September 12, 2013 / 4:12 PM / 4 years ago

UPDATE 1-Moody's sees smaller recovery rates in muni defaults

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Sept 12 (Reuters) - Investors holding defaulted municipal bonds sold by Alabama's Jefferson County and other local governments will recover less than the average 80 cents on the dollar of recent decades, Moody's Investors Service said on Thursday.

"After historically being extremely high, recoveries in future local government defaults are likely to be closer to the lower ones experienced in the corporate sector," Moody's said in a commentary.

Moody's also said local government defaults will remain rare.

In addition to Jefferson County, whose sewer system creditors have signed off on a pending agreement that promises bondholders about 60 cents on the dollar, Moody's analysts led by Cristin Jacoby said recoveries in Detroit; Harrisburg, Pennsylvania; and California's Stockton and San Bernardino will likely fall short of 80 percent.

Bondholders appear to be losing expected safeguards when competing with other creditors in municipal bankruptcies, Moody's said.

"Recent cases highlight the uncertain outcomes for the treatment of bondholders in Chapter 9 bankruptcy proceedings. In particular, the relative standing of debt versus unfunded pension liabilities is under challenge in Stockton, San Bernardino, and Detroit," the analysts said.

Moody's added that defaults and bankruptcies may become more attractive for local governments if they prove to be effective at regaining solvency.

"Depending on the final outcome of local government bankruptcies, such as Detroit, we could see more stressed local governments turn to bankruptcy as a tool for reducing or restructuring their debt or pension obligations," they said.

However, the analysts concluded that risk for contagion is limited. Only half of U.S. states allow local governments to file for bankruptcy, and it is still unclear "what stigma investors may attach to issuers who file."

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