Closed-End Funds and ETFs Face Detroit Bankruptcy Risks After Downgrade from S&P

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Was Meredith Whitney’s prediction about municipal and state bankruptcies more reality than she was attacked for? The ratings team of Standard & Poor’s issued a substantial downgrade to the city of Detroit on Wednesday evening. The threat of bankruptcy or credit reorganization is beginning to look more likely than just possible. S&P’s downgrade was already from a junk bond rating of B down to CCC-, and the outlook is Negative.

If another downgrade occurs, it takes Detroit down into the “default” zone. A rating of CCC- is one that most investors tend to avoid. That is a rating that also should not be in any widows and orphans funds. S&P’s downgrade pertains to the general obligation bonds, on top of the other individual bond/credit issues from the city.

The CCC- rating implies a restructuring is intended, and bankruptcy can be one of the options. S&P did specifically use the word “bankruptcy” in the downgrade. The report said, “While the city has not stated its intent to file for Chapter 9 bankruptcy, it appears to remain one of the Emergency Manager’s potential outcomes, and the filing is under his control, with the governor’s approval.”

S&P said the downgrade is based on a recent announcement from the city’s emergency financial manager that Detroit may have to take steps to adjust payments to its bondholders and that the city plans to meet with bondholders to discuss its financial condition. It was noted also that S&P had revised its outlook to negative earlier this year, when an emergency financial manager was appointed.

It was interesting to see that the emergency manager’s appointment was actually a positive step towards Detroit regaining a structural balance and improving its financial conditions. The bad news is that the manager’s latest communication on the adjustment of debt payments and meeting with creditors significantly reduced the positive factors. S&P also said that this remains an evolving situation, and it expects that communications with bondholders will continue.

While this was not mentioned in the S&P report, we also took notice that the state of Michigan was the only one of the 29 individual states tracked by ADP in the month of May that actually lost jobs.

The news is really bad for municipal bond investors, even those who try to avoid individual risks by hiding in state-specific closed-end mutual funds tracking muni bonds. Here are some of the closed-end mutual funds that track the state of Michigan’s municipal bond market. You know they have to have some exposure or even high exposure to Detroit, considering that Detroit and its surrounding area is such a large component of the state’s local and state municipal bonds outstanding.

BlackRock MuniYield Michigan Insured Fund Inc. (NYSE: MIY) is down more than 1% and hit a new 52-week low of $13.46.

BlackRock MuniYield Michigan Insured Fund II Inc. (NYSE: MYM) is down almost 1% and hit a new 52-week low of $12.37.

Eaton Vance Michigan Municipal Income Trust (NYSEMKT: EMI) is also down almost 1% and hit a new 52-week low of $12.32. There is also the Eaton Vance Michigan Municipal Bond Fund (NYSEMKT: MIW), but it has not yet traded and is very thin in trading volume.

Nuveen Michigan Quality Income Municipal Fund Inc. (NYSE: NUM) is down by 1.13% and just hit a new 52-week low of $13.75.

On a national level, muni-bond ETFs have suffered as well. Some credit has improved in many geographies nationally, but the threat of rising Treasury yields and the ability for many closed-end funds (and even ETFs and ETNs) to trade at a discount to the net asset value (NAV) have been acting against the muni-bond sector in general. The iShares S&P National AMT-Free Municipal Bond (NYSEMKT: MUB) exchange-traded product is currently trying to recover with a rally of a whole four cents to $106.57, but it also put in a new 52-week low of $106.40 early on Thursday, against a 52-week high of $114.52.

Another risk for the Michigan-only closed-end funds is that a Michigan bankruptcy or reorganization of payments in any form could seriously harm the ability of these funds to pay dividends at the same historic rates, depending on the exposure to Detroit. Lower dividends, or temporary dividend delays, can occur and they generally are not exactly greeted by investors favorably.

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