pimco viewpoint after detroit rigorous research and credit selection is the key to investing in...

7/27/2019 PIMCO Viewpoint After Detroit Rigorous Research and Credit Selection is the Key to Investing in Municipal Bonds P

1/4

ViewpointOctober 2013

Your Global Investment Authority

David HammerSenior Vice PresidentPortfolio Manager

Sean McCarthy

Senior Vice President

Municipal Credit Analyst

After Detroit: Rigorous Researchand Credit Selection Is the Keyto Investing in Municipal Bonds

Detroit recently declared bankruptcy, setting off the largest

municipal Chapter 9 proceeding in history. There has been

and will continue to be a lot of noise in the media,underscoring challenges but also presenting opportunity for

experienced investors. In this interview, PIMCO senior vice

president and municipal credit analyst Sean McCarthy and

senior vice president and municipal bond portfolio manager

David Hammer discuss the outlook for the muni market.

Q: What are your expectations for Detroits Chapter 9 process now that

the city has filed for bankruptcy?

A:We expect that the bankruptcy process will be rife with headline controversy

and legal challenges, and investors should prepare themselves for a long and

contentious process with a lot of noise. Ultimately, there are several potentially

precedent-setting issues that will be decided by the federal bankruptcy judge. It

is worth noting that the Chapter 9 process may be unfamiliar to many traditiona

municipal bond investors as municipal bankruptcies are rare relative to corporate

bankruptcies. Unlike the corporate Chapter 11 process, only the debtor (i.e.,

Detroit) can file a formal Plan of Adjustment under Chapter 9. There is also no

liquidation test to protect bondholders in Chapter 9 since a municipality cannot

be forced to liquidate its assets. These differences could ultimately set the bar

low for overall recoveries. The emergency managers restructuring proposal for

Detroit contemplates a recovery for unlimited tax general obligation (GO) bonds

that is far lower than the historical average for municipal GOs.

The restructuring proposal contemplates a haircut on unfunded pension

liabilities, which are protected from impairment in the State Constitution in

Michigan, and gives all of the City of Detroits creditors equal priority across the

capital structure, including holders of unlimited tax general obligation debt.


2/4

OCTOBER 2013 | VIEWPOINT

Any rulings contrary to the perceived priority of payments

in the municipal market will be challenged by adversely

affected creditors and may serve as precedent for future

Chapter 9 filings, making the situation in Detroit relevant

to all municipal market investors.

These facts all suggest a long and complex road to the

ultimate reorganization of the citys liabilities. The

emergency manager is targeting a September 2014 exit

from bankruptcy, but a conclusion may take several years.

In addition, the importance of the rulings may ultimately

lead Detroits case to the U.S. Supreme Court, which may

need to decide on issues of state sovereignty, including

whether federal law (Chapter 9) supersedes state law

(Michigan constitution) with regard to reducing pension

benefits.

Q: Is the Detroit bankruptcy an idiosyncratic event or

a sign of systemic stress in the municipal bond

market?

A: Detroits economic collapse was attributable to a variety

of long-term secular trends specific to both the city and

the U.S. automotive sector, which steadily lost global

market share over three decades. These trends initiated a

feedback loop that drove the destruction of the citys tax

base. The citys fiscal condition eventually became

untenable when revenues were overwhelmed by rising

debt service, including expenses owed to retirees.

Investors in municipal bonds should consider carefully the

promises governments have made to public sector

employees and whether they are willing and capable of

meeting those promises in the future. According to

research compiled by the Center for Retirement Research

at Boston College, which included data for plan assets for

90% of U.S. states and 30% of U.S. cities, the total

unfunded pension liability was approximately $1 trillion for

fiscal year 2012. At the same time, employers contributed

only 80% of their annual required contributions (ARC) to

plans during 2012. These figures exclude public unfunded

healthcare obligations, which are generally funded on a

pay-as-you-go basis. At PIMCO, our municipal credit

research team carefully examines an issuers entire capital

structure, including obligations from tax-supported debt

and pension and healthcare plans, as a key component to

our bottom-up credit process. Analysts regularly make

adjustments to capture all these obligations in our debt

metrics and consider an issuers historical contribution

pattern to their retiree obligations as well as any reform

measure when forecasting the growth of future liabilities

over the cyclical horizon.

Q: What are the implications of the Detroit

bankruptcy for investors in municipal bonds?

A: The Detroit bankruptcy is challenging the perceived

priority of payments within the municipal capital structure.

It has long been assumed by many investors that unlimited

tax GO bonds and pension benefits were at the top of the

municipal capital structure, followed by limited tax GOs,

then pension obligation certificates (POBs) and all other

general fund claims, and, finally, retiree healthcare

obligations. The emergency managers plan, however, puts

all of these obligations on equal footing. And while we

expect that legal challenges and negotiating may restore

some hierarchical separation to these classes, lowerrecovery assumptions for GO bonds are still likely to be the

most significant result. The outcome will help define the

options for Detroit to reorganize, and also clarify the

balance of power between unfunded pension claims and

bondholders. If theres a positive, it is that the Detroit

reorganization ultimately may clarify the parameters for

negotiations between pensions, bondholders and

politicians, and lead to a call to arms for greater pre-

emptive pension reform in other stressed states and cities.

Q: Do we expect there will be federal intervention?

A: PIMCO ascribes a low probability for a direct federal

bailout simply because the federal government is more

likely to let the process play out through the Chapter 9

proceeding, particularly as there is the potential for

precedent-setting outcomes. Intervention could also create

a disincentive for pensions to negotiate outside of the

Chapter 9 process by introducing moral hazard.


