When Municipal Bonds Fail.....Ten Points!! If a municipality goes bankrupt....?

Question

If a municipality declares themselves bankrupt (Vallejo, CA recently), what happens to the muni bond holders? Is their debt wiped out by the bankruptcy or do they have claim to the face value of their bond(s) when that things improve for the municipality? I have had a tough time finding an answer to this one and am curious if there is a difference with muni and corporate bonds in this instance. Thanks in Advance!!

Answer 1

It depends on the specific bond.  Some are general obligation bonds but others are revenue bonds.  General obligation bonds most generally get paid off.  Revenue bonds on the other hand may never get paid off. For example some municple bonds are tied to airport revenues supplied by particular airlines.  If that airline goes belly up, the bond holder can kiss their bonds good bye.

Answer 2

Muncie gave a good part of the answer. However, a default on a revenue bond does not bring a municipality to declare bankruptcy. As in the case of Vallejo, I think that the main reason of bankruptcy is a the financing of a sewer network, which I guess should be classified as a general obligation bond and the main reason Vallejo went to declare bankruptcy.

I might also add that it also depends on the seniority of the debt holder. All bonds are equal, but some are more equal than other, to paraphrase Orwell. But in general, institutions, corporations, municipalities declare bankruptcy either to protect themselves from lenders or because bondholders push them to (but in the case of municipalities, bondholders have nothing to gain in the latter case - as opposed to corporations where bondholders may push the company to declare bankruptcy in order for them to collect the maximum on their bonds and shareholders are the once who get screwd).

It also depends on which chapter (7 or 11) does the municipality seeks bankruptcy. A municipality can declare chapter 11 and seek protection (and time) from its debtholders to reorganize itself in order be able to pay them at an earlier date. In this case, Municipalities, most often, suscpend the payment of coupons and are protected from bondholders who want to claim their bonds which lose much of what is worth on the open (secondary) market (they can still be traded) to the fair value of assets.

If the municipalities goes officially bankrupt (chapter 7) and if the assets by which bonds are backed (and if they are sellable and liquidable), bondholders usually get paid what the assets are worth, usually less than a dollar on a dollar (60 cents on a dollar, that is the bondholders lose 40% of the value of their bonds). It is very rare that a bondholder loses all his face value (not in fugurative meaning)