U.S. Downgrade

Confident Despite Psychological Blow

Calm, yet cautious. Skeptical and apprehensive. Unfazed.

Those are the mixed emotions that both retail and institutional investors have amid all the speculation and uncertainty swirling through the municipal market following last week’s unprecedented downgrade of the U.S. by Standard & Poor’s.

While several municipal experts said it is still too early to gauge the long-term effects of the downgrade in the nation’s sovereign debt rating to AA-plus from AAA, they said many buyers are suffering from a case of psychological trauma in the near term.

“It’s perception that runs the market and there’s a new paradigm right now,” said Jay Alpert, executive vice president and manager at M.R. Beal & Co. “People are starting to see that all that glitters isn’t gold.”

“It’s going to make our investor side, at least, rethink strategies and what they want to do going forward,” he said. “Everyone is scratching their heads.”

In the absence of a large new-issue calendar to test the market and offer price discovery, Alpert said it is difficult to fully evaluate investors’ reaction to the downgrade.

“When you have a run like this in Treasuries, sticker shock does start to take hold,” he said, pointing to the monster rally last Thursday that saw the 30-year plummet 21 basis points on the day to 3.68% — 67 basis points from the previous week. Munis have also followed suit, but have not rallied nearly as much as Treasuries.

Also complicating matters is that investors barely had time to digest the other news — the resolution to the debt-ceiling crisis and the Treasury rally — before Standard & Poor’s announced the one-notch downgrade.

“We are kind of in that assessment mode. People need time to digest fast-moving events,” Alpert said. “There’s no knee-jerk response.”

“Psychologically, it doesn’t help, but the market looks at the majority rating,” added Anthony Valeri, senior vice president and market strategist at LPL Financial in San Diego. He noted that since Moody’s Investors Service affirmed its Aaa U.S. rating and Fitch Ratings also rates the sovereign debt AAA, that the market in general will still view the nation in a triple-A light.

But it will take some time before the stigma of the downgrade wears off.

“Because this is an unprecedented event in most fixed-income investors’ lives, there is no way to say with any confidence what will happen,” said Dave Manges, managing director of municipal trading at BNY Mellon in Pittsburgh.

“I think both individually and collectively, we need to wait and see, and we need to be careful about making quick judgments because we truly don’t know what the fallout will be,” Manges, who has been in the market for over 30 years, said on Monday.

Apart from temporary cautiousness, others said there will be minimal effects on the buy side in the grand scheme of things.

A Chicago trader said while investors are “spooked” by the downgrade, they also are feeling apathy toward the low nominal yields in the current market.

“We’re not seeing any large-scale selling,” he said. “The downgrade does lie in the backdrop, but the effect is more smoke than fire.”

“There’s going to be skepticism and apprehension, but the AAA to AA-plus is not that significant, it’s just a function of whether it will be a continuous slide or not,” the trader said.

The greater problem for the market as a whole is low nominal yields, he said.

On Tuesday, the generic, triple-A general obligation scale in 2016 yielded just a 1%, while the 2041 bond yielded a 3.92% — 37 basis points richer than where it was on Aug. 1, according to Municipal Market Data.

The downgrade may be compounding the uncertainty in the muni market, but some believe its impact is manageable.

“In the municipal market, I’m not really sure it’s going to have a significant long-term effect on investor decisions,” said Ken Williams, chief executive officer at Stone & Youngberg in San Francisco.

“Like any other noteworthy event, it gives investors pause and it might make people cautious — at least in the short term,” he said.

On Monday, municipal trading was relatively quiet and there were no signs of investors looking for the exit, he said. “People are just being cautious in light of the downgrade. There was enough speculation last week that this was going to occur, so I don’t know if the market was totally surprised,” Williams added.

Nat Singer, a partner at Swap Financial in South Orange, N.J., said he expected the downgrade and believes the municipal market will be largely unscathed.

“Even for those governmental entities that receive transfer payments from the U.S. government, these payments are secondary or tertiary sources in terms of being credit determinants,” he said. “The S&P downgrade to AA-plus does not affect the Treasury’s willingness to pay, and in terms of ability to pay, the impact is minimal.”

Going forward, Singer said the one-notch downgrade will not deter him from participating in the market.

“While I wouldn’t expect a flight to quality into munis, I would be surprised if there were any large-scale selling or significant negative price adjustments in the muni market as a result,” he said.

Others said it will be a while before some normalcy returns to the municipal market and, in the meantime, investors will have to get used to the bumps in the road.

There will be increased scrutiny by broker-dealers, traders, underwriters, and analysts on the buy-side as the potential effects of the downgrade permeate the market in the weeks and months to follow. 

“Credits that rely on federal spending will have to be looked at with a fine toothed comb,” said a managing director at a large New York firm.

“We don’t feel the S&P downgrade has anything to do with the ability of the country to pay, it has to do with the need for implementing meaningful programs to get our house in order,” the managing director said. “But without economic growth, it’s going to be a long road.”

Standard & Poor’s on Monday downgraded 1067 housing issues and put 226 more on credit watch negative in the wake of the U.S. downgrade, according to a spokesman. It also downgraded prerefunded bonds backed by Treasuries and bonds backed by federal leases.

Standard & Poor’s rates 13 states AAA, according to a report it issued on July 15. They are Delaware, Florida, Georgia, Indiana, Iowa, Maryland, Minnesota, Missouri, Nebraska, North Carolina, Utah, Virginia, and Wyoming.)

Maryland Treasurer Nancy Kopp in a statement Tuesday said Standard & Poor’s has informed her there has been no action on Maryland’s rating.

Indeed, the agency said late Monday it will retain AAA ratings for strong muni credits despite the U.S. downgrade.

Kopp touted Maryland’s prudent financial management, diverse economy, and constitutionally dedicated tax for debt service on bonds.

“We are pleased to see that Standard & Poor’s is looking at the states individually, and we believe that Maryland’s prudent fiscal management will be viewed positively by the rating agencies as they review the states,” Kopp said.

Kopp noted there was “very strong investor demand” for $490 million of GO bonds, Series A-D, the state sold on July 27. The transaction closed on Aug. 5.

But the downgrades of “hundreds of pre-re, guaranteed housing, AAA state downgrades that will follow S&P’s action may undermine retail confidence either directly or, through their impact on price evaluations and [net-asset values], indirectly,” said Matt Fabian, managing director at Municipal Market Advisors, in his weekly report on Monday.

“The psychological effects of the downgrade could push consumers and businesses back into the recession hiding hole they only recently exited,” wrote Tom Kozlik, director and municipal credit analyst at Janney Montgomery Scott, in a report on Monday.

The timing of the downgrade could effect riskier sectors, outflows among mutual funds, and credit spreads, noted Triet Nguyen, an independent municipal credit consultant based in Massachusetts.

“We need to worry about the impact on the market’s already fragile psychology,” he said. “The nominal downgrades of government-backed bonds, such as pre-res, should be a non-event. [But] if investors decide to take risk off the table and mutual fund redemptions re-accelerate, we should expect credit spreads to widen out in the short term, particularly for sectors such as health care.”

 But overall, municipal investors should gain confidence in the fact that “few municipal bond credit ratings will move in lock-step along with the U.S. government ratings,” Kozlik’s report said. Valeri of LPL said given all that the municipal market has endured recently — such as predictions there would be widespread defaults — “munis are still a high-quality investment, even ultimately if some [triple-A] munis get downgraded to double-A.”

“If the last two years have illustrated anything, it is that state and local governments and other municipal issuers have proven to be very resilient credits,” Kozlik said.

Lynn Hume contributed to this story.


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