How Detroit's breakdown will hit you

  @Money August 19, 2013: 5:57 AM ET
detroit
(Money Magazine)

Detroit's July bankruptcy is the tragic culmination of 60 years of decline.

Indeed, among localities still coping with fallout from the recession and housing bust, the Motor City stands alone in awfulness: 78,000 blighted structures, 18% unemployment, a $327 million operating deficit last year. Yet with the city looking to cut pensions and restructure debt, Detroit's comeback bid could have ramifications beyond Michigan's borders.

Your town may feel freer to slice retiree benefits. With so many state and local pensions facing funding shortfalls, cutting back retirement benefits -- or trying to -- is nothing new. What worker advocates fear is that bankruptcy-court approval of pension changes for Detroit, where pension protection is part of the state constitution, would embolden government leaders elsewhere to seek deeper cuts.

Related: Just how generous are Detroit's pensions?

In Detroit, pension changes are most likely to follow the national trend: eliminate cost-of-living adjustments and convert current workers to defined-contribution plans, says area financial planner Leon LaBrecque, rather than reduce payments.

Why Detroit filed for bankruptcy

The muni market could take a hit. Detroit has proposed treating certain general obligation bonds as "unsecured," instead of backed by city taxing power, and offering investors just 10 cents on the dollar.

The odds are long, but if Detroit succeeds, the precedent would shake up the bond market.

Also at risk: retiree health care, which lacks the same protections as pensions. Detroit would shift retirees to new federal exchanges or Medicare, a move other governments are studying.

Related: Detroit's stealth business boom

Still, for most of the country, "credit quality remains quite strong," says John Bonnell, a fixed-income manager for USAA. The five-year default rate in the $3.7 trillion muni bond market is less than one-half of 1%, reports Moody's; 93% of municipal issuers are rated single A or higher.

Michigan muni funds already have. Funds that specialize in the state's bonds are down as much as 17% this year, but at this point you shouldn't rush to sell, says Chris Ryon of Thornburg Funds. Even funds with big stakes in Detroit primarily hold the water and sewer bonds that Detroit is still fully backing, not the unsecured debt the city is defaulting on.

But the real story on bonds is ... Munis are less liquid than the Treasury market, and thus have taken a bigger hit as interest rates have risen of late. But David Kotok, chairman of money manager Cumberland Advisors, thinks the fear has been overplayed.

"High-grade munis are remarkable bargains," says Kotok. Still, stick with a short-term fund, such as Fidelity Short-Intermediate Muni Income (FSTFX) (recent yield: 1.77%), to cushion any losses as rates rise. To top of page

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