Detroit and The Risk of Chasing Yield

Last June, investors bought $667 million of newly issued bonds from the city of Detroit. The offering to fund sewers was oversubscribed – meaning that there were more buyers than bonds available.

These investors didn’t buy the bonds for safety and security. In fact, these bonds were barely given an “investment grade” rating.

The reason investors bought up the debt was simple.  These bonds offered a yield of 5% in a world of 2% Treasuries. One portfolio manager – John Bonnell of $5.5 billion USAA Investments – was quoted in the Wall Street Journal saying, “Let’s face it, in this interest-rate environment, a lot of people are very yield-hungry.”  Well said…

Now, the investors who bought these bonds weren’t stupid. Most of the offering was likely taken by institutional investors managing municipal bonds funds. Of course, some individuals bought bonds in the offering as well.

The situation in Detroit is a classic example of the real risks that happen when investors chase yield.  With interest rates so low, investors have the urge to earn a little bit more.

But when they stretch for that extra 1% or 2% in income, they are making an important decision. They’re trading a little bit of safety and security in exchange for a bigger check.

More than 95% of the time, that trade works out and the investor simply collects extra income. But in rare occasions – like Detroit – a risky investment goes belly up. And when that happens, investors can lose their entire investment. 

It will be at least a year – and perhaps many more – before Detroit’s bankruptcy proceedings are wrapped up. Until then, little is known about how much bondholders will lose.  What we do know is that the $18.5 billion bankruptcy is the largest failure of a U.S. municipality ever.

The legal battles ahead will be a fight for the scraps, with various stakeholders trying to get the most out of the broke city.  This means labor unions trying to protect pensions, and investors trying to get paid on their loans to the city. In the end, everyone will lose.

Unless you’re a Detroit or Michigan resident, you probably don’t directly own Detroit bonds. So you’ll be largely unaffected by this single bankruptcy. 

However, Detroit should serve as a reminder that higher yield mean greater risk.  The fact that a city or state is the issuer of debt doesn’t make it “risk free.” There is no such thing as a risk free investment.

I’m advising Income & Prosperity readers who own municipal bonds take a moment to closely review your holdings. Even if you have a financial advisor, it’s your responsibility to understand the financial health of the issuer of these bonds. 

Since 2010, there have been 36 municipally bankruptcies in the U.S.  Big cities including Birmingham, New Orleans, and Philadelphia are also on shaky financial footing. Many governments have been living far beyond their means for many years, and bankruptcy is one way to escape those debts.

Most municipal bonds aren’t at risk of default. In many cases, they offer more income than U.S. Treasuries.

However, there is one looming risk to muni bonds that is far greater than the next Detroit. The effects could be disastrous, even for the safest muni bonds.  Look for the details in tomorrow’s letter…stay tuned. 

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