Buy Side

Standard & Poor's Downgrade of United States Had Modest Impact on Munis

Standard & Poor’s downgrade of the United States government a year ago has had a wide but shallow impact on municipal bonds.

Standard & Poor’s AAA rating for the United States dated back to 1941, when Standard Statistics merged with Poor Publishing.

Moody’s Investors Service has given the government a Aaa rating since 1917.

Given the ratings’ long provenance, when S&P downgraded the government on Aug. 5, 2011, it shocked many in the U.S. financial community.

When S&P put the government on CreditWatch for a downgrade on July 14, 2011, many analysts wondered if a U.S. downgrade might also threaten S&P’s AAA ratings for those states and municipalities awarded that gilt-edged rating.

However, S&P did not downgrade any of the AAA-rated states or localities because of its U.S. downgrade. Instead, it pointed to its underlying concern about the federal deficit that contributed to its downgrade of the U.S. rating as potentially also affecting the states and localities.

In August 2011, S&P wrote, “From the perspective of state and local governments, the credit implications of these recent events stem more from potential reductions in federal funding than from the U.S. downgrade itself.”

As a consequence of the U.S. downgrade, S&P lowered ratings for a variety of municipal bond issues and issuers with financial connections to the federal government.

S&P downgraded public finance debt issues reliant on the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac) or the Government National Mortgage Association to AA-plus with a negative outlook. It dropped 12 U.S.-guaranteed municipal housing issues to AA-plus with a negative outlook. It lowered five public housing authority ratings and some large public power entities. It also lowered the rating on bonds backed by eight federal leases and some defeased bonds to AA-plus with a negative outlook because they were secured by U.S. Treasury and U.S. agency securities. Finally, the agency lowered the ratings of 73 investment pools that held Treasuries.

However, the downgrade “didn’t affect munis dramatically,” said Richard Ciccarone, chief research officer at McDonnell Investment Management LLC. It came at a time when investors had greater concerns about the safety of European sovereign debt than U.S. sovereign debt. Therefore, the downgrade had little impact on Treasury yields.

“On the long-term basis, I think the market shrugged off the impact,” said Tom Weyl, director in municipal research at Barclays.

S&P doesn‘t expect to take any further actions affecting munis due to the U.S. downgrade, managing director Steven Murphy said last week.

The yield on the 10-year Treasury note declined roughly 90 basis points from Aug. 5, 2011, to Monday as concern about fiscal troubles in Europe overwhelmed fears about the U.S.

With European governments having major problems with their own sovereign debt, the U.S. downgrade was offset by a flight to quality and familiarity, said Tom McLoughlin, managing director at UBS Wealth Management.

Municipal bond prices also benefited from the flight to quality.

After the downgrade, there initially were predictions that the action might make it more difficult for municipalities to borrow. Instead, the Treasury rally “rubbed off” on munis, said Natalie Cohen, managing director at Wells Fargo Securities.

Municipal bond yields on The Bond Buyer 20-bond index went from 4.19% on Aug. 4, 2011 — the day before the downgrade — to 3.75% as of Friday.

Many investors believe that a state or locality can have a higher rating than that of the sovereign government, Ciccarone said.

S&P’s ratings of a large number of U.S. muni issuers above those of the sovereign government diverges from its practice elsewhere in the world, where it has done this with only a few sub-sovereign governments. The agency has used the same criteria to look at all sub-sovereign governments. The divergence is due to differing government relationships.

It is unlikely that any of the rating agencies will downgrade the United States in the next 12 months, Weyl said. However, if Moody’s did downgrade the government, that would affect more investors in credits relying on the sovereign rating.

Yet even without further downgrades of the United States, fiscal issues at the federal level will likely continue to affect municipal bonds for the foreseeable future. The pressure to address the federal deficit will likely lead to diminished U.S. transfers to states and localities, McLoughlin said.

Cuts to federal funds for social programs like long-term unemployment insurance may also indirectly increase demands on local and state governments, Cohen said. When people get less help from the federal government, they may end up placing greater strains on local and state government social services.

Attention is now turning to how Congress deals with the so-called fiscal cliff, which looms in early 2013, McLoughlin said. Those concerns center on the impact on the U.S. government of the Budget Control Act of 2011 that mandates draconian automatic spending cuts to a wide variety of federal programs.

Federal fiscal problems may bolster interest in munis, Cohen said. If Congress decides to increase taxes that would make investors more attracted to munis given that, in general, they are exempt from federal income taxes.



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