When Detroit defaulted on $19 billion in general obligation bonds, it barely caused a ripple in the $3.7 trillion muni market. But for the unlucky few who held those bonds, it’s a dime-on-the-dollar catastrophe. What’s the lesson we can learn from the Detroit experience?
Bond defaults are very rare these days. The wave of big muni defaults that Meredith Whitney famously and emphatically predicted in 2011 – which she promised would total hundreds of billions of dollars – never materialized. Most cities and agencies are able make interest payments on schedule.
But that does little to appease Detroit bondholders who will lose big. The Detroit calamity is a good reminder that a bond is a loan, in this case a loan to the mayor and city council of a city with a shrinking population and endless economic problems. Some such loans are tied to specific and generally reliable revenue streams, such as tolls collected on an expressway, or revenues from casinos. Detroit’s general obligation bonds, however, were backed only by a promise from the city to repay them, a promise the city is not able to keep.
Spread the risk
Rare situations like this reinforce our ETF investment strategy. The municipal bond asset class is an important ingredient in many of our client portfolios, but instead of holding individual bonds, we utilize municipal bond ETFs. These ETFs are essentially pools of hundreds of bonds offered by municipalities across the country. The value of the ETF moves based on interest rates and the ability of those bond issuers to make payments. With so many issues in the pool, a single default like Detroit’s has minimal impact on the ETF as a whole.
Yes, this is just plain old diversification. We see spreading the risk as essential not just for stocks, but for bonds as well. ETFs make it easy.
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