Kevyn Orr, the Michigan city’s emergency manager, stunned the $3.7 trillion municipal market when he lumped Detroit’s unlimited general-obligation bonds with those that are defined as “limited,” describing both as unsecured. While the former are backed by taxes on voter-approved projects, the latter don’t require such a referendum and are paid off out of general funds.

Yet holders of the “unlimited” debt may get as little as 3 percent of their face value, if the bankruptcy court rules the debt is unsecured. Orr proposed paying pennies on the dollar on some securities before he sought court protection for the city, contributing to a $13.8 billion loss in muni values, according to Standard & Poor’s. Tom Weyl, Barclays director of muni research, suggests those bondholders may fare much better.

“Investors with appropriate risk appetite may wish to consider standalone UTGO bonds,” Weyl said in an Aug. 7 report, discussing the general-obligation securities involved in the largest U.S. municipal bankruptcy. “Such debt will likely have a strong argument for special revenue status in bankruptcy, through there is no guarantee such argument will prevail.”

Postponed Deals

Since the record bankruptcy filing on July 18, three Michigan municipalities have postponed bond deals after investors demanded higher interest rates to compensate for the new risk that Orr’s plan would set a precedent. J.R. Rieger, S&P’s vice president for fixed-income indexes, said the filing spurred a $13.8 billion muni-market loss through Aug. 7.

Yields on 30-year municipal bonds reached about 4.64 percent, the highest since May 4, 2011, as prices for the securities fell.

Detroit unlimited-tax general-obligation bonds maturing in April 2028 and backed by Assured Guaranty Ltd. traded at an average of about 88 cents on the dollar to yield 6.2 percent, or 2.7 percentage points more than top-rated debt with similar maturities, according to data compiled by Bloomberg.

That’s 0.1 percentage point less than the average spread of 2.8 percentage point since Feb. 26, the data show.

Judge’s Decision

U.S. Bankruptcy Judge Steven Rhodes, the overseer of Detroit’s case, will determine whether the unlimited tax general obligation bonds are treated as secured or unsecured debt.

Under amendments made to the U.S. Bankruptcy Code in 1988, voter-authorized general-obligation debt for capital projects backed by a specific tax levy that doesn’t feed the general fund would be considered special-revenue debt, which is secured, Weyl said. He cited research in a book by Chapman & Cutler LLP, entitled “Municipalities in Distress.”

The description in an offering statement for the bonds provides support for its status as secured debt, Weyl said. Language in a document describing the 1999 unlimited-tax general-obligation bonds says the projects to be financed were voter-approved and subject to a specific debt-service tax.

A 2008 offering statement for a $204.9 million issue of such bonds says Detroit is obligated to collect taxes to pay the debt without regard to any “constitutional, statutory or charter tax-rate limitations,” Weyl said.

Some Unsecured

Detroit’s 2012 annual report also identifies a separate revenue stream to pay off its unlimited-tax bonds.

The city’s $161 million in limited-tax general-obligation bonds weren’t voter-approved and are repaid from general revenue, Weyl said. Those securities are unsecured, he said.

There is risk that the court sides with Detroit, Weyl said. That may be trumped by the bankruptcy judge’s desire to move the city quickly through a reorganization and limit appeals, he said. A ruling against treating the unlimited bonds as secured would probably be appealed, he said.

“If the judge is really concerned about, not the legal merits, but what’s in the best interest of Detroit and trying to craft a solution that works for them, tying up the city in appeals is not in their best interest,” Weyl said.

Assured Guaranty, which backs $146 million of the unlimited tax debt, probably will fight over its secured status, he said.

Different Level

“We believe the city’s pledge of its unlimited taxing power and resources is not, legally or morally, on the same level of priority as unsecured obligations to vendors and other creditors,” Dominic Frederico, Assured’s chief executive officer, said during an Aug. 10 conference call with investors.

“The city’s voters approved the debt, and the bond resolution unequivocally and irrevocably pledges the city’s full faith and credit, unlimited taxing power, and the resources of the city, for the timely payment of the principal and interest,” Frederico said. He said the company-backed portion calls for about $15.3 million in annual payments over the next 10 years.

In addition to the $530 million of unlimited and limited general-obligation bonds Orr classified as unsecured, another $479 million is secured by a pledge of state aid, Weyl said.

The ratio of 30-year top-rated muni yields to those for comparable U.S. Treasurys is also near the highest in more than a year. The ratio fell to 121 percent after reaching 125 percent Aug 9, the most since June 1, 2012. The greater the percentage, the greater the relative value of municipal securities.