal Analyst, TIAA-CREF Fixed Income Research
July 23, 2013
Detroit became the largest city to ever file for municipal bankruptcy on July 19, leading to questions from investors about the overall impact of this event on the municipal bond market and the potential for further municipal bankruptcies. Detroit’s financial problems have been well-documented and this filing did not surprise most market participants. But while the filing was largely expected, there have been relatively few municipal bankruptcies over the last several decades, which make this a landmark event for an asset class known for its stability. There are many complex questions about how Detroit’s problems will get resolved, but we believe most investors will feel little impact from this event.
Barnet Sherman, Portfolio Manager of the TIAA-CREF Tax-Exempt Bond Fund, and Joel Levy, Senior Municipal Analyst and member of the TIAA-CREF Fixed Income research team, say that Detroit’s bankruptcy appears to be an isolated event in the municipal bond market and that the effects are not expected to spread into the larger market. In this Q&A, they discuss the recent filing and the potential impact on investors.
I have been reading many different media reports about Detroit. What happened?
On July 18, 2013, Detroit filed for Chapter 9 bankruptcy protection. It was the largest municipal bankruptcy in U.S. history. The filing has the legal effect of stopping the enforcement of certain financial obligations while allowing the city to prepare a solution with its creditors. It is fully expected that all creditors, including bondholders, will receive less than the amount they are owed.
Does TIAA-CREF own any municipal bonds in the City of Detroit?
No. TIAA-CREF does not own any direct municipal bond obligations of the City of Detroit or its related entities.
Is Detroit a harbinger of other large municipal filings?
We do not believe so. Due to individual state laws, each municipality is unique and should be assessed on its own merits. Detroit has been suffering financial difficulties for many years and market participants had been expecting this filing for more than a year. The city’s financial difficulties are well-documented, having paralleled the decline of the U.S. automotive industry in the area. Since 1970, the city has lost more than 50% of its population, which in turn has led to a dramatic reduction in its tax base. As tax revenues declined, Detroit’s large fixed expenses increased — most notably in unfunded pension obligations, which are estimated to be greater than $3.5 billion. This structural imbalance was not rectified, forcing the city into a financially untenable position and, ultimately, compelling it to file for bankruptcy protection. Detroit continues to operate under an Emergency Manager, who was appointed on March 14, 2013.
Can any state or municipality file for bankruptcy?
No. Federal bankruptcy code, along with the U.S. Constitution, prohibits states from entering bankruptcy. Municipalities, such as Detroit, are only permitted to enter bankruptcy if their state legislature specifically allows it as part of their municipal law. In addition, a federal bankruptcy judge has to agree that no other option, including raising tax rates, is appropriate.
Historically, municipalities have met strong judicial resistance in court. Most recently, the county of Boise, Idaho, and the city of Harrisburg, Pennsylvania, each had their cases dismissed by a federal judge, while Stockton, California, was permitted to continue the proceedings.
Additionally, municipalities need access to the capital markets to run their core services, which can be difficult after filing for bankruptcy. Therefore, they take that step only as a last resort.
How will Detroit’s bankruptcy filing affect municipal bonds in general?
We do not anticipate immediate material changes to the market as a result of Detroit’s bankruptcy filing. Detroit’s filing emphasizes the need for extensive research prior to making an investment decision. Additionally, a diversified portfolio of well-researched credits significantly reduces the long-term risks for investors. Research is an on ongoing process and continues long after an investment has been purchased.
TIAA-CREF has a long-term investment perspective, which we believe benefits us and our investors. While the Detroit bankruptcy filing could cause some volatility in municipal markets in the days and weeks to come, we believe investors should keep a long-term perspective, which is one that stretches out over years, not months or even quarters. Investors that take a long-term view can reinvest their dividends in periods of volatility, thus reaping the benefits of compounding returns while avoiding the effects of daily price fluctuations.
To read more about Barnet Sherman’s recent insight on municipal bonds, please see “Muni Bonds: Looking past today’s volatility.”
TIAA-CREF is a national financial services organization and the leading provider of retirement services in the academic, research, medical and cultural fields. Further information can be found at www.tiaa-cref.org. Securities are distributed through TIAA-CREF Individual & Institutional Services, LLC, and Teachers Personal Investor Services, Inc., registered broker/dealers, members FINRA, distribute securities including the TIAA-CREF Tax-Exempt Bond Fund (Ticker: TIXRX). The Fund’s investment advisor is Teachers Advisors Inc.
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