Moody's U.S. downgrade unsurprising but potential pain point for munis

The municipal bond market Monday shrugged off Moody's Investors Service's late-Friday downgrade of the U.S. sovereign rating but investors warned the downgrade adds a future pain point for municipal credits along with higher rates and a large tax and spending bill winding its way through Congress.

"Given that two ratings were already in double-A category, I don't think [the Moody's downgrade] is a major issue one way or another," said Mikhail Foux, head of municipal research and strategy at Barclays.

"But we do have to be concerned about the deficit and the growth of our debt," Foux said. "And we need to be concerned about rates, because the volatility we saw in April was driven by rate volatility."

Moody's was the third ratings agency to strip the U.S. of its prized triple-A rating. S&P Global Ratings Agency was the first to cut the sovereign in 2011. Fitch Ratings followed suit in 2023. Moody's said its downgrade was driven by growing deficits and debt and significantly higher interest payments.

S&P and Fitch followed their downgrades with targeted cuts on certain municipal bonds that are closely linked to the federal government, such as pre-refunded bonds, housing bonds with federal guarantees and bonds backed by federal leases.

But widespread downgrades never materialized, even for triple-A rated states like Texas or cities like Columbus, Ohio, which are now ranked higher than the nation.

"There's no sovereign ceiling, we know that now" after the S&P downgrade, Foux said.

Moody's did not comment on whether or when it expects to release a report on the public finance impact from the U.S. downgrade.

While some muni issuers are now rated higher than the U.S., there's "no doubt" that the U.S. Treasury remains the strongest credit in the country, opined Vikram Rai, former municipal strategist at Wells Fargo and Citi.

"I disagree with the idea that a state or local government can be rated above the U.S. Treasury," Rai said, noting that Treasurys enjoy the "ultimate safe haven status" and the government can print money.

"There's no doubt that Texas is a very strong credit, but I think the U.S. Treasury is the strongest credit in our land."

The timing of the Moody's downgrade is important in the context of Congress' large reconciliation bill, which includes at least $5 trillion of tax cuts as well as spending cuts to many state and local programs, market participants said.

"The combination of the Moody's downgrade plus if lawmakers push through a tax bill which does not make any material spending cuts, I think that will be bearish for rates," Rai said. "And cities and states will have to issue more debt in a market where rates are higher and the cost of capital will go up, which is not good for the credits."

The impact, if any, of the downgrade on the formation of the reconciliation tax bill remains to be seen, said Mohammed Murad, head of municipal credit research at PT Asset Management LLC.

Murad noted that municipal credits have proven resilient so far this year amid tariff-related and tax bill volatility but that higher interest costs for the federal government could trickle down to issuers.

"The potential for higher cost of borrowing could add an extra layer of complexity to trimming the deficit, which could translate into larger than planned cuts to funds meant for municipal issuers," Murad said.

Like the muni market, the Trump administration shrugged off the importance of the latest downgrade.

"I think that Moody's is a lagging indicator," Treasury Secretary Scott Bessent said Sunday on Meet the Press. "I think that's what everyone thinks of credit agencies."

Jessica Lerner contributed to this report.