Detroit’s bankruptcy filing means it’s time for advisors to reassess their holdings, says Warren Pierson, lead manager of Baird’s intermediate-term municipal bond fund, but not to over-react to what is sure to be a panicked client base.

“That includes individual municipal bonds as well as funds,” says Pierson, who wasn’t surprised by the Detroit bankruptcy filing and doesn’t think it’ll be sorted out any time soon. “Investors have been desperate for yield in recent years. Within fixed income, they’ve gone longer in maturity and lower in quality. Often, that has meant turning a blind eye to risk.”

Investors holding Detroit munis, directly or through a fund, have learned a painful lesson about chasing yield in lower-quality bonds and that lesson doesn’t look to be ending any time soon. City emergency manager Kevin Orr has stated that he’d like to complete the bankruptcy process by 2014 but Pierson said resolution could take longer.

For now, advisors are wondering whether the Detroit general obligation (GO) bonds will pay the promised interest. They’re also fretting essential service revenue bonds such as water and sewer issues, where interest payments are backed by specific streams of cash. Pierson says that nothing is off the table.  

“Many investors have looked at municipal bonds, especially GOs, as being just a step below Treasuries, in terms of credit quality,” Pierson said. “Investors might have thought that cities and states can raise taxes, if they need cash to pay bondholders. Well, Detroit might raise tax rates but it’s uncertain how much the city will collect.”

Issues such as water and sewer bonds might be differentiated, Pierson said, so interest payments could continue. “In bankruptcy, however, shoulds and oughts can change,” he pointed out.

For now, it’s likely that Detroit munis will trade at steep discounts from face value. “I’d probably want to let the dust clear a bit before selling,” Pierson said. “In times of panic, there are huge disparities in pricing.” A bond that looks like it could be worth 30 cents on the dollar, say, might get bids of 20 cents.

Looking at the overall asset class, Pierson said, “it’s not a minefield but there is a fair amount of stress in the muni market.” If Detroit succeeds in reducing its debts and obligations via bankruptcy, other troubled muni issuers could follow suit. For advisors, this could be a good time to go over clients’ muni holdings to see if adjustments should be made, to reduce exposure to low-quality issues.