Detroit s bankruptcy may have come as a surprise to the general public, but the $3.7 trillion municipal (“muni”) bond market has largely ignored it. Despite the dire predictions for the bond market in 2010, the relatively few defaults across the U.S. haven t had much of an impact, as investors still see both revenue and general obligation (GO) bonds as safe investments.

In this article, we will explore Detroit’s bankruptcy and its potential implications on the muni bond market both now and in the future.

GO Bonds & Detroit’s Bankruptcy Primer

General obligation bonds are municipal bonds backed by the credit and taxing power of a municipality, which makes them among the safest types of bonds that investors can purchase. In contrast, revenue bonds are muni bonds backed by revenue from a specific project or utility, which makes them generally more risky for investors than GO bonds.

Detroit’s bankruptcy marks the first time a municipality might default on the principal of a GO bond, after Kevyn Orr classified the bonds as unsecured. If the bankruptcy court deems the GO bonds are in fact unsecured, their holders could end up with as little as three percent of their face value, resulting in billions of dollars in losses, according to Standard & Poor’s.

Still, most muni bondholders remain confident in a positive resolution. As of mid-August, Detroit s GO bonds maturing April 2028 and backed by Assured Guaranty Ltd. traded at about 88 cents on the dollar and yielded 6.2%. Financial firms like Barclays have also insisted that there s a “strong case” for the GO bonds to be treated as secured debt in the bankruptcy.

Looming Risk of Setting New Precedents

The key remaining question for the muni bond market is: If Detroit can side step these obligations in bankruptcy court, does unlimited taxing power really guarantee repayment?

On one hand, the vast majority of muni bondholders don t appear to be at much risk. As of August 2013, less than 40 of the 7,500 municipalities rated by Moody’s were classified as “junk” bonds, while Assured Guaranty, a muni bond insurance firm, expects to take losses on fewer than 12 of the roughly 11,000 municipal bonds that it covers.

Many state laws also provide GO bondholders and certain other muni bondholders with first rights on specific revenues and permit payments during bankruptcy. For example, Central Falls, Rhode Island hasn t missed any payments on its GO bonds since bankruptcy in May of 2010, because of a state law protects those bondholders from losses.

On the other hand, many ratings agencies and investors remain cautious ahead of future bankruptcy court decisions that could quickly change the rules. Moody s warned earlier this year that, these bankruptcies reinforce [the] belief that large tax bases and stabilizing economies are not sufficient by themselves to ensure repayment.

The taxation used to cover GO bonds may also be limited in some cases. In more than two-thirds of states, there are substantial restrictions in place on local governments’ ability to raise cash, with tax ceilings and/or limits on debt issuance. While these can be lifted by popular vote, taxpayers may prove unwilling to approve of necessary tax increases.

Even in Crisis, Markets Are Forgiving

The financial markets are generally very resilient to bankruptcies, from airline stocks to municipalities. Simply put, cities that undergo bankruptcy often emerge with few or none of the debt problems that plagued them before entering bankruptcy. And after a few years, the bond markets tend to forgive their transgressions and lower yields.

For instance, California experienced three high-profile bankruptcies last year and has since shown robust signs of recovery. Ratings agencies have actually upgraded the state’s credit rating following the housecleaning, while its yield penalty has been steadily narrowing over the past year, making it cheaper for the state to issue bonds on the open market [see also How Broke Is Your State?]

In Michigan’s case, three municipalities have postponed their bond issuances after investors demanded higher interest rates to make up for the higher risk of a new precedent. But if history is any guide, these yield penalties could fall in the future when the regulatory picture becomes more clear and bad debts are wiped away to create a clean slate for the future.

The market for muni bonds may also be especially resilient given the lack of alternatives. With the Federal Reserve poised to increase interest rates, muni bonds remain a more attractive alternative to cash, given their high yields and tax-free nature. These dynamics could create net fund inflows that could help drive valuations higher over the coming quarters.

Key Takeaway Points for Bondholders

The municipal bond markets remain largely unfazed by Detroit’s bankruptcy, apart from some higher yield demands by investors in Michigan. The reason for this is two-fold: (1) The vast majority of muni bonds remain safe and highly rated, and (2) history suggests that bankruptcies tend to be forgiven by the financial markets over a relatively short timeframe.

However, muni bondholders should carefully follow Detroit’s case for any changes in bankruptcy law as it relates to GO bonds. If bankruptcy courts decide that GO bonds are unsecured, a troubling new precedent could be set and bondholders could demand higher yields for GO bonds in the future to compensate them for the added risks.