In the event that Moody’s Investors Service strips the U.S. sovereign credit of its gilt-edged rating, top-rated state and local governments would be more at risk of a downgrade than similarly rated corporate or structured finance products.

So says Moody’s in a June 29 study. The gist of the nine-page report is that credits enhanced by, or directly linked to, the federal government’s rating would move in lockstep with any negative outlook or downgrade on the sovereign credit.

These credits include debt issued by Fannie Mae and Freddie Mac and those issues guaranteed by the Federal Deposit Insurance Corp. Pre-refunded municipal bonds with debt service payments backed by Treasury bonds held in escrow would also reflect the sovereign rating. 

Corporate and structured-finance credits sufficiently autonomous from the federal government would not necessarily be affected, but the rating impact isn’t so clear for sub-sovereign credits.

“Those with the weakest standalone credit profiles within their rating category and greatest dependence on the U.S. government for ongoing financial support are most susceptible to downgrade,” the report says.

The agency currently gives 15 states and more than 400 local governments a triple-A rating. Moody’s said if those governments retain their credit score, they would boast ratings that are one or two notches higher than the federal government for the first time ever.

For credits that do suffer, the downgrades wouldn’t be immediate. According to Anne Van Praagh, chief credit officer at the agency, directly linked credits would “all move in a matter of days” if a sovereign action were taken, whereas other credits would see the impact in a matter of weeks.

“We want to take our time and review them on a case-by-case basis to identify how they may be vulnerable and what mitigating factors there may be to keep their triple-As,” she said.

The process has already begun and Van Praagh said Moody’s should be publishing more research on the pressing issue in the coming weeks.

As the situation has never arisen in the United States before, Moody’s has looked to foreign examples to understand how the dynamic has shaped up.

“Generally, the sovereign rating acts as a cap outside the U.S., but there are select cases where we have rated regional and local governments higher than their sovereign,” Van Praagh said.

Some examples include Basque Country in Spain, the Flanders community in Belgium, and autonomous provinces in Italy, including Trento and Bolzano.

“Certainly the sub-sovereign examples outside the U.S. have helped inform our thinking on the linkages that we’re looking at for U.S. states and local governments,” she added. 

What can local and state governments do to retain their ratings? Constitutional protections that delineate a formal separation of powers is one bonus, fiscal autonomy another. Economic strength and competitiveness help too, along with limited reliance on the capital markets or bank loans to fund operating expenses.

“The capital markets and banks have historically provided a reliable source of external funding for states,” Van Praagh said. “Those that are more dependent on cash-flow notes, or variable-rate debt, or other types of debt structures that require more periodic refinancing are somewhat more susceptible to the broader changes in the operating environment.”

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