Municipal bonds are issued by various cities. Munis, as they are called, are attractive to individual investors in higher tax brackets because the interest income is tax free. As a result, they generally have slightly lower interest rates than taxable bonds. You can buy them from a registered municipal bond seller, or indirectly through a municipal bond fund.

Traditionally, very few cities default, and municipal bonds are considered very low risk.

Most individual municipal bond holders do not sell during the life of the bond. However, those that do find the price of the bond itself changes based on supply and demand in an open market.

How Detroit's Bankruptcy Changed the Game for Municipal Bondholders

However, in July 2013, the city of Detroit filed for Chapter 9 bankruptcy, making history as the largest American city to take this desperate action. This is important for the U.S. economy because the legal battles that follow will set national precedents. The main issue at stake is who will pay the price -- bondholders or city workers, whether currently employed or retired.

Chapter 9 protection means Detroit could default on some or all of the $18 - $20 billion it owes bondholders, the wages and benefits it's negotiating with unions, and the $9.2 billion in pensions it's promised its retirees. Default on these obligations could give Detroit the funding it needs to improve services to residents.

For example,  it could speed up 911 response time, which currently takes 58 minutes, compared to the 11-minute national average.

 Although the bankruptcy is a response to current debt, exacerbated by the 2008 financial crisis, Detroit Gov. Rick Snyder said it was really 60 years in the making.

The next step is probably lawsuits from creditors, which could delay the process for a year or more. That's what happened when Jefferson County, Ala., and Stockton, CA  filed for Chapter 9. Analysts warned a bankruptcy could drive up bond costs for cities statewide, and the losses that could be forced on the city's 30,000 current and retired city workers remain unknown.

More Hidden Threats in Municipal Bonds

In 2014, former Federal Reserve Chairman Paul Volcker co-authored a three year study with the boring title: "Final Report of the State Budget Crisis Task Force." Its findings were anything but boring. The team uncovered structural flaws in state and city financing that is only worsening. This represents a future threat to all municipal bondholders. At its worst, it could trigger another financial crisis.

1.  Contributions to employee pension funds aren't enough to cover future guaranteed payouts to retirees. Cities will either have to raise taxes, hurting everyone, or cut benefits, hurting city workers who are counting on these benefits to retire.
2. The largest expenditure for state budgets is Medicaid.These health costs are rising, which could cut into state revenue-sharing with cities.   
3. Cities and states are issuing bonds to cover current operating costs.
4. They are selling off assets to pay operating expenses.

As a result, they don't have the funds to invest in new infrastructure -- not only roads, bridges and buildings but education as well. (Source: WSJ,  More Detroits Are on the Way?, May 15, 2014)

How It Affects You

Detroit's bankruptcy could eventually drive up the interest rates on new municipal bonds for all cities. That's if bond investors demand more return for the greater risk of municipal default.

If this happened, the municipal bonds you own could drop in value because the newer bonds will pay more. However, most analysts don't think it will affect the $3.7 trillion municipal bond market. That's because most investors realize that most cities aren't in the same kind of financial straits as Detroit.

In the long run, the outcome of Detroit's bankruptcy could dictate how secure other pensions are. However, it will take years for the legal battles to be resolved in court. (Source: Detroit Free Press, Detroit Files for Bankruptcy, July 19, 2013; Detroit News, Business Leaders Don't Expect Major Impact, July 18, 2013)

The best way to protect yourself is to carefully review how the city and state are financing their operating expenses, including future pensions. You have to look at more than just the credit-worthiness of the bond itself.  

Even if you're not invested in municipal bonds, keep an eye out for articles about future city and state bankruptcies. The study warned that Detroit's problems are shared throughout the country. Article updated June 6, 2014

What Are the Different Types of Bonds?

• What Are Treasury Bills, Notes and Bonds?
• What Are Savings Bonds?
• What Are I Bonds?
• What Are Municipal Bonds?
• What Are Corporate Bonds?
• What Are Junk Bonds?