Charles L. Evans,
Daniel G. Sullivan,
Executive Vice President and Director o Research
Senior Vice President and Economic Advisor
Senior Vice President
fnancial markets group
microeconomic policy research
Jonas D. M. Fisher,
macroeconomic policy research
William A. Testa,
and Economics Editor
Helen O’D. Koshy and Han Y. Choi,
Rita Molloy and Julia Baker,
Sheila A. Mangler,
Editorial Assistant.Chicago Fed Letter
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2. Yield spreads of municipal bond portfolios, 2013
The sample of 92 bonds was selected by choosing at most two bonds fromeach issuer from the set of uninsured fixed-rate general obligation bonds issued bythe cities included in Pew Charitable Trusts (2013). When multiple bonds from thesame issuer met these criteria, the two with a maturity closest to ten years wereselected. H9 is a portfolio of bonds issued by cities with high per capita pensionand other post-employment benefit (OPEB) obligations located in Chapter 9 states.L9 is a portfolio of bonds issued by cities with low per capita pension and OPEBobligations located in Chapter 9 states. Hno9 is a portfolio of bonds issued bycities with high per capita pension and OPEB obligations located in non-Chapter 9states. Lno9 is a portfolio of bonds issued by cities with low per capita pension andOPEB obligations located in non-Chapter 9 states. “High” and “low” obligations aredefined as above and below the median, respectively. The plots are the spreadsbetween the weighted average yields of the portfolios. The solid vertical line indicatesthe first trading day (June 17) after the Detroit emergency manager’s proposal tocreditors. The dashed vertical line indicates the first trading day (July 19) afterDetroit’s bankruptcy filing.
Authors’ calculations based on data from Bloomberg and Pew CharitableTrusts (2013).
o nancial woes and structural economicproblems is unique, a substantial num-ber o local governments nationwide acelarge pension and OPEB obligations. Forthese governments and their creditors,Detroit’s case is a potential bellwether. Another surprising aspect o the EMproposal was its ailure to dierentiatebetween debt backed by the unlimitedtax pledge and debt lacking such a pledge.UTGO debt is typically repaid rom aspecial property levy that has no limit and,as such, relies on revenues that are entirely separate rom those used to cover general-und operations.
This eature o UTGOdebt makes it quite similar to other se-cured debt, contrary to the EM’s state-ments implying that none o the GObonds have legal security. This issue willbe ultimately settled by the court, and it might have wide-reaching consequencesor the pricing o voter-approved GO debt.
Implications for municipal bonds
In the preceding section, we touched onthe potential market ramications o legal rulings with re-spect to the treatment o pension and OPEBobligations, as well asGO debt backed by unlimited tax pledges.The standing o pen-sion obligations relativeto other municipalliabilities is particu-larly important tobondholders and thebroader public giventhe multitude o well-publicized undingshortalls in a great number o Americancities. For example,data rom a recent Pew Charitable Trustsstudy o large citiesindicate that they have unded only 57.5% o the $5. bil-lion o retirement benets promised totheir employees.
There is a confict between state andederal laws as to whether pension obligations can beimpaired by a ederal bankruptcy court.Michigan’s state constitution prohibitsreductions o promised pension benets,but Detroit’s EM argues that Michiganlaw allows or pension cuts in ederalbankruptcy court. Pension unds havechallenged the EM’s interpretation onthe grounds that it violates both the Tenth Amendment to the U.S. Constitutionand state law. To date there is no juris-prudence addressing the question o whether a municipality can diminishpension obligations protected by a stateconstitution. I the court agrees withpension creditors that state protectionshold supreme, this could change market expectations with respect to the relativestanding o municipal debt issued by cities located in states with such protec-tions (e.g., Chicago, Los Angeles, andNew York City). Furthermore, any prec-edent that makes pension obligationssenior to municipal bonds on broadTenth Amendment grounds couldhave a material eect on the pricing o municipal debt or any city with largeunderunded pension obligations.
How have the markets reacted thus far?
Apart rom Michigan municipalities, themarket reaction to the Detroit bank-ruptcy ling has been negligible. In the week ollowing the EM’s June 4, 0,proposal to subordinate GO bonds,the dierence (spread) between the yield on the nationwide Standard &Poor’s (S&P) Municipal Bond GeneralObligation Index (SAPIGO) and the yield on ten-year U.S. Treasury bondsdeclined 8 basis points (gure ). TheSAPIGO–ten-year U.S. Treasury bond yield spread did increase by 9 basis pointsthe day ater Detroit’s Chapter 9 lingon July 8 but quickly returned to itspre-bankruptcy level. In contrast, thespread between the yield on the S&PMunicipal Bond Michigan GeneralObligation Index (SAPIMIG) and the yield on SAPIGO increased 4 basispoints ollowing the EM proposal. Thespread urther jumped by 9 basis pointson the day ater Detroit’s bankruptcy ling and has remained elevated since,suggesting that the ling has had amaterial impact on borrowing costs o Michigan municipal issuers.
Jan. Feb. Mar. Apr. Jun. Jul. Aug. Sep.−0.4−0.20.00.20.40.6L9−Lno9H9−Hno9Hno9−Lno9H9−L9May