3/4

OCTOBER 2013 | VIEWPOINT

The White House recently sent a delegation to Detroit

which pledged on behalf of the administration a modest

$320 million in federal and private-sector funding for

rehabilitative purposes (e.g., transit repairs and blight

demolition) instead of debt relief. The federal share of this

funding includes largely a redirection of already approved

grants and not newly appropriated funds. If the

bankruptcy is drawn out over an extended period of time

without a foreseeable exit, Detroit may need additional

financing, but in our view a major federal bailout is

unlikely.

Q: What about Detroits water, sewer and other

essential services bonds?

A: PIMCO has long favored special revenue essential

service bonds over GO bonds. Detroit Water and Sewer

bonds are payable by a pledge of and statutory lien on net

revenues of the water or sewer system, and as such

benefit from provisions in the federal bankruptcy code

ensuring that the pledge is not affected by the petition.

However, that does not mean that there will not be some

kind of haircut on these bonds. First, many of the bonds

were issued with higher coupons and were trading at apremium prior to the announcement of the restructuring

plan. The current plan calls for redeeming these bonds at

par to issue new notes at prevailing market rates that,

while still preserving capital, would create financial losses

for existing holders. The proposal also calls for a

transaction payment to be paid senior to debt service on

the exchanged notes, which would be an additional cost

to existing bondholders. Most recently, the emergency

manager revealed in a deposition that the city may

attempt to access $1.2 billion maintained in the water and

sewer systems capital fund, which would adversely impact

the quality of the systems services. These costs are

dramatically different from the loss severity proposed for

GO bonds, and any attempts to modify the terms of the

notes or subject bondholders to exorbitant charges would

be a source of contention and likely lead to legal

challenges, as they have in the past.

Q: Should investors alter their approach to municipal

bonds in light of Chapter 9 bankruptcies?

A: PIMCO continues to have an underweight bias on local

GO credit. The vast majority of our municipal exposure is

in bonds backed by dedicated revenue streams.

It is still important, however, for investors to understand

the credit strength of the underlying service area and the

related municipality or territory for revenue-backed bonds.

Although revenue pledges can offer a secured interest,

essential service revenue credits can still be adversely

affected if the local service area is weak or if the related

municipality is under financial stress. In some instances,

the municipality or territory may transfer cash from

enterprise funds or municipal utilities to bridge operating

deficits or, conversely, support the utilitys obligations with

government loans. Rating agencies are also likely to

downgrade affiliated revenue bonds as the underlying area

becomes more stressed. These weaknesses could result in

spread widening, diminished liquidity and an increase in

mark-to-market volatility.

Post financial crisis, the municipal bond market has

transitioned from a duration-based market to one driven

by credit, combining investment grade, high yield and

distressed issues. The municipal credit research team looks

at the management of municipalities the same way we

look at the management of a company, examining its

fundamental health and the potential aggregate demand

for services in the underlying area. Our municipal credit

research analysts build forward-looking models for

revenue bonds, which are based on both the future cash

flow and the financial strength of the underlying service

and incorporate PIMCOs cyclical forecasts. These

projections help us focus on avoiding spread-wideningevents before they occur. This type of bottom-up analysis

is geared to help avoid blowups and can also identify

opportunities created by the type of indiscriminate or

forced selling we have seen in the wake of the Detroit

filing. At the moment, for example, were seeing some

high quality revenue-backed bonds offered at distressed

prices. This repricing is temporary, but it has made many

bonds inexpensive relative to their value.


4/4

Newport Beach Headquarters840 Newport Center DriveNewport Beach, CA 92660+1 949.720.6000

Amsterdam

Hong Kong

London

Milan

Munich

New York

Rio de Janeiro

Singapore

Sydney

Tokyo

Toronto

Zurich

pimco.com/investments

Biographies

Mr. Hammer is a senior vice president and municipal bond portfolio manager in the New Yorkoffice. Prior to joining PIMCO in 2012, he was an executive director at Morgan Stanley, wherehe served as head of the high yield and distressed municipal bond trading group. Mr. Hammerwas previously a vice president and investment grade bond trader in Morgan Stanleysmunicipal bond department. He has 10 years of investment experience and holds a bachelor'sdegree from Syracuse University.

Mr. McCarthy is a senior vice president and municipal credit analyst in the New York office,covering municipal credits, asset-backed commercial paper (ABCP) conduits and property andcasualty insurance companies. Prior to joining PIMCO in 2009, he analyzed ABCP credits as aconsultant to the firm. Previously, he was a senior vice president in the fixed income syndicate atLehman Brothers and product manager for global ABCP, structured investment vehicles andconduit origination. Prior to this, he was a vice president in Lehman's securitized productsbusiness, and a research analyst with Duff & Phelps and Fitch. He has 15 years of investmentexperience and holds an undergraduate degree from James Madison University.

A word about risk: Past performance is not a guarantee or reliable indicator of future results. Investing in thebond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Income frommunicipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentratingin a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Allinvestments contain risk and may lose value.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material hasbeen distributed for informational purposes only and should not be considered as investment advice or a recommendation ofany particular security, strategy or investment product. Information contained herein has been obtained from sources believedto be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other

publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks orregistered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC,respectively, in the United States and throughout the world. 2013, PIMCO.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO.

Investment Products

Not FDIC Insured | May Lose Value | Not Bank Guaranteed

pimco viewpoint after detroit rigorous research and credit selection is the key to investing in...

Documents