How Detroit’s bankruptcy is helping fuel the equity bull market

The fallout from the largest municipal bankruptcy in U.S. history may be the fuel the equity bull market needs to keep rolling.

In the wake of Detroit’s filing for Chapter 9 bankruptcy in July 2013, most major U.S. states and several cities are either considering, or already have, raised taxes to relieve the pressure on underfunded pensions.

Rather than go the route of investing in stocks and take on the associated risks, many pension plans have opted for aggressive credit and credit-related funds. Those funds, as Canaccord Genuity analyst Brian Reynolds explains, provide the support for companies to buy back stock and boost shareholder value.

“These flows are likely going to intensify the credit-led bull market despite investor worries,” Reynolds said.

Equity investors are undoubtedly worried about various geopolitical issues, the dysfunction in Washington, and high valuations. Yet stocks continue their upward ascent as many indexes, particularly in the U.S., continue to hit record highs.

Even if these factors trigger a selloff, it will be a brief one, because U.S. public pensions don’t care about the macro environment much at all. They’re much more focused on meeting their objectives, which means achieving returns of about 7.5 per cent due to past underfunding and losses.

In an effort to get a better handle on what’s behind the credit boom, Reynolds sees a lot of value in tracking the investment decisions pensions are making with new money, which is ending up in credit “no matter what the current macro worry is.”

The past three weeks alone yields a long list, including New Jersey’s pension putting US$100 million into a distressed debt fund, the Connecticut pension investing US$65 million in a real estate fund, and the Pennsylvania State Employee’s pension placing US$100 million in private equity funds and US$150 million in a distressed debt fund.

There are many more across the country, with the value of the investments ranging from as little as US$4 million to as much as US$425 million.

Reynolds points out that if this nearly US$3.5 billion in recent commitments is put to work at 5x leverage (compared to 10x-50x leverage of the past two credit cycles), history suggests the money will return to the stock market in the form of more than US$17 billion in buybacks.

The July figures may sound big, but they are not abnormal, as the analyst noted that public pensions have allocated more than US$330 million of fresh tax dollars to credit and credit-related funds since Detroit’s troubles began in 2012. In every month since, the total has grown, regardless of the geopolitical risks investors faced.

So despite the inevitable pullbacks in equity markets, investors should keep in mind the drivers behind why pension plans keep the money flowing into credit markets, thereby keeping the bull market in stocks not only alive, but potentially stronger.

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