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April 2 (Reuters) - After a court decision allowing Stockton, California to push ahead with its bankruptcy, investors in the $3.7 trillion U.S. municipal bond market will have a ringside seat as the nation's biggest public pension system and bondholders duke it out.
In one corner is the 800-pound gorilla, the behemoth $254 billion California Public Employees' Retirement System (CalPERS), which is set to battle with bondholders over who will have to take a haircut as the broke city looks to reduce its debt. Public employees are also in the match, as the city is expected to renegotiate labor contracts.
The market for U.S. state and city debt, worn down by years of negative headlines about financially distressed local governments, on Tuesday welcomed news of the case's continuation.
"The market is looking forward to some resolution and clarity here," Charles S. Pulire, senior portfolio manager with Oppenheimer Rochester municipal funds, which has $38 billion in management in 20 different municipal funds.
Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said bond owners may emerge unscathed.
"There are lots of areas where the city can go before looking for a big discount from bondholders," Heckman said. "We don't think it will be as much a negative as many believe."
U.S. Bankruptcy Court Judge Christopher Klein signaled that CalPERS' position in the case was not above review. Stockton, a city of 300,000, has so far not reduced pension payments to retired city workers, although it has eliminated their healthcare benefits.
Since at least the 1930s, bondholders in major municipal bankruptcies have consistently been repaid their entire principal.
Stockton became the biggest U.S. city to file for Chapter 9 bankruptcy protection in June 2012. But muni bond insurers and bondholders challenged the case, arguing that the city was not truly insolvent when it filed and that it impropertly failed to seek concessions from CalPERS.
After Monday's ruling investors in the massive municipal bond market did what they've learned to do over the past few years: shrug it off.
"We've seen this coming for quite some time and the market has expected it, so it's not the big attention grabbing headline that would necessarily create volatility or a selloff in the market," said Peter Hayes, head of the municipal bonds group at BlackRock, which oversees $109 billion.
Portfolio managers said that despite years of bad news for struggling cities and some high-profile bankruptcies, the market remains safe relative to other investments.
Of nearly 8,000 local governments rated by Moody's Investors Service, only 36, or less than 0.5 percent, are rated below investments grade. While miniscule that number has been creeping up, with six of those added over the last five months.
The court decision on Monday was having little effect on muni bond prices tied to Stockton, or other cities and towns especially hit by the U.S. housing bust, portfolio managers said.
"Investors are watching and waiting," said Chris Mier, chief strategist of Loop Capital's analytical division. "The lack of precedent is likely encouraging investors who own Stockton debt to maintain their holdings since it is very difficult right now to anticipate an outcome."
Gregory Serbe, who oversees $230 million of municipal assets as president of Municipal Asset Management at Lebenthal & Co., said that Stockton and San Bernardino, another bankrupt California municipality, will probably make investors more cautious.
But the cases are unlikely to cause widespread fear among mom and pop retail investors, who dominiate the muni market, of an asset class that's normally considered safe.
"Will this make people afraid of municipal bonds? Probably not," he said. "But I think it will make people look at it a little more closely and more at the fine print of the credit quality."