Recent negative news about Detroit’s bankruptcy and Illinois’s pension overhaul has raised fears about the poor financial health of many cities and states. And it’s shaken individual investors’ confidence in municipal bonds. Just how worried should investors be? Not very, in our opinion, as bond defaults remain very rare. In fact, we view recent events in Detroit and Illinois as positives for the market.
Judge Declares Detroit Pensions Not Protected
Last week, Detroit was declared eligible to enter Chapter 9 bankruptcy. The municipal world had been expecting this decision, so the real surprise was the federal judge’s ruling that public employee pensions would not be protected in a Chapter 9 filing.
How will this affect bondholders? While any decision of the bankruptcy court has to be fair and equitable, bringing pension benefits to the bankruptcy table will potentially help bondholders, as pension holders may now have to share the pain of bringing the budgets of distressed municipalities into balance.
And assuming that this ruling withstands legal challenges, it will have strengthened the bargaining position of municipalities where Chapter 9 is an option, while weakening the standing of labor unions. The decision should push unions in financially stressed municipalities to the bargaining table more quickly. The downside is that it also could give municipalities an incentive to file for bankruptcy more frequently than they would have otherwise, or at least to threaten to file.
But the impact of this ruling on municipal bonds in general should be small. In about half the states in the US, municipalities are either not permitted to file for bankruptcy or to benefit from constitutional provisions that would make their pensions immune to bankruptcy. We estimate that less than 15% of total debt outstanding was issued by municipalities eligible to be impacted by this ruling, and that only a tiny fraction of that amount will ever be directly impacted.
Municipal Defaults Are Scarce
Individual investors may feel anxious about Detroit’s fate, but it’s truly an anomaly, even though it’s a big one. The 10-year cumulative default rate for municipalities is just 0.1%, and only 13 filed for bankruptcy last year out of 90,000 units of government in the US. Markets tend to ignore this information, but the fact is that the finances of most cities and states are improving along with the economy—and states are working to repair their problems. For example, more than 40 states have made changes to their pension systems to ease the pressure of large liabilities. We believe that the muni market is safe, and that news about troubled municipalities should be read in this context.
Illinois Passes a Significant Pension Reform Bill
One troubled municipality seemed to take a step forward recently: The Illinois General Assembly approved an overhaul of the state’s woefully funded pension system last week, and Governor Pat Quinn quickly signed it into law. This law proposes to raise the state’s pension-funded ratio from 39.3%, the lowest among all states, to 100%, fully funded status, by the end of fiscal year 2044. Overhauls like this have been tried before, without long-term success, but the provisions of this particular agreement look stronger.
Among the major changes were:
- The inclusion of a pension-funding guarantee, under which the Illinois Supreme Court can compel the state to make required annual pension payments
- An increase in the retirement age for employees 45 years of age or younger
- The removal of almost all pension matters from collective bargaining
Longer term, the legislation is undoubtedly a positive for the state, but the unions will most likely mount legal challenges. In the short term, the agreement may increase budgetary pressures due to a possible increase in pension contributions. If that should occur, these and other pressures will make it difficult to delay or eliminate the scheduled phaseout of Illinois’s last income tax increase.
Recent events in Detroit and Illinois are examples of the positive developments that we’ll continue to see as cities and states stabilize—improvements that should ultimately benefit bondholders.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Michael Brooks is a Senior Portfolio Manager for Municipal Investments at AllianceBernstein.