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Munis Apathetic as U.S. Faces Debt Ceiling Impasse

The municipal market is prepared to withstand a congressional impasse over raising the debt ceiling this month as a U.S. credit downgrade that roiled the tax-free market during the 2011 debate is considered unlikely to recur this time around.

Worst-case scenarios should politicians fail to raise the debt ceiling range from reduced federal funding to states to credit cuts and changes to municipal tax exemptions. They are largely being shrugged off by analysts and investors, because they assume the government will again sidestep the dire consequences by lifting its cap on borrowing.

"Munis are tired of D.C. politics," Dan Toboja, senior vice president of fixed income trading at Ziegler Capital Markets, said in an interview. "We panicked about it a year ago, we panicked two years ago; it doesn't feel like it's going to happen this time around."

In August 2011, Standard & Poor's dropped the country's credit rating to AA-plus from AAA amid congressional gridlock over whether to raise the debt ceiling. Municipal ratings with direct ties to the federal government saw downgrades as a result. The U.S. is expected to reach the new $16.7 trillion cap on borrowing by Oct. 17. Failing to raise the ceiling would bring the unprecedented scenario in which the Treasury would no longer be able to borrow money to pay bills.

"We expect the debt ceiling to be raised and as long as these congressional impasses remain short-lived, under those assumptions we do not foresee it impacting the sovereign rating," Marie Cavanaugh, a primary credit analyst at Standard & Poor's Ratings Services, said in an interview.

Without the impending threat of another sovereign downgrade, munis will be spared much of the fallout that occurred in 2011 with S&P's cut, according to Janney Capital Markets.

"This is much like a re-run of an old sitcom," Tom Kozlik, director and municipal credit analyst at Janney, said in an email. "We have already seen this episode, did not like it the first time around and are not fond of the re-run either. But it is the only thing on and we must watch it."

Any concern over the debt ceiling stalemate hasn't yet manifested itself in market activity, Toboja said.

"There's more concern about something like tapering," Toboja said, referring to the possibility that the Federal Reserve will cut back its economic stimulus. "I don't see much related to the debt ceiling right now in the market. The market has really plodded along and stalled out. It's a bit morose and apathetic right now, not reacting one way or another."

The potential impact on municipals surrounding the debt debate will be much more limited this time, Kozlik said. Less economic uncertainty and a strengthening recovery will also help brace the municipal market as the congressional stalemate continues. The index of Economic Policy Uncertainty is fairly low right now, and isn't likely to jump as high as it did during the first debt ceiling debate, Janney said.

"Right now the market knows this is just a political game," Kozlik said. "This time we are not expecting any U.S. rating agency actions, unless DC policymakers really fumble the political football over the next few weeks."

Implications of a failure to raise the ceiling remain unclear. It could require a cut in government spending of up to 20%, Moody's Investors Service said in a Sept. 30 report. Not raising the debt limit would make the fallout from 2011 look like an afternoon at Disney World, Kozlik said. The fervor of political posturing could even lead to lawmakers raising questions over how municipals are treated as tax-exempt products, according to Toboja.

"The other problem, too, is politicians will have a conversation with all kinds of white noise coming out about what D.C. might do to the muni market," Toboja said. "D.C isn't always quite as sensitive as it should be when it hints of changes to the muni market."

In the scenario of a binding debt ceiling limit, muni issuers could have funding jeopardized as the federal government fails to provide federal transfers to states. States have relatively high dependence on federal revenues and some have high economic reliance on federal procurement and healthcare spending, Moody's said in its report.

Lower funding to states could then trickle through to less aid to local governments, according to the report.

"One of the risks to the debt ceiling not being increased would be that the federal government would start to issue cash management actions so not to default on its own debt, and there would be effects on state and local governments," Nick Samuels, senior credit officer at Moody's, said in an interview.

Cuts to Medicaid funding could delay reimbursements to healthcare providers, a credit negative for hospitals. Medicaid provides as much as 71% for some hospitals, according to the Moody's analysis. The states would have to determine if they would use their own funds to send the reimbursements along to the providers, Samuels said.

“Several municipal credits receive federal revenues necessary to make their P&I payments,” Peter Delahunt, managing director of the municipal bond department at underwriter Raymond James, said in an email. “This could be via grants, appropriations or quite simply the interest payments on treasury or agency debt that backs a municipal escrow. Any delay in these federal payments will impede the credit on the associated municipal bond.”

Federal revenue provides as much as 37% of total government revenue to some states, according to a Bank of America Merrill Lynch report on Sept. 27. A lengthy shutdown that turns into a stalled debate over the debt ceiling could impair states, BofA said.

"Our concern is with the effect on state and local governments resulting from issues collateral to federal funding issues," BofA said in the report.

Mississippi, Louisiana and Alabama are the most exposed to a cutoff of federal transfers, with 37.2%, 36.9% and 34.9%, respectively, of those states' revenue coming from the federal level.

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