Detroit’s bankruptcy points to a nationwide epidemic. Learn what three cities may be next to wave the white flag and how you can profit…
It was a painful pill for the people of Detroit to swallow, but they knew it was bound to happen sooner or later.
Last week, the Motor City became the largest city in US history to file for Chapter 9 bankruptcy.
Even Titans Fall
Although once the symbol of our nation’s industrial might and manufacturing prowess, Detroit has been in decay for decades.
A slow, mass exodus made for a gaping hole in tax revenues; Detroit’s population plummeted from its 1.8 million peak in the 1950’s to fewer than 700,000 today… and will likely fall further.
Tack on soaring debt obligations — including billions of dollars owed to bondholders, retired cops and current city workers – and the burden was too much for Detroit’s finances to bare.
In all, Detroit listed more than 100,000 creditors in their IOU file before declaring bankruptcy.
Now, the city is being forced to restructure roughly $18 billion worth of debt, with most creditors likely only to receive a fraction of the money they are owed.
But where others see pain, I see opportunity.
You see, leading up to the bankruptcy announcement, Detroit municipal bondholders had been bailing out in droves – driven by the threats of receiving huge haircuts should Detroit not be able to meet its obligations.
However, not all bondholders are slated to get the shaft.
For example, Detroit’s bankruptcy is providing a buying opportunity in the city’s $5.4 billion of water and sewer debt. Investors believe that these bonds will be paid in full and are therefore snatching some of them up for only $0.86 on the dollar.
People are calling it one of the single-best values in the entire bond market right now.
What’s even more interesting is that Detroit’s collapse has created fear in the municipal bond market across the board.
According to Lipper data, U.S. municipal bond funds reported $1.23 billion of net outflows in the week ended July 24 — on top of $1.56 billion outflows the previous week.
In fact, it marks the ninth straight week of net outflows, including a record $4.53 billion outflow four weeks ago, and the seventh week of the past eight in which withdrawals topped the billion-dollar mark.
The knee-jerk reaction to Detroit means that skilled bond investors could potentially capitalize on steeply discounted muni-bonds that have strong credit ratings with little chance of default.
So for you muni-bond opportunity seekers, there are a number of cities across America that are falling into a similar financial trap but could still hold some value. Here are three I find particularly interesting…
Though overshadowed by Detroit’s downfall, the city of Chicago is currently undergoing a major economic struggle of its own — a double-whammy in fact, both of which were declared last week.
Firstly, Chicago rating for general bond obligations dropped three grades down to A3 in Moody’s Investors Service credit rating.
Moody’s cited the Windy City’s credit rating cut as due to it amassing a debt of $7.7 billion, as well as owing $19 billion in underfunded pension liabilities.
The tipping point here could come in 2015.
That’s when Chicago is scheduled, under state law, to significantly raise its annual pension payments from $467 million to $1.2 billion.
It’s a move that’s expected to cripple the city’s finances.
Not helping matters is higher than average unemployment. The city-wide unemployment rate has increased for four straight years and now hovers at 10.3%.
Los Angeles, CA
With a population of around 3.8 million people, L.A. is the second most populous city after New York.
But they are in bad shape.
Similar to Chicago, they also have one of the highest unemployment rates in the country at 10.3%.
And they have a big financial headache on their hands as well.
Revenues for fiscal 2013-2014 are projected to be $4.62 billion while expenses are $4.84 billion – leading to a $216 million shortfall.
Under Mayor Antonio Villaraigosa’s tenure, the city has slashed more than 5,000 civic jobs and cut pension and healthcare expenses in an effort to pare down its deficit.
And like many troubled cities across America, L.A.’s pension payouts could be the death knell.
According to a 2012 study by the Stanford Institute for Economic Policy Research, 37,000 beneficiaries across three pension systems — the City of LA Fire and Police Pension System, the LA City Employees’ Retirement System, and the City of LA Water and Power Employees’ Retirement Plan — have accrued over $27 billion in unfunded liabilities.
Paying pensions while trying to keep the city above water will prove to be a very tough task for L.A.
California Pension Reform president Daniel Pellissler predicts that the city is 2 to 3 three years away from following in Detroit’s footsteps if nothing is done to ease the pension burden.
Strict austerity measures will need to be in place, which means that increased expenses such as the planned 5.5% pay hike for city employees in January will likely be pulled.
While the city may still be basking in the glow of their beloved Ravens’ Super Bowl win this year, the harsh reality off the field is much a different story.
An independent study was commissioned by the city back in February to see what’s in store for the city in the next ten years.
It’s not looking good.
The study, published by The PFM Group, shows Baltimore is on track to rack up $745 million in budget deficits in the coming decade due to rising expenses and revenue shortfalls.
If the city includes ongoing infrastructure costs and health care liabilities, the total shortfall could increase to $2 billion.
Like Detroit, Baltimore has a declining tax base. Since 1950, the city has lost nearly a third of its population from its peak of 950,000.
The lack of revenue also makes it one of the most under-funded cities in America with regards to retiree health care.
A Pew Charitable Trusts Study found that funding in terms of cost per household amounts to $10,208 – a massive number considering Baltimore’s median household income is just $40,100. The US median is $52,762.
Their unemployment rate stands at 9.4% while over 22% of its population lives below the poverty line. This is a stark contrast to the Maryland average of 6.5% unemployment and 9.0% poverty level.
Best Stocks to Buy Now:
As you can see, municipal bondholders today are looking at some ominous storm clouds. But as I said earlier, opportunity often accompanies the pain. And scooping up some municipal bonds at a steep discount could payoff.
However, if you’re not able to (or don’t want to) speculate on individual municipal bonds, then look to an ETF.
One ETF to consider is the Market Vectors High-Yield Muni ETF (HYD:AMEX). This is the most popular high yield muni bond fund on the market and has just under $900 million in assets. It also holds about 300 securities in its portfolio, and interestingly, has a very small allocation to City of Detroit bonds (less than 0.1%).
Another option is the SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB:AMEX). This ETF gives you broad exposure to the high yield muni bond market. Exposure is well spread out across a number of local bonds, while City of Detroit Sewage Disposal System Revenue Bonds account for 0.4% of the total.
As you know, we here at Top Stock Millionaire have always had a strong equity bias because we believe that over the long term, stocks will always outperform bonds.
So while I’ve outlined ways for bond investors to potentially profit off underpriced assets at the moment, don’t over-allocate your investment resources here.
These horror stories can be seen all across America, and for many of these cities – it will get a lot worse before it gets better.
Detroit Mayor Dave Bing said it best when he warned: “We may be one of the first…but we absolutely will not be the last.”
If you are a bond investor, prepare to see the reset button hit a few more times before the decade is out.