U.S. Downgrade Will Have Impact on Munis

AUG 6, 2011 1:49pm ET
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The downgrade of the U.S. by Standard & Poor’s to AA-plus from AAA will reverberate through the municipal bond market.

Some states may lose their triple-A ratings. Other gilt-edged muni credits may be jeopardized. Munis with direct backing from the federal government, such as some housing bonds, will face downgrades, at least by Standard & Poor’s.

Those could be some of the nearer-term implications for muni credits. Longer term, state and local governments are likely to see less funding from the federal government as Washington struggles to get its fiscal house in order. What happens to state and local government bond ratings will depend to a large degree on how they manage with less federal funding.

Standard & Poor’s made the dramatic announcement Friday evening that it had decided to downgrade the U.S. and said it would issue “separate releases” on Monday “concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors.”

Municipal analysts and traders will be paying close attention.

Standard & Poor’s in a report released July 21 said a downgrade of the U.S. could “disrupt the capital markets, making it more challenging for some public issuers to get financing…” On the other hand, it’s also possible that investors would view U.S. public finance issues as a safe haven.

State governments would be evaluated in light of the flow of federal funds and the potential impact of fiscal contraction on a state’s economy. Liquidity and financial flexibility would be key considerations. There would likely be no sector-wide rating actions.

Local governments would be evaluated on a case by case basis but widespread rating actions weren’t anticipated. Higher interest rates as a result of the downgrade might potentially pressure financially weaker governments, especially those with variable-rate exposure.

Not-for-profit heath care ratings would depend on various factors, including the still unfolding health care reform rules. U.S. higher education and not-for-profit corporations could see a modestly negative impact. Public utilities would likely not be affected but some outlooks could be revised to negative.

In the transportation sector: the outlook for Garvee bonds — secured by federal transportation grants — could be changed to negative, as “all federal budget priorities would be uncertain.” Most other transportation group ratings would not be affected. Public housing issues with federal guarantees would generally move in lockstep with the sovereign rating.

“It’s dangerous to predict how the market will react,” Janney Capital Markets municipal credit analyst Thomas Kozlik said Saturday.

But if there is nervousness in the muni market about a sovereign downgrade it hasn’t affected prices of late. They have been going up.

Municipal bond yields have plummeted in recent days in lockstep with Treasuries as investors have fled the stock market and dumped commodities due to jitters about the state of the economy and the drawn out debate in Washington over raising the federal debt ceiling.

Standard & Poor’s cited the histrionics in Congress over raising the debt ceiling as a factor in its downgrade decision, as well as the failure of lawmakers to agree on significant spending cuts and revenue enhancements.

It remains to be seen whether munis will continue to track Treasuries so closely, given that the municipal market is comprised of thousands of different credits. And analysts will now have to evaluate how these individual credits fare in a brave new world where the federal government is no longer triple-A across the board.

Kozlik said the market will be looking for more guidance from the rating agencies. He has been tracking trading in the five triple-A states that Moody’s Investors Service on July 19 targeted for a possible downgrade if it should decide to downgrade the U.S. — Maryland, New Mexico, South Carolina, Tennessee, and Virginia. Moody’s rates 15 states Aaa. It assigns its highest rating to 400 local governments.

“They have been through or on top of [Municipal Market Data’s] triple-A yield curve and didn’t change that much,” said Kozlik. That seems to demonstrate that traders aren’t showing too much concern.

Moody’s has a negative outlook on the U.S. but has indicated it is in no rush to cut its rating. Fitch Ratings has a similar outlook.

But if the U.S. is no longer triple-A can any municipal credit still be triple-A?

The rating agencies may decide to say no but Kozlik points out that state and local governments for the most part are required to balance their budgets, unlike the federal government. And they have been doing so, for the most part, despite the ravages of the recession and plummeting tax revenues. The federal government, meanwhile, has been footing the bill for costly wars, entitlements and economic stimulus programs.

Analysts have said municipal credits are more vulnerable in a U.S. downgrade scenario than corporate credits given their reliance on federal funding. Those with greater reliance are the most vulnerable.

Government officials in triple-A rated states and communities have voiced frustration with the notion that fallout from the federal government’s budget problems could threaten their hard won gilt-edged ratings.

Bond attorneys meanwhile have been studying the implications of a downgrade on advance refunded muni bonds. Debt service for advance refunded bonds is paid out of escrow accounts typically funded with U.S. Treasury securities. Advance refunded bonds long have been prized by muni investors, who consider them tax-free Treasuries. The lawyers have said that most bond covenants indicate the escrows must be funded with Treasury securities but don’t mention that they must be triple-A. (An actual U.S. default could trigger issuer buy back requirements.)

Analysts also have said housing bonds backed by mortgages insured by Ginnie Mae, which is backed by the full faith and credit of U.S. government, and the Federal Housing Administration would be downgraded in step with the sovereign credit.

The federal government’s problems have created other concerns for the muni market. During the debt ceiling crisis there was talk that federal subsidies for Build America Bonds could be delayed if the U.S. ran low on funds.

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