Detroit’s Bankruptcy: Unconstitutional or Just Complicated?
The name of the game is to obtain optimal return for any given investment. This means finding a security — a bond, stock, or perhaps some arcane financial product — with a yield that is worth the risk of the investment. Treasury notes have low yields because they are safe; junk bonds have high yields because, well, it’s in the name.
The risk-versus-reward aspect of the market’s quest for returns may be the thing that gets it into the most trouble. Interest rates — the reward for an investment in, say, a municipal bond — are also a proxy for risk. The bigger the yield, the higher the risk. This is a double-edged sword, and the market is, on a good day, clumsy. On a bad day, such as in the wake of the late-2000s financial crisis when interest rates were pushed to record lows, the market become desperate for yield and inadvertently set itself up for the chopping block.
In many ways, failure to wield this double-edged sword with sophistication contributed to the fallout from the Detroit bankruptcy filing. The scope of the damage is still unclear, but bondholders, pension funds, and other debt holders — many of whom were compelled to invest because of the relatively high yields offered on municipal bonds — are on the chopping block and face the possibility of massive losses on their investments